Revision: Comparative Advantage

First introduced by David Ricardo in 1817, comparative advantage exists when a country has a ‘margin of superiority’ in the production of a good or service i.e. where the marginal cost of production is lower.

Countries will usually specialise in and then export products, which use intensively the factors inputs, which they are most abundantly endowed. If each country specialises in those goods and services where they have an advantage, then total output can be increased leading to an improvement in allocative efficiency and economic welfare. Put another way, trade allows each country to specialise in the production of those products that it can produce most efficiently (i.e. those where it has a comparative advantage).
This is true even if one nation has an absolute advantage over another country. So for example the Canadian economy which is rich in low cost land is able to exploit this by specialising in agricultural production. The dynamic Asian economies including China have focused their resources in exporting low-cost manufactured goods which take advantage of much lower unit labour costs.
In highly developed countries, the comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and high-knowledge services.
Comparative advantage for the UK
Using trade data drawn from our balance of payments with other countries, the UK’s comparative advantage now lies in the following areas: oil, chemicals & pharmaceuticals, aerospace and medical technology, insurance, financial services, computer services & software, other business services, and entertainment. We have lost much if not all of our comparative advantage in textiles, steel, coal and many other areas of traditional manufacturing industry where we run structural trade deficits.

Comparative advantage is best viewed as a dynamic concept meaning that it can and does change over time. Some businesses find they have enjoyed a comparative advantage within their own market in one product for several years only to face increasing competition as rival producers from other countries enter their markets and under cut them on price or take market share through non-price competition. For a country, the following factors are often seen as important in determining the relative costs of production:

1.The quantity and quality of factors of production available (e.g. the size and efficiency of the available labour force and the productivity of the existing stock of capital inputs.)

2.Investment in research & development (this is important in industries where patents give some firms a significant market advantage) – there is quite strong evidence that an emerging comparative advantage often comes from entrepreneurial trial and error – the never ending process of engaging in research and innovation to find more efficient processes and new products.

3.Fluctuations in the real exchange rate which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers.

4.Import controls such as tariffs, export subsidies and quotas can be used to create an artificial comparative advantage for a country’s domestic producers.

5.The non-price competitiveness of producers (e.g. covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support.)

Comparative advantage is often a self-reinforcing process.

Entrepreneurs in a country develop a new comparative advantage in a product (either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets). Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on.