What Is Comparative Advantage? (Definition And Benefits)
Updated 10 September 2023
Comparative advantage, which some people refer to as relative advantage, is when one company can produce a product or service at a lower cost than a competitor. A company that has a relative advantage can remain competitive and offer the savings it generates to its consumers. Understanding what relative advantage is, could help you increase a company's profitability and efficiency.
In this article, we explain what comparative advantage is, what its benefits and potential drawbacks are, how to calculate it and how it compares to absolute and competitive advantage.
What Is Comparative Advantage?
Comparative advantage is when a party, whether it be a business or country, can produce services and goods at a lower cost than its competitors. A party that has a relative advantage produces an offering more efficiently and does not spend as much money as another party would to produce the same offering. In the professional world, individuals can also use relative advantage to discuss their strengths and weaknesses in comparison to other employees and professionals.
The concept of relative advantage comes from David Ricardo, an influential economist in the early 19th century. He stated that a country could experience optimal economic growth when it focused on the industries in which it had the greatest relative advantage. Even though relative advantage is most common in goods-based industries, it is also relevant to industries like banking, entertainment and customer service industries.
How Opportunity Cost Relates To Relative Advantage
Opportunity cost (OC) is the benefit that a party surrenders when it chooses one option over another. When discussing relative advantage, the opportunity cost is what a party needs to sacrifice to gain something else. The party that has the lowest opportunity cost for a particular good or service has the relative advantage.
General Example Of Relative Advantage
Here is a general example of relative advantage:
Shyla is a high-level executive at a technology firm. She feels overwhelmed with her duties, so she hires an assistant. She asks her assistant, Devaj, to perform secretarial duties that she previously completed, like answering emails, organising files and scheduling meetings. While Shyla has experience with performing these secretarial duties, she does not have the time to commit to completing them.
She is able to generate more profits for the company she works for by attending conferences and developing business strategies. She needs to give up the completion of secretarial duties, but she can instead dedicate her time to more profitable tasks. Even though Devaj is still in the training stages of his career as an assistant, he contributes to the company's success because he does not have the qualifications to perform Shyla's executive-level tasks. Together, Shyla and Devaj are more productive because they emphasise their relative advantages.
Benefits Of Relative Advantage
Here are some benefits of relative advantage:
Obtain increased efficiency
A party can achieve increased efficiency when it has a relative advantage. It may specialise in the production of a specific good or service. This focus may allow it to become especially good at what it does and increase the quality of its final offering.
Access better profit margins
When a party has a relative advantage, it has a lower opportunity cost. It does not have to sacrifice as much to produce its desired offering. It can dedicate its resources, capital and labour more adequately to achieve better profit margins.
Capitalise on other advantages
When a party has a relative advantage, it may capitalise on other advantages. For example, a party with a relative advantage may gain a competitive advantage. It can also gain an absolute advantage, although these two advantages do not always have a direct correlation.
Potential Drawbacks To Relative Advantage
Here are some potential drawbacks to relative advantage:
Challenges with scaling
When a company specialises in the production of a product, it may experience the disadvantage of overspecialisation. Overspecialisation may make it challenging for a business to scale its operations. Expanding into different regions may be difficult, as the company would have to train its staff in specialised processes.
Unfair working conditions
As a company seeks a relative advantage, it may outsource unskilled labour to other countries. These countries may allow employees to participate in unfair working conditions with few regulations. A company can overcome this potential drawback by only hiring employees who receive fair compensation.
Fewer opportunities within developing economies
On a larger scale, relative advantage may result in fewer opportunities within developing countries. Developed countries may be able to find more opportunities and exploit them. This can result in a larger gap between developing and developed countries, making it more challenging for developing countries to prosper economically.
How To Calculate Relative Advantage
Here is a list of steps on how to calculate relative advantage using a simple example:
1. Calculate each good's opportunity cost from each manufacturer
The first step is to calculate each good's opportunity cost from each unique manufacturer. In this example, there are two goods and two unique manufacturers. According to the below table, both Chile and Algeria produce cars and motorcycles. The table indicates that Chile can produce 80 cars or 100 motorcycles, while Algeria can produce 90 cars or 60 motorcycles.
To calculate Chile's opportunity cost of one car, you can consider that 80 cars equal 100 motorcycles. You can reduce the number of cars to one unit by dividing both numbers by 80. The result is that one car equals 1.25 motorcycles. Repeat this process three more times for the three additional cells in the table.
2. Create a new table with the opportunity costs of each product and country
The next step is to create a new table. Create the same row and column headings that were in the table in step one. Fill in the four cells with the opportunity costs of each product and country. Use the same formula that you used in step one to discover Chile's opportunity cost of one car.
3. Interpret the table to find the relative advantage
The final step is to interpret the table to find the relative advantage. Relative advantage is when a manufacturer can produce a product with the lowest opportunity cost. In terms of cars, Algeria has an opportunity cost of 0.57 motorcycles and Chile has an opportunity cost of 1.25 motorcycles. Therefore, Algeria has the lowest opportunity cost. It makes the most financial sense for Algeria to produce cars.
In terms of motorcycles, Algeria has an opportunity cost of 1.75 cars and Chile has an opportunity cost of 0.8 cars. Chile's opportunity cost is lower. This means that it is the most financially sound decision for Chile to produce motorcycles.
Relative Advantage Vs. Absolute Advantage
Absolute advantage is when a party is the best and most efficient at producing a good or service. For example, a country that has fertile farmland has an absolute advantage in agriculture. Although it has an uncontested ability to grow more crops, it may not have a relative advantage in another commodity.
For instance, the country may not have any oil. It can trade with a neighbouring country that has plenty of oil reserves but no farmland. In this case, the country with farmland would have a relative advantage in agriculture, and the country with the oil would have a relative advantage in oil.
Competitive advantage is when a party can offer greater value to customers than its competitors can. One of the most common strategies a company implements to gain a competitive advantage is offering the best product with the most desirable features. Other strategies include pricing the offering as low as possible and producing something for a niche market.
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