Theory of Comparative Advantage
Trade allows countries to specialise in what they do best and exchange goods for others they need. One of the most important ideas in trade is comparative advantage (CA), which explains why countries benefit from specialisation and trade.
What is Comparative Advantage?
A country has a comparative advantage in producing a good if it can produce it at a lower opportunity cost than another country. This means that even if a country is more efficient in producing everything (absolute advantage), it should still specialise in the good where it has the lowest opportunity cost.
Example: Singapore and Indonesia
Singapore specialises in financial services and high-tech manufacturing, while
Indonesia focuses on palm oil and natural resources.
Even though Singapore is more developed, it does not produce palm oil because Indonesia has a lower opportunity cost in doing so. Both countries benefit by trading with each other.
Understanding Comparative Advantage Through Opportunity Cost
Opportunity Cost and Trade
Opportunity cost is the value of the next best alternative forgone. A country should specialise in goods that have the lowest opportunity cost to maximise trade benefits.
Step 1: Calculate Opportunity Costs
Country A:
1 unit of wheat = 10/20 = 0.5 cloth
1 unit of cloth = 20/10 = 2 wheat
Country B:
1 unit of wheat = 5/10 = 0.5 cloth
1 unit of cloth = 10/5 = 2 wheat
Since both countries have the same opportunity cost for wheat, there is no clear comparative advantage. However, in real-world scenarios where opportunity costs differ, specialisation leads to trade benefits.
Real-World Example: India and the US
India has a CA in software development due to lower labour costs.
The US specialises in high-tech manufacturing.
This is why many US tech firms outsource software development to India, benefiting both economies.
Assumptions of the Theory of Comparative Advantage
The theory of CA is based on six key assumptions, which often do not hold in reality.
1. Two Goods, Two Countries
The theory assumes only two countries producing two goods.
Limitation: In reality, many countries trade multiple goods at the same time.
2. Constant Opportunity Cost
Assumes opportunity costs remain constant, meaning resources move easily between industries.
Limitation: In reality, workers and capital cannot always switch between industries without extra costs.
3. No Transport Costs
The model ignores transport costs.
Limitation: Shipping costs, tariffs, and trade barriers impact trade decisions.
4. No Economies of Scale
Assumes that larger production does not lower costs.
Limitation: In reality, mass production reduces costs, making large producers more competitive.
5. Full Employment of Resources
Assumes that all labour and capital are fully used.
Limitation: Many countries face unemployment or underused resources.
6. Free Trade Exists
Assumes that there are no tariffs, quotas, or restrictions.
Limitation: Many governments protect local industries through tariffs.
Real-World Example: US-China Trade War
The US imposed tariffs on Chinese goods, increasing their price.
This disrupted trade and made comparative advantage less relevant.
Dynamic Comparative Advantage
Comparative Advantage Can Change
CA is not fixed—it changes over time due to investments in technology, education, and infrastructure.
Example: South Korea’s Transformation
In the 1960s, South Korea’s CA was in agriculture.
Today, it leads in electronics and automobiles due to R&D investments.
How Government Policies Influence Comparative Advantage
Education and Training
A skilled workforce improves CA in high-value industries.
Example: Germany’s apprenticeship system enhances manufacturing skills.
2. Infrastructure Development
Better infrastructure lowers production costs.
Example: China’s Belt and Road Initiative strengthens trade routes.
3. Industrial Policies and Subsidies
Government support helps industries gain CA.
Example: Japan’s post-war car industry subsidies boosted brands like Toyota.
4. Technology and Innovation
R&D investments help countries develop new advantages.
Example: Singapore’s Smart Nation initiative strengthens fintech and AI.
Conclusion
Comparative advantage explains why countries specialise and trade. However, its assumptions do not always hold in real life. Trade barriers, transport costs, and economies of scale affect trade decisions. Additionally, CA is dynamic—it evolves with education, technology, and government policies. Countries that invest in these areas can shift their CA towards higher-value industries, improving their position in the global economy.
Discussion Questions
What is the difference between comparative advantage and absolute advantage?
Why is opportunity cost important in determining comparative advantage?
Explain one assumption of comparative advantage that may not hold in reality.
How can government policies influence a country’s comparative advantage?
Provide a real-world example of a country that has changed its comparative advantage over time.
