Comparative advantage is a term in economics that refers to the ability of an entity to produce goods or services at a lower opportunity cost than other entities in the same market. Opportunity cost is referred to as the amount of benefit that has been forfeited by an individual in choosing between purchasing one item over the other. Therefore, when a company has a lower opportunity cost for a product, it means that by purchasing that company’s product, the benefit that an individual has lost is small. When the interest forfeited is small, then in economics, the company is said to have a comparative advantage for the product over the alternative companies that offer a similar product. What does it mean when an entity has a comparative advantage over another?
When a company has a comparative advantage over another, it simply means that the company can sell goods and services at a lower price than its competitors. This, in turn, means that the company can achieve higher sales margins than its competitors. This is because the trade-off benefits of buying goods or services from that entity have advantages that outweigh the disadvantages.
In international trade, David Ricardo, an Economist in the eighteenth century, argued that countries will only boost their economy if they focus on the industry in which they have the most comparative advantage. This was seen in practice by looking at England and Scotland. In Economic history, England had the resources to manufacture cheap cloth while Scotland had the necessary resources to manufacture cheap wine. Eventually, England stopped producing wine, and Scotland stopped producing cloth, and they both symbiotically benefited from trading with each other what they produced most efficiently.
Comparative advantage may overstate the benefits of specializing in one product by ignoring many costs. Ignoring these costs will lead to inadequate consideration and projection of profit margins. The costs that may be overlooked can include the high cost of air or road transport involved in shipping the goods from one country to the other; the taxation affected in importation and exportation. Etc.
The external costs of trade specialization are the effects of extensive production of one specific product on surrounding matters. An example of this is the environmental impact extensively harvesting mining products. Another example is the pollution effect of manufacturing companies.
This is brought about by over exploitation of the resources related to the raw material of the industry of specialization. For example, if a country specializes in agricultural products, they may farm extensively until the country runs out of suitable land for farming. In the same manner, if a country specializes on mining and manufacturing products like metals or precious stones, it is highly likely that they will deplete the natural resources which will lead to the country returns from the product diminishing over time.
Static comparative advantage is when 2nd or 3rd world countries that have struggling economies specialize in primary products that have a low elasticity of demand. Low elasticity of demand refers to when a difference in production or a difference in the price of a product does not have a significant difference in the overall demand of the product. Specializing in products of this nature holds back these countries from making ventures in industries that would otherwise be more profitable to the country’s economy.
This theory suggests that the countries that are inclined to trade with each other are the countries that are around a similar size in economic capacity and countries that geographically close to each other due to the ease of doing business considering product transportation logistics. These countries are defined as being at optimum levels of bilateral trade. The challenge with this theory is that areas that are geographically close to each other normally produce the same products due to similar climatic conditions and geographical soil properties. This creates a trade barrier of competition between the countries. Countries trade better when they each offer a product that the other does not produce.
Whereas specialization improves productivity and improves the overall economic welfare of the country, not everybody will be well off since alternative industries tend to collapse when most of the government’s investments are driven to one specific industry. The collapse of the alternative industries leads to downsizing of companies and loss of employment to many people who rely on these industries for livelihood.
Comparative advantage naturally assumes the opportunity cost of a single product between two different countries to determine the best positions for trade. In real practice, there are multiple products and multiple countries that are involved in international trade between countries. This means that comparative advantage has to be analyzing with several other factors so as to determine the best dynamics for international trade.
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