Comparative Advantage

The principle of comparative advantage explains how trade can benefit all parties involved, as long as they produce goods with different relative costs. The net benefits of such an outcome are called gains from trade. Usually attributed to the classical economist David Ricardo, comparative advantage is a key economic concept in the study of trade.

Adam Smith had used the principle of absolute advantage to show how a country can benefit from trade if the country has the lowest absolute cost of production in a good. The principle of comparative advantage shows that what a matter is not the absolute cost, but the opportunity cost of production. The opportunity cost of production of a good can be measured as how much production of another good needs to be reduced to increase production by one more unit.

The principle of comparative advantage shows that even if a country has no absolute advantage in any product (i.e. it is not the most efficient producer for any good), the disadvantaged country can still benefit from specializing in and exporting the product(s) for which it has the lowest opportunity cost of production. It has been argued that it is impossible to falsify the Theory of Comparative Advantage

Criticism

Opponents of free trade often point out that the comparative advantage argument for free trade has lost its legitimacy in a globally integrated world–in which capital is free to move internationally. Herman Daly, a leading voice in the discipline of ecological economics, emphasizes that although Ricardo’s theory of comparative advantage is one of the most elegant theories in economics, its application to the present day is illogical: “Free capital mobility totally undercuts Ricardo’s comparative advantage argument for free trade in goods, because that argument is explicitly and essentially premised on capital (and other factors) being immobile between nations. Under the new globalization regime, capital tends simply to flow to wherever costs are lowest–that is, to pursue absolute advantage.”

It has also been argued that comparative advantage may reduce economic diversity to risky levels. Focusing on a few narrow products may increase risk and instability. The principles of diversification in personal finance may apply on a national level.