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Scottish economist Adam Smith helped originate the concepts of absolute and comparative advantage in his book, The Wealth of Nations. Smith argued that countries should specialize in the goods they can produce most efficiently and trade for any products they can’t produce as well. The differentiation between the varying abilities of companies and nations to produce goods efficiently is the basis for the concept of absolute advantage. As such, absolute advantage looks at the efficiency of producing a single product. It also looks at how to produce goods and services at a lower cost by using fewer inputs during the production process compared to the competition.

  1. Both countries benefited economically by exporting what they could produce most efficiently and importing what they couldn’t produce as easily.
  2. His models provide multiple insights on the correlations between vectors of trade and vectors with relative-autarky-price measures of comparative advantage.
  3. Table 33.1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good.
  4. Even if laborers would be most productive by switching from making shoes to making computers, nobody in the shoe industry wants to lose their job or see profits decrease in the short run.
  5. However, the relative costs or ranking of cost of producing those two goods differ between the countries.

So whilst France is better at producing wine and cheese, it may be more productive in making wine. In other words, nations still trade if they have an absolute advantage because there is an element of opportunity cost. In this example, the US makes 30 million cars and 10 million trucks, whilst Japan produces 25 million cars and 2.5 million trucks. Although it is 1.2 times better than Japan in producing cars, it is 4 times better at producing trucks.

Comparative advantage refers to the ability to produce goods and services at a lower opportunity cost, not necessarily at a greater volume or quality. Additionally, when comparing the opportunity cost of 1 wine for France and the United States, we can see that the opportunity cost of wine is lower in France. Therefore, France enjoys a comparative advantage in the production of wine.

Comparative Advantage Illustrated

By contrast, India can produce either 80 kilograms of wheat or 100 kilograms of potatoes. Cristiano Ronaldo, a famous soccer star has a clear advantage over the average person in his ability. For instance, he is consistently rated as one of the best players in the world.

Understanding Comparative Advantage

This example also illustrates how comparative advantage occurs in the first place. With the same labor, the baker can make three loaves of bread, but no steaks, and the butcher can make a steak but no bread. Thus they leverage their strengths through trade to overcome their weaknesses and satisfy their needs; they ultimately acquired a higher standard of living through the beneficial concept of interdependence. So even though France is good at making wine and cheese – because it is more efficient at making wine, it will make more profit from such endeavors.

Examples of comparative advantage

To simplify, let’s say that Saudi Arabia and the United States each have 100 worker hours (see Table 33.2). Figure 33.2 illustrates what each country is capable of producing on its own using a production possibility frontier (PPF) graph. Recall from Choice in a World of Scarcity that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers, and its level of technology.

Owing to their diversity of skills, Michael Jordan and Joe would likely find this to be the best arrangement for their mutual benefit. In this lesson, we learned the definitions of and differences between comparative and absolute advantage. Answer the following questions to test your knowledge on these two types of advantages.

This desire leads the shoemakers to lobby for, say, special tax breaks for their products and/or extra duties (or even outright bans) on foreign footwear. Appeals to save American jobs and preserve a time-honored American craft abound, even though, in the long run, American laborers would be made relatively less productive and American consumers relatively poorer by such protectionist tactics. Say, for example, the producers of American shoes understand and agree with the free-trade argument but they also know that their narrow interests would be negatively impacted by cheaper foreign shoes. Even if laborers would be most productive by switching from making shoes to making computers, nobody in the shoe industry wants to lose their job or see profits decrease in the short run.

Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. David Ricardo started out as a successful stockbroker, making $100 million in today’s dollars. After reading Adam Smith’s The Wealth of Nations, he became an economist.

Suppose you and your roommate want to clean the house and cook a magnificent Chicken Kiev dinner for your friends one night. It’s easy to see that you each have a comparative advantage in one activity because you each have an absolute advantage in one activity. The following is a typical modern interpretation of the classical Ricardian model.[15] In the interest of simplicity, it uses notation and definitions, such as opportunity cost, unavailable to Ricardo. Competitive advantage is what a country, business, or individual does that provides a better value to consumers than its competitors. There are three strategies companies use to gain a competitive advantage.

Comparative advantage is a key principle in international trade and forms the basis of why free trade is beneficial to countries. The theory of comparative advantage shows that even if a country enjoys an absolute comparative advantage example advantage in the production of goods, trade can still be beneficial to both trading partners. Opportunity costs are the advantages an individual sacrifices when opting for one option over another.

What is the approximate value of your cash savings and other investments?

Everyone has something that they can produce at a lower opportunity cost than others, and by trading with others everyone is better off. In addition, it takes Sally 1 full hour to produce a term paper, while Adam can produce the same term paper in half the time – it’s a 1/2 hour to produce a term paper for Adam; therefore, Adam has an absolute advantage in producing term papers. When one individual can produce a single good more efficiently than another individual, they have an absolute advantage and are the superior producer of that good. Where absolute advantage can center around a single good, comparative advantage is the more complex side regarding the production of at least two goods.

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. In other words, the Ricardian model is both one of the most misunderstood and one of the most compelling models of international trade.