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Comparative Advantage
The theory of comparative advantage was devised by David Ricardo and can be used to advocate free trade agreements. It states that a country should produce and export goods which it can make with a low opportunity cost and then import goods from other countries. This improves the allocation of resources and global trade improves; a larger output is produced without an increase in inputs.










The table above shows how much beer and wine England and France can produce respectively. France has an absolute advantage (meaning it can produce more of both), however it shouldn’t produce both. For France the opportunity cost of producing 1 barrel of beer is 4/3 bottles of wine. For England the opportunity cost of producing 1 barrel of beer is only 1.2 bottles of wine. 1.2 < 4/3 therefore England should produce beer and France should produce wine and the 2 countries should trade. Competitive advantage is linked to price and quality differences which can be influenced by government policies.

From the PPF we can see the comparative advantages of the different entities. Entity A has a comparative advantage in producing Good A whereas Entity B has a comparative advantage in producing Good B. This can be shown in the slope of the PPF.  

The 2 entities decided to produce P1 (say 30 units) units of Good A and Good B respectively. World output is therefore 60 units of Good A and 60 units of Good B. But if each entity were to specialise in producing the good in which it has the comparative advantage and then trade, there would be an increase in world output. So if Entity A produces 100 units of Good A (as it has a comparative advantage in this) and Entity B produces 100 units of Good B then world output would now be increased to 200 units. They could then trade, Entity A could sell 50 units of Good A and Entity B could sell 50 units of Good B. Both entities would be better off by 20 units of each good respectively.

This example demonstrates the mutually beneficial nature of world trade through the law of comparative advantage. In this example both countries gain equally, however in reality different goods are priced differently and so 1 country may gain more through trade than another.

In the global economy there are a variety of factors which lead to a country having a comparative advantage over another. These include climates (particularly notable in the production of agriculture), skills and education (a more skilled economy will be more productive), and the 3 factors of production. Land is a striking example as this includes commodities which may give a specific country a large comparative advantage. These factors help to explain why MNCs chose to locate where they do. Consumers also benefit from this trade not only through cheaper prices and better quality but also through a greater choice in what they buy.

Page last updated on 15/04/14