Comparative advantage

The law of comparative advantage is the principle that firms, people, or countries should engage in those activities for which their advantage over others is the largest or their disadvantage is the smallest. First articulated by English economist David Ricardo (1772–1823), the law of comparative advantage demonstrated that both weak and strong nations benefit from trade by doing those things they do relatively more efficiently than others. At the time, Ricardo’s ideas were revolutionary. The predominant economic doctrine, MERCANTILISM, espoused accumulation of WEALTH in the form of precious metals and maintaining a favorable TRADE BALANCE. The idea of comparative advantage was used to convince the English parliament to replace protective TARIFFs with a FREE TRADE policy. England’s success with these changes influenced other countries to change their policies. Comparative advantage is based on relative COSTS and exchange. Considering the alternative, self-sufficiency, raises the question whether quality of life would improve or decline if one had to produce everything one consumed. There are few people who have the skills and other resources to come close to matching the quality of life they currently have in an economic system based on specialization and exchange. Relative costs are also critical to the idea of comparative advantage. If one person (firm or country) can do something well, the OPPORTUNITY COST (the value of the output foregone) of not using those resources in that capacity is quite high. Meanwhile the opportunity cost of using personal skills and resources in production of what one does well is relatively low. For example, Tiger Woods plays golf exceptionally well and earns significant INCOME doing so. Knowing golf courses, Mr. Woods could also probably do an excellent job cutting the grass on the courses he plays. If he chose to cut grass, his opportunity cost would be the income foregone from playing and winning on a lot of golf courses. By playing golf, Mr. Woods sacrifices the income he could earn cutting grass, but that is quite small compared to his income from playing golf. The same principal, relative costs, applies to specialization and trade among firms and countries. In the last decade, one of the trends in American business has been OUTSOURCING. Firms are finding it less expensive to pay others for skills or products that would be expensive to produce internally. Advances in communication technology are allowing firms to contract out a variety of service needs, including many human resource, accounting, and development functions. Increasingly U.S. countries are contracting for billing, engineering, and technology services with skilled English-speaking professionals around the world. For the last two centuries, economists have studied the concept of comparative advantage, looking for the sources of relative-cost advantages. The Heckscher-Ohlim theorem suggests that relative factor endowments of countries are the principal determinant of comparative-cost differences. According to this theory, countries with highly skilled workers will have an advantage in the PRODUCTION of goods and SERVICES requiring skilled labor. Countries with significant mineral resources will have a comparative advantage in the production of those minerals. Empirical studies have both supported and challenged the Heckscher-Ohlim theorem. Other research suggests DEMAND considerations, ECONOMIES OF SCALE, and technology are important sources of comparative advantage. Governments sometimes attempt to create comparative advantage through subsidies to important domestic industries and tariffs placed on imported products.