What is mean by theory of comparative advantage ? How does opportunity cost act as basis for comparative advantage ? What is relation between theory of comparative advantage and free trade ? How does trade off affect consumer decision making ? Let’s begin…
“Nowadays, business without profit seems too hypothetical to trust. In this race everyone strive to prove his or her superiority. So, being a comparative advantage over competitor is necessity now”
Meaning of comparative advantage
It is all about to exploit the benefits of cost difference in the factors of production. Naturally, every nation has always an economic edge over competitor in the international market. Expectedly, product of that nation remains cost effective than trading partner.
Simply, it is called advantage for a particular nation comparatively other trading member in terms of a product.
For, more clarification, let’s see more explanation of both– opportunity cost and theory of comparative advantage.
What is mean by opportunity cost and how does it support the theory of comparative advantage ??
As per this theory, opportunity cost is potential cost. A firm sacrifices this cost while making product in which it has advantage.
For example, Tom is professional carpenter. He used to make two chairs per day. By selling these chairs, he earns $100. That means, he earns $100 dollars per day.
Suppose, instead making chairs, he one day decides to work as a painter. So far, as a painter, he has no experience. In spite of, he takes a contract to paint a house for $200. And, he works there for a week to complete that job. Finally, he gets $200 for his labor.
If you compare these examples, you can realize that as a carpenter, Tom earned more than as a painter. It means that, as a painter, Tom has sacrificed more opportunity cost than as a carpenter.
Notably, opportunity cost acts as a basis of comparative advantage for a firm or person. Then only, firms decides what to produce and what to neglect.
Surely, in the same line, nation can sell one and purchase other to avoid more opportunity cost.
Explaining the theory of comparative advantage
Suppose, in China, factors of production such as, labour and raw material are more affordable compare to US, Australia, and UK. In this case, labour intensive product made in China remains more competitive than others.
In another situation, suppose, in the same countries, knowledge expertise, technology, and other factors are more effective compare to China, then technology and capital intensive product of these nations remains more competitive than competitor.
But, when these two trading partners decide to produce things in which they don’t have any economic edge, they have to pay more cost. Here, more cost mean, instead to make $100 product, they are bound to produce $10 product by investing higher wages. Consequently, product would be lesser competitive.
Instead to do this, they can purchase it from China to save expensive labor and expertise. By doing so, they can save resources and concentrate on the product in which they have greater edge.
Similarly, China can purchase products in which it has no advantage. Instead, can concentrate on things with greater advantage to sell in the global market.
Comparative advantage and free trade
On the basis of comparative advantage, economists advocate for free trade. By doing so, both sellers, as well as buyer would be in a great surplus. This surplus, they can employ for future investment or to improve standards of living.