Comparative Advantage Theory

Comparative advantage is an economy's ability to produce a particular good or service at a

lower opportunity cost than its trading partners. When we say opportunity cost, this is the
potential benefit that someone loses out when selecting a particular option over another. 

For example, if a company is skilled at making both cheese and chocolate, they may determine
how much labor goes into producing each good. If it takes one hour of labor to produce 10 units
of cheese and one hour of labor to produce 20 units of chocolate, then this company has a
comparative advantage in making chocolate. This is because for every 10 units of cheese the
company produces, they are giving up 10 units of chocolate that they could have produced
during the same time period. By allocating more of their resources toward chocolate production
instead of cheese production, this company can increase their exports to other companies and
improve their revenue margins.

In the international trade sense, it is better to explain comparative advantage using an example.
For instance, In Puerto Rico, one hour of labor can produce either ten bottles of wine or five
pieces of cloth. In France, one hour of labor can produce either 20 bottles of wine or 20 pieces
of cloth. While France has an absolute advantage in both the production of wine and cloth,
Puerto Rico has the comparative advantage in producing wine. This is because if Puerto Rico
allocates more of its resources toward wine production and less of its resources toward cloth
production, it has a lower opportunity cost than France. If Puerto Rico decides to just focus
more on wine production, then they can only give up 5 pieces of cloth per hour while France has
to give up 20 pieces of cloth.

In the case of comparative advantage, the company with the lower opportunity cost such as
Puerto Rico holds this type of advantage.

Comparative advantage can also refer to the products that a country can produce more cheaply
or easily than other countries. Comparative advantage is used to explain why companies,
countries, or individuals can benefit from trade. While this usually illustrates the benefits of
trade, some contemporary economists now acknowledge that focusing only on comparative
advantages can result in exploitation and depletion of the country's resources. Why? It’s
because focusing only on one certain production will result in the excessive demands of raw
supplies for that certain product which will eventually exhaust the resources of the country.

The theory of comparative advantage is popularly attributed to English political economist David
Ricardo and his book “On the Principles of Political Economy and Taxation” written in 1817,
although it is likely that Ricardo's mentor, James Mill, originated the analysis. Comparative
advantage is one of the most important concepts in economic theory and a fundamental tenet of
the argument that all actors, at all times, can mutually benefit from cooperation and voluntary
trade. It is also a foundational principle in the theory of international trade.

Another way to think of comparative advantage is as the best option given a trade-off. If you're
comparing two different options, each of which has a trade-off (some benefits as well as some
disadvantages), the one with the best overall package is the one with the comparative
advantage.