011 min
The problem comparative advantage answers
A common belief says that a party that is better at everything gains nothing from trading with a weaker one. It should make everything itself. Ricardo's argument shows this belief is wrong.
The mistake is to compare absolute skill. A person's time is limited, so every hour spent on one task is an hour not spent on another. What matters is how much of one thing must be given up to get another. That quantity is the opportunity cost. Two parties almost never have the same opportunity costs, and the difference is where the gain from trade comes from.
021 min
Where comparative advantage comes from
David Ricardo set out the argument in chapter 7, "On Foreign Trade", of his 1817 book On the Principles of Political Economy and Taxation. He wrote about trade between nations, and about wine and cloth. The chapter does not use the phrase "comparative advantage". The phrase was applied to his reasoning by later economists.
Ricardo was also clear about the benefit he expected. Ricardo wrote: "Under a system of perfectly free commerce, each country naturally devotes its capital and labour to such employments as are most beneficial to each." The point of the sentence is that no planner has to assign the work. Each country's own interest leads it to the same result.
032 min
Ricardo's example: wine from Portugal, cloth from England
Ricardo used numbers of workers. In his example, "England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time." "To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time."
Portugal is better at both products, since 80 is less than 120 and 90 is less than 100. Even so, Ricardo then makes the point that startled his readers: "This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England."
The table shows the arithmetic. It uses Ricardo's figures, and the final column is our calculation, not his.
| Labour to make one unit of wine | Labour to make one unit of cloth | Cost of one cloth, counted in wine | |
|---|---|---|---|
| Portugal | 80 | 90 | 90 / 80 = 1.125 |
| England | 120 | 100 | 100 / 120 = 0.83 |
England gives up less wine to make a unit of cloth, so England has the comparative advantage in cloth. Portugal gives up less cloth to make a unit of wine (0.89 against 1.2), so Portugal has it in wine.
If each country makes two units of each product itself, the total labour is 2 x (80 + 90) for Portugal and 2 x (120 + 100) for England, which is 340 and 440, or 780 in all. If Portugal makes four units of wine and England makes four units of cloth, the labour is 4 x 80 plus 4 x 100, which is 720. The same output needs 60 fewer units of labour, and both countries can share the saving by trading. Ricardo reached the same conclusion without a table: England would give "the produce of the labour of 100 men, for the produce of the labour of 80."
041 min
How comparative advantage shows up in product and business work
The reasoning applies to any two parties that divide work, not only nations. Here is an illustrative case. A founder can run a customer demo in 2 hours, and a sales hire needs 4 hours. The founder can write a product specification in 1 hour, and the hire needs 8 hours. The founder is faster at both. The founder is twice as fast at demos but eight times as fast at specifications. The founder's comparative advantage is the specification, so the founder should write the specifications and let the hire run the demos, even though the founder could do both better.
The same logic guides hiring decisions, outsourcing and the split between a team and a vendor. A related idea is the force multiplier, where one person's work raises the output of many others. The question to ask in each case is the one Ricardo's example answers: what does this person give up when they do this task? That cost is the opportunity cost.
051 min
Applying comparative advantage
- List the tasks that need to be done and the time each takes for each person or team.
- Compare the ratios, not the totals. For each pair of tasks, find who gives up the least of one to do the other.
- Assign each task to the party with the lower opportunity cost, then check that the capacity exists.
- Recalculate when the numbers change. A new tool or a new hire can reverse the ratios.
- Count the cost of coordination. Splitting work only helps if the gain is larger than the cost of handoffs.
061 min
When comparative advantage does not hold
The argument depends on assumptions, and Ricardo stated one of them himself. For nations, he assumed capital stays in the country. He explains: He gives the reason capital does not move freely between countries as "the difficulty with which capital moves from one country to another". He adds that if capital did move, it would be advantageous to make both goods in Portugal.
Three other limits apply to business use. The first is that opportunity costs must be real. If a task can be done in spare time, doing it yourself costs nothing, and handing it off gains nothing. The second is that handoffs cost time. The gain from specialising can be smaller than the cost of coordination, which is a trade-off between division of labour and overhead. The third is that costs can fall on people outside the exchange. Trade between two parties can raise an externality for a third, and the calculation does not count it.
The tell for misuse is someone using "comparative advantage" to mean "what we are best at". That is absolute advantage. Comparative advantage can point to a task you are worse at than another party, if the other party is even better at something else.
071 min
Comparative advantage versus absolute advantage
| Absolute advantage | Comparative advantage | |
|---|---|---|
| Compares | Output per unit of input | Opportunity cost |
| Question | Who is better at this task? | Who gives up less to do this task? |
| Can one party have it in every task? | Yes | No |
| Decides who should specialise? | No | Yes |
The last two rows are the important ones. One party can be better at everything, so absolute advantage cannot divide the work. Comparative advantage always leaves each party with something it should do, because a ratio cannot be larger for one task in every pair.
081 min
Frequently asked questions
What is comparative advantage in simple terms?
Comparative advantage is being able to make something at a lower opportunity cost than someone else. You give up less of other things to make it.
Who invented comparative advantage?
David Ricardo set out the argument in 1817 in his book On the Principles of Political Economy and Taxation. He used the example of wine and cloth.
What is the difference between comparative and absolute advantage?
Absolute advantage compares output per unit of input. Comparative advantage compares opportunity cost. A party with an absolute advantage in everything still has a comparative advantage in only some tasks.
Can both sides gain if one side is better at everything?
Yes. If their opportunity costs differ, both gain by specialising in what each gives up least to make and trading. Ricardo's example shows this.
Does comparative advantage apply to individuals and companies?
Yes. The logic depends only on limited time and different opportunity costs. It applies to a founder and a hire as well as to two countries.
?3 questions
Questions people ask
What is comparative advantage in simple terms?
What is the difference between comparative and absolute advantage?
Can both sides gain if one side is better at everything?
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§1 source
Sources
David Ricardo, On the Principles of Political Economy and Taxation, 1817, chapter 7, "On Foreign Trade". marxists.org
