MBA Help - Economics

Comparative Advantage

Comparative advantage has been a recognised part of economics since the 18th century, when different European countries proved more adept at trading different goods. The principle of comparative advantage is that some producers will be better able to produce certain goods than others, and hence production efficiency will be maximised when these specialities are taken account of.

This can be seen in the example of two farmers: farmer A and farmer B. Farmer A has rich arable land and farmer B has a more rocky and hilly farm, but B’s farm is bigger. The two goods produced by these farmers are grain and cattle. As farmer A’s farm is bigger, he can produce more of both cattle and grain. Their maximum production capabilities are shown below:

Grain

Cattle

A

20

20

B

4

16

These numbers are the maximum of one commodity which can be produced: A can only produce 20 units of grain or 20 of cattle. As such, these values are the ends of the production possibility frontiers for each individual.

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If the farmers operated individually, they would produce according to their own capabilities. As such, A would produce 10 grain and 10 cattle and B would produce 2 grain and 8 cattle. This gives A an opportunity cost of 1 grain per cattle and B has an opportunity cost of 1 grain per four cattle. As A has a lower opportunity cost A has a comparative advantage in producing grain. However, B has a lower opportunity cost of producing cattle, as B must only sacrifice a quarter of a unit of grain to produce one unit of cattle, hence giving B a comparative advantage in the production of cattle.

Therefore, if A and B are competing in the same market, with similar demands for grain and cattle, A should produce all grain and B should produce all cattle. This would maximise each of their profits: B would produce as much as possible and A would maximise his comparative advantage and avoid competing with B in the cattle market. However, if the markets for grain and cattle are identical, the optimal solution is for A to produce 18 grain and 2 cattle. This will mean that 18 units are produced for each market, thus maximising profits. Comparative advantage is thus a key indicator of the importance of specialisation: even though A can produce more than B overall, but specialising the in market where A’s comparative advantage is higher, A can maximise its profits.

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