Economic Principles

Comparative Advantage

Consider two countries, we’ll call them Rich and Poor. Rich is fully industrialized and has, on average, twice the productivity in producing stuff as Poor. That means that it takes on average twice as much labor to produce something in Poor as in Rich. If we assume that Rich and Poor trade with each other, then (ignoring capital costs for simplicity) workers in Poor can only be paid half of what workers make in Rich if the prices of goods made in the two countries are going to be equal. For example, if it takes 1 hour of labor to produce a shirt in Rich and the labor rate is $10 per hour, then the shirt would cost $10 plus materials and shipping etc. In Poor it would take 2 hours to produce the shirt, so the maximum labor rate would be $5 per hour for the shirt to cost the same and be competitive in trade. Simply put, because of a lack of capital, workers in Poor can only make half as much stuff in the same time as workers in Rich, and so can only have half the effective pay rate per hour.

Now suppose that in Poor, there is a product that doesn’t take twice as much labor to produce as in Rich. Say bicycles can be put together in 5 hours in Rich but it takes 7 hours to make one in Poor, so not twice as long. At $10/hour the labor component of the bike in Rich is $50, but in Poor, where the labor rate is $5/hour, the labor to make the bike is only $35. So, bikes made in Poor can undercut bikes made in Rich and the owners of bike factories in Poor can make a tidy profit.

This tendency of trade to favor higher relative labor productivity is called “comparative advantage” and was first described by the brilliant early economist David Ricardo in his book “On the Principles of Political Economy and Taxation” in 1817. In our example, Rich has an absolute labor advantage in producing both shirts and bicycles, but Poor has a relative (aka comparative) advantage in producing bikes compared to shirts.

Let’s look a bit more at what happens to the manufacture of bikes in Rich and Poor. Since Poor can undercut Rich in bicycles, bicycle manufacture in Poor will expand but will decline in Rich. As prices for bikes decline in Rich, demand will increase, and eventually the supply and demand curves will meet in the usual way, and the number of bicycles manufactured in Poor for export to Rich will reach a more or less constant level of say 20,000 bicycles a month. This will increase employment in bicycle manufacturing in Poor and it may help to raise wages there depending on how “tight” the supply of labor is and how big the bike segment is relative to the entire economy.

What happened to the workers displaced from bike manufacturing in Rich? We have been implicitly assuming that labor is a mobile factor of production for bikes, so the bike workers in Rich should be able to find other work at $10 per hour. In fact, there will be many other industries in Rich that have a comparative advantage over Poor and where Rich will in fact export to Poor.  The United States, a rich country in terms of capital, exports a lot of vehicle parts and integrated circuits because it has a comparative advantage in those products relative to some other countries[1].

There are some other lessons we can learn from this example of comparative advantage. Note that the price of bicycles has gone down in Rich. This not only puts extra dollars in the pockets of bicycle buyers but also allows some people who couldn’t afford bicycles before to buy one. If bike workers in Rich had to match the labor rate in Poor, $5 per hour, then every such dollar would have to come out of their pay but if the general labor rate in Rich is not affected and the bike workers find other employment, possibly in an industry in which Rich has a comparative advantage, then clearly Rich benefits from the trade. And so does Poor since they can trade goods in which they have a comparative advantage for goods in which they have a relative disadvantage. In other words, it is a win-win for both countries and that applies even if the bike workers in Rich can’t quite get the $10 per hour they were getting before because of the lower price of bicycles in Rich.

Don’t worry if you have a bit of difficulty “getting” comparative advantage through the example above[2]. The more intuitive way to put it is that you should do what you do best.  Sure, you’d like to be the absolute best, and hence make the most money, but doing what you do relatively well is the next best thing. If you think about it, that’s what we usually do, or try to do, in our work lives. Comparative advantage says that two countries with differences in relative productivity will always be able to trade to mutual advantage. Prices will come down (which is equivalent to wages going up), more goods will be produced (because a decline in prices or increase in wages means an increase in sales), and there will be more diversity of goods and services.

A quick note on the equivalence of falling prices and increasing wages. If the cost of a car, say, goes down by 20% or your pay goes up by 20%, you still pay less for the car relative to your income. “Real” income changes are measured in terms of how much income goes up relative to a basket of goods. This is the “inflation” adjustment we’re all aware of and mentioned above. Since we’re measuring real wages in terms of a basket of goods, it doesn’t matter whether the basket of goods has gotten cheaper, or wages have gone up. Of course, both can go up due to inflation, which is a general price increase, but the ratio of wages to the basket of goods will change, and that change will be positive for both increased productivity and trade in the comparative advantage model. However, workers in trade competitive industries can in fact lose out at least in the short run because the benefits are not evenly distributed. If I work in a profession that is unaffected by trade, then a cheaper bike is great. But not so much for the bike worker who may take a pay cut in shifting to a different job. Since trade is not restricted to bicycles, large segments of the population may find themselves seeming to earn less. Sure, they will pay less for bicycles and other traded goods, but for non-traded goods such as health care and education their lowered incomes will now not go as far. This does not mean that trade overall has not benefited the country in dollar terms, but it does mean that the benefits are unevenly distributed and overall “utility”[3] may go down unless redistributive mechanisms are in place.

One last wrinkle. Let’s say Poor, like China 30 years ago, has abundant labor. Bicycle manufacturers won’t have to raise wages to attract all the labor they need. Instead, competitively, they will keep prices low, which will expand their sales to Rich. In local terms, wages haven’t gone up, nor have prices gone down (unlike in Rich). How is this a win?  Well, exports will increase, which will either increase GDP or allow for more imports or, more realistically, both. And there is only “spare labor” because the wages on offer are still better than, say, working as a subsistence farmer. So, in fact Poor will benefit.

Comparative advantage, like the perfect free market, describes a simplified ideal which helps us understand and model trade. Like the perfect free market there are many assumptions that underlie the model and numerous real-world imperfections and additional considerations. We can learn a lot about trade in the real world by considering how it differs from the ideal of comparative advantage.

First of all, our two country two product example which only considers labor is way too simple and makes many unrealistic assumptions[4]. Economists have worked hard to show that comparative advantage holds when considering many countries and many products even when some of the assumptions are made more realistic. And the fundamental insight of comparative advantage still applies when other factors of production, in particular capital, are added to the mix to create more comprehensive trade models. There is also statistical research to support comparative advantage[5].

In the real world most goods have to be shipped and many services can only be performed locally. The cost of a good includes not just the cost of production but also shipping costs and any tariffs. For many heavy, lower priced items the shipping costs can outweigh any productivity advantages. This explains why countries tend to trade most with their closest neighbors. The US’s top trading partners in 2019 were Canada and Mexico, and only then China.


[1] Comparative advantage is often defined as an economy’s ability to produce a particular good or service at a lower opportunity cost than its trading partners. If as a businessman I can earn a better return investing money in making tablecloths for export versus making tables for export, then I will do so. The reason for the difference in opportunity costs is related to differences in relative labor productivity among other things.  Opportunity cost is a fancy way of saying getting the best return for money. Your opportunity cost for investing in one thing is the return you could have made investing in the best possible alternative. Opportunity cost = Return on option A – Return on option B.

[2] The famous economist Paul Samuelson once said, “Thousands of important and intelligent men have never been able to grasp the principle of comparative advantage or believe it even after it was explained to them.” I’ve always intuitively wondered why people don’t fall off the bottom of the earth, even though I know the answer. We’ll look at the evidence on comparative advantage in Part II.

[3] The workers who are hurt economically may feel more pain than the larger group that benefits from lower prices feels the benefit. “Utility” to individuals cannot be summed in straight dollar terms.

[4] A good list of assumptions underlying the 2 country, 2 product example can be found at: Borad, Sanjay Bulaki. n.d. “Comparative Advantage.” Accessed August 27, 2021. https://efinancemanagement.com/international-financial-management/comparative-advantage.

[5] See “Economists Find Evidence for Famous Hypothesis of ‘comparative Advantage.’” n.d. Accessed August 25, 2021. https://news.mit.edu/2012/confirming-ricardo-0620 or Krugman, Paul R., Maurice Obstfeld, and Marc Melitz. 2011. International Economics: Theory and Policy, 9th Edition. Addison-Wesley pp 45-47.

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