Comparative Advantage

Posted in Finance, Accounting and Economics Terms, Total Reads: 192
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Definition: Comparative Advantage

The ability of an economy or a firm or an individual to produce goods and services at a lower opportunity cost is known as Comparative Advantage. This term was coined by economist David Ricardo in the 19th century.

 

The theory of competitive advantage states that an economy or a firm or an individual should specialize in the goods and services in which they have competitive advantage.

 

Examples

Suppose that there are only two goods produced say cloth and bread in two economy world i.e. Nation A and Nation B and there is only one input i.e. labour. Now refer the below table to see the amount of labour required to produce the goods

Nation

Goods

Nation A

Units of labour

Nation B

Units of labour

Cloth

10 units

10 units

Bread

5 units

10 units


In the above situation, as observed the Nation B has to reduce production of one unit of cloth to produce one unit of bread. But in case of Nation A, it has to reduce production of half unit of cloth to produce one unit of bread.

 

Nation A can produce bread at a lower opportunity cost, hence it can specialize in production of bread. Similarly Nation B can produce cloth at lower opportunity cost, hence it can specialize in production of cloth.

 

Limitations of Comparative Advantage

1. Government policies/Trade barriers are not accounted which may lead to restriction of trade.

2. Comparative advantage is static in nature does not account to changing dynamics of production techniques which may led to a particular country to achieve comparative advantage in other goods in the future.

3. It does not account for the transportation and trading cost.

4. Increased specialisation may result in diseconomies of scale in some cases.

5. Exchange rate fluctuations are not accommodated in the model.

 

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