Understanding how to calculate comparative advantage is crucial for any type of business. In today’s world, you can often see countries, firms or individuals specialize in producing a certain product, even if they have the capability to manufacture other goods. In this case, you might wonder why they do that. The concept of comparative advantage can answer that question.
The theory of comparative advantage explains how a country, company, or individual will produce more of and consume less of a product for which they have a comparative advantage. This can help you weigh in the available options and specialize your business based on comparative advantage. By doing so, you can maximize the production output of your business.
This article will show you the formula for calculating comparative advantage, and provide you with a step-by-step guide on how you can calculate it. The article will also demonstrate some examples to help you understand the concept of comparative advantage better. If this piques your interest, keep reading!
Formula for Calculating Comparative Advantage
Comparative advantage is calculated by identifying the opportunity cost for a set of products. Consider two neighboring countries or rival companies produce two sets of similar goods. Comparative advantage is calculated by finding out the opportunity cost for producing one product over the other product.
The formula for calculating comparative advantage can be expressed as,
Comparative Advantage = Quantity of “Product 1” for Country A ÷ Quantity of “Product Y” for Country A
Calculation Step by Step
To calculate the comparative advantage, follow the steps given below:
Step 1: First, calculate the opportunity cost of each product from each manufacturer or country.
Step 2: Plot the opportunity costs of each product in a two-way table.
Step 3: Finally, calculate the comparative advantage.
Let’s try to grasp the concept of comparative advantage with the help of the following example. Consider this hypothetical situation where the two neighboring countries the United States and Mexico both produce cars and aircraft. The quantity of each product produced by each country is presented in the table below.
|Car||100 Unit||80 Unit|
|Aircraft||40 Unit||30 Unit|
Find out which country has a comparative advantage over the other one for these two products.
Now, first, using the formula mentioned above, we need to calculate the opportunity cost of 1 unit of the car for both neighboring countries.
For the United States of America, they can produce 100 units of car or 40 units of aircraft.
100 cars = 40 aircraft ………… (i)
We need to find out how many aircraft it can produce as opposed to producing one car. To do that, divide both sides of equation (i) by 100.
100 car ÷ 100 = 40 aircraft ÷100
1 car = 0.4 aircraft
Similarly, find out Mexico’s opportunity cost of 1 unit of the car.
From the table, we can see that Mexico can produce 80 cars or 30 aircraft.
80 cars = 30 aircraft ………… (ii)
Now, to make it one car, divide both sides of equation (ii) by 80.
80 car ÷ 80 = 30 aircraft ÷ 80
1 car = 0.375 aircraft
We need to calculate the opportunity cost of one unit of aircraft for each of the neighboring countries in this example. To do that, follow the same process as before, just with one unit of aircraft instead.
The United States can produce 40 aircraft or 100 cars.
40 aircraft = 100 cars………… (iii)
Now, to make it one aircraft, divide both sides of equation (iii) by 40.
40 aircraft ÷ 40 = 100 cars ÷ 40
1 aircraft = 2.5 cars
In the case of Mexico, they can produce 80 cars or 30 aircraft.
30 aircraft = 80 cars………… (iv)
We need to find out how many cars they can produce as opposed to producing one aircraft. To do that, divide both sides of equation (iv) by 30.
30 aircraft ÷ 30 = 80 cars ÷ 30
1 aircraft = 2.667 cars
Now, plot the opportunity costs for each product that we’ve calculated so far in a two-way table like the one below.
|Car||100 Unit1 car = 0.4 aircraft||80 Unit1 car = 0.375 aircraft|
|aircraft||40 Unit1 aircraft = 2.5 cars||30 Unit1 aircraft = 2.667 cars|
When a country can produce a product with a lower opportunity cost compared to another country, the first country is said to have a comparative advantage over the other one.
In this example, the opportunity cost for a car is 0.4 aircraft in the United States and 0.375 in Mexico. As Mexico has the lowest opportunity cost for cars, therefore, they have a comparative advantage in car production over the United States.
In the case of aircraft, the opportunity cost of one unit of an aircraft is 2.5 units of cars in the United States as opposed to 2.667 units of cars in Mexico. As the opportunity cost is the case in the United States, they have a comparative advantage in the production of aircraft.
Use and Importance of Comparative Advantage
In economics, the concept of comparative advantage bears great importance. An individual, company, or country that has a competitive advantage at producing something can produce the product much more efficiently compared to others at a lower cost. In that sense, the concept of comparative advantage helps companies, individuals, or countries in specializing.
Let’s assume that Country B’s costs in producing both “Product 1” and “Product 2” are lower than Country A’s. This indicates that Country B has an absolute advantage in manufacturing both the goods as opposed to Country A.
But it is best for country B to specialize and focus on one product that has a comparative advantage over Country A and leave the production of the other product to them rather than trying to master both. If a country specializes in one product, it lowers the opportunity cost. And this results in a phenomenon commonly known as “The Benefits of Trade”.
I’m going to use the example above to explain this phenomenon to you. From the example, you can see that Mexico has a comparative advantage in producing cars over the United States. So, let’s shift 13 working days from manufacturing aircraft to producing cars in Mexico.
Therefore, the production of cars in Mexico = 80 × 13 = + 1040 units of car
And the production of aircrafts in Mexico = 30 × (-13) = – 390 units of aircraft
On the other hand, the United States has a comparative advantage in producing aircraft over Mexico. So, just like before, let’s shift ten working days in the United States from producing cars to aircraft.
So, the production of cars in the United States = 100 × (-10) = – 1000 units of car
And the production of aircraft in the United States = 40 × 10 = + 400 units of aircraft
Because of this specialization, the net output of these products from these two neighboring countries will result in higher production by (1040-1000) = 40 units of car and (-390 + 400) = 10 units of aircraft. Hence, by specialization of production depending on the comparative advantage, the total output of both countries can be increased.
In this age of globalization, comparative advantage has become one of the key elements of every global trade. Countries weigh in their options to determine whether producing or importing something will be beneficial to them based on this concept. Eventually, they end up specializing in something that has a higher comparative advantage.
Criticism of Comparative Advantage
Just like any other thing in this world, comparative advantage theory also has some flaws. First of all, the theory assumes there are no trading costs between different countries. But that assumption doesn’t hold in most cases. Countries impose tariffs, taxes on products which significantly increases the trading costs.
That’s not all. The comparative advantage model usually focuses on only two products from two different countries. But in the real world, there are multiple countries and products involved in a trade. All these should be considered when you are applying the theory of comparative advantage in real life.
In today’s world of globalization; individuals, companies and nations engage in trades based on their advantages. And most of the time, these advantages are determined based on the theory of comparative advantage. So, learning how to calculate comparative advantage will also help you understand how you can gain most from your business trades.