Comparative Advantage and Free Trade

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In the early 1800s, economist David Ricardo set out to explain why some countries produced lots of some types of goods but very little of other types of goods. In particular, he noted that Portugal made lots of wine but little cloth, while England made lots of cloth but little wine. This struck him as odd, since both the Portuguese and the English liked both wine and cloth. His explanation for why each nation didn't just produce wine and cloth for itself hinged on a concept called comparative advantage.

Defining Comparative Advantage

In economics, a business has a comparative advantage if it can produce a good or service at lower cost than the competition. A baker who invents a new, more efficient technique for baking bread would have a comparative advantage over other bakers, for example. He would be able to sell bread at a lower price than other bakers without sacrificing profits, allowing him to corner the market and grow his business.

Comparative advantage applies at a macroeconomic level to entire nations. A country with rich soil and an optimal climate for growing cotton, for instance, has a comparative advantage over other nations in terms of the cotton market. Nations with rocky soil and harsh climates won't be able to produce as much cotton as cheaply, so their cotton will be more expensive. Under normal economic theory, the nation with rocky soil will eventually stop producing its own cotton and opt to import cotton from the nation that can grow and process it more efficiently.

Tip

  • Opportunity cost plays a big role in determining who has a comparative advantage. Switzerland might be able to make better cheese at lower cost than France, but it could use the same resources to make chocolate. If chocolate is a more profitable business, economic theory dictates that the Swiss should make chocolate, even though they have an advantage in cheese production as well.

Barriers to Trade

The problem with the standard economic theory is that nations impose all sorts of barriers to international trade. These barriers, like tariffs on imported goods or subsidies for domestic production, can erase natural comparative advantages. In the example above, the country with rocky soil might put a high tax on cotton imports. The tax would allow the country's domestic cotton growers to compete with farmers from the more verdant cotton-growing country by raising the price of imported cotton.

The policy would effectively nullify the comparative advantage and keep the domestic cotton industry alive. However, it also would force consumers to pay higher prices for cotton than they would if there were no barriers to trade.

Comparative Advantage and Free Trade

One of the primary aims for free trade agreements to eliminate trade barriers. That encourages countries to play to their strengths, focusing their economies on sectors where they have a comparative advantage. Many economists argue this improves the overall economic efficiency of every country participating in trade. Nations with great soil grow lots of cotton, while nations with poor soil but high-tech industries build machines to help pick cotton, for example. The idea is that every country specializes in what it does best, and as a result everything costs less and runs smoother.

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