Updated July 27, 2023
Definition of Comparative Advantage Example
The following example of Comparative Advantage provides an overview of the most popular comparative advantages.
Comparative Advantage can be defined as a firm’s or the organization’s comparative advantage: its ability to produce service or goods compared to another firm or entity at a lower opportunity cost.
Economist David Ricardo was the one who first coined the terminology of comparative advantage. According to his theory, the country should specialize in what they enjoy this advantage and should import what the country lacks or is behind.
Examples of Comparative Advantage in the real world (With Excel Template)
Let’s take an example to understand the calculation of Comparative Advantage in the real world in a better manner.
Below are a few examples of Comparative Advantages:
Comparative Advantage Example – #1
Consider 2 countries (the United States and the United Kingdom) that use input such as labor to produce 2 different goods: cloth and wine.
In the United Kingdom, 1 hour of labor can produce either 20 wines or 10 cloths.
In the United States, 1 hour of labor can produce either 30 wines or 30 cloths.
You are required to determine how each country should optimize the use of labor, that is, by producing the good in which they have a comparative advantage.
Solution:
One can note that the US has an absolute advantage in producing Wine or cloth compared with the United Kingdom. With one labor hour, it’s either 30 units of cloth or 30 units of wine. From this, one can conclude that the United States has an absolute advantage.
To determine the comparative advantage, we shall determine both countries’ opportunity cost of wine and cloth.
For the United Kingdom:
- Opportunity Cost of 1 wine = ½ unit of cloth
- Opportunity Cost of 1 cloth = 2 units of wine
For the United States:
- Opportunity Cost of 1 wine = 1 unit of cloth
- Opportunity Cost of 1 cloth = 1 unit of wine
From above, we can see that the opportunity cost of producing 1 cloth in the United States is less than the United Kingdom. The opportunity cost of producing 1 wine in the United Kingdom is less than the United States; hence from this we can conclude that the United States has a comparative advantage in producing cloth and the United Kingdom has a comparative advantage in producing wine.
Comparative Advantage Example – #2
Company A produces cars and bikes; similarly, their rival company B does. However, Company B dominates in terms of producing both products. Company A claims it has a comparative advantage in producing cars over company B. Based on the table below, you must justify the company’s A claim.
Solution:
As mentioned in the problem statement, Company B indeed has an absolute advantage in producing either car or bikes when compared with Company A.
In order to determine the comparative advantage, we shall determine the opportunity cost of car and bikes for both firms.
For Company A:
- Opportunity Cost of 1 car = 2.5 unit of bike
- Opportunity Cost of 1 bike = 0.40 unit of a car
For Company B:
- Opportunity Cost of 1 car = 2 unit of bike
- Opportunity Cost of 1 bike = 0.50 unit of a car
It can be observed that Company A’s opportunity cost of producing a car in place of the bike is more than Company B. Hence, the claim made by Company A that has a comparative advantage in making a car is incorrect. Rather it has a comparative advantage in producing bikes.
Comparative Advantage Example – 3
Below is the comparative advantage summary of PQR country and XYZ country :
For Country PQR:
- Opportunity Cost of 1 Smartphone = 20 units of Beer
- Opportunity Cost of 1 Beer = 0.05 units of Smartphone
For Country XYZ:
- Opportunity Cost of 1 Smartphone = 25 units of Beer
- Opportunity Cost of 1 Beer = 0.04 units of Smartphone
Determine which country will trade for which product and, given that smartphones can be produced using equal scarce resources when both countries apply a comparative advantage technique.
Solution:
The comparative advantage for smartphones lies with country PQR, and the advantage for Beer lies with Country XYZ. And if there is free trade and both countries decide to use the comparative advantage technique, then company XYZ should import smartphones. Company PQR should import Beer, increasing the available quantity of both products.
Comparative Advantage Example – 4
JP Morgan uses two web-based applications for booking their trades for fixed-income securities and reports: FISCO and IMPACT. Both are used in different regions. One is used for the EMEA region, and another for the North America Region. The management has been seeing that the following are the outputs.
The company’s management wants to switch the system into one or use one system for one product type. You must advise the management which system should be more preferred and for which type of product or should combine all into one system?
Solution:
As mentioned in the problem statement, IMPACT indeed has an absolute advantage in booking Bond or Repos compared to FISCO as it takes less time.
To determine the comparative advantage, we shall determine the opportunity cost of booking Bond and Repo for both web-based systems.
For IMPACT:
- Opportunity Cost of booking bond trade = 2.5 mins of Booking Repo
- Opportunity Cost of booking Repo trade = 0.40 units of Booking Bond Trade
For FISCO:
- Opportunity Cost of booking bond trade = 2.0 mins of Booking Repo
- Opportunity Cost of booking Repo trade = 0.50 units of Booking Bond Trade
Since FISCO takes less time than IMPACT for booking bond trade, the same should be used to book Bond trade, whereas Repo trade should be booked in IMPACT as it takes less time to compare to FISCO.
Conclusion
Comparative advantage can be said a theory that is based on the concept of relativity. If a company or country is relatively better at producing or making a particular product, it should make that product and should ignore anything else. As such, comparative advantage can be considered as an important concept in global trade, and that’s the reason for several countries to concentrate on trying to make or to produce certain services or goods more efficiently when compared to other countries.
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