Comparative advantage is an economic law that demonstrates the ways in which protectionism (mercantilism,
at the time it was written) is unnecessary in free trade. Popularized
by David Ricardo, comparative advantage argues that free trade works
even if one partner in a deal holds absolute advantage in all areas of production - that is, one partner makes products cheaper, better and faster than its trading partner.
The
primary fear for nations entering free trade is that they will be
out-produced by a country with an absolute advantage in several areas,
which would lead to imports, but no exports. Comparative advantage
stipulates that countries should specialize in a certain class of
products for export, but import the rest - even if the country holds an
absolute advantage in all products. (To learn more, read What Is International Trade?)
The
essence of this law can be illustrated with a simple example. Imagine
that you are a skilled cabinetmaker as well as a gifted painter. It
takes you a day to build a cabinet or a day to paint a picture. In the
local economy, paintings sell for $400 and cabinets go for $350. Your
neighbor also shares the same skill sets, but it takes him a day and a
half to build a cabinet and three days to complete a painting. You have
an absolute advantage over your neighbor in both areas, so you should
try to outproduce him across the board, right? Wrong.
Here's
why: If you flip between painting and cabinetmaking over a six-day work
week, you would produce three paintings and three cabinets worth $2,250.
If your neighbor embarked upon the same work schedule, he would produce
one painting and two cabinets worth $1,100. There would be a total of
four paintings and five cabinets produced: a total of nine production
units. If, however, you were to choose to focus on painting, the area
where you have the greatest comparative advantage and the most profit,
and leave cabinetmaking to your neighbor, something magical would
happen. You would produce six paintings worth $2,400 per week, while
your neighbor would produce four cabinets worth $1,400, bringing the
total to 10 production units. In real terms, both you and your neighbor
would be richer for specializing - and the local economy is one
production unit the better for it.
This example rings true on
the level of international trade as well. Britain provided support for
comparative advantage by essentially outsourcing
its food growth (importing grains, meat, cheese, wine, etc.) and
focusing on manufacturing goods for export, thus, becoming the workshop
of the world during the industrial revolution. comparative advantage
urges nations to engage in true free trade and to specialize in areas
where they have the highest comparative advantage, instead of looking to
bolster weak industries from foreign competition by imposing protective
tariffs that otherwise stifle the production that leads to overall
gains in wealth.
For more on economic laws, be sure to read our Economics Basics Tutorial.
Ref: http://www.investopedia.com/ask/answers/09/law-comparative-advantage.asp
