Comparative Advantage Example

Overview 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 that is its ability to produce service or goods when compared to another firm or entity at a lower cost of opportunity.

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 in which 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.

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 should each country make 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 is having an absolute advantage in either producing Wine or cloth when compared with the United Kingdom. With one labor hour its either 30 units of cloth or its 30 units of wine. From this one can conclude that the United States has an absolute advantage.

In order to determine the comparative advantage, we shall determine the opportunity cost of wine and cloth for both countries.

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 and 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 United Kingdom has a comparative advantage in producing wine.

Comparative Advantage Example – #2

Company A produces cars and bikes and 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 than company B. Based on the below table you are required to 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 bike when compared with Company A.

In order to determine the comparative advantage, we shall determine the opportunity cost of car and bike for both the 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 the Company’s B and hence the claim made by Company A that has a comparative advantage in making a car is incorrect and rather it has a comparative advantage in producing bike.

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 unit of Beer
• Opportunity Cost of 1 Beer = 0.05 units of Smartphone

For Country XYZ:

• Opportunity Cost of 1 Smartphone = 25 unit of Beer
• Opportunity Cost of 1 Beer = 0.04 units of Smartphone

Determine which country will trade for which product and given that smartphone that can be produced by using equal scare resources when both countries decide to apply a comparative advantage technique.

Solution:

The comparative advantage for smartphones lies with country PQR and the comparative advantage for Beer lies with Country XYZ. And if there is free trade and both the countries decide to use the comparative advantage technique than company XYZ should import smartphones and Company PQR should import Beer which shall increase the available quantity of both the products.

Comparative Advantage Example – 4

JP Morgan uses two web-based applications for booking their trades for fixed income securities and reports which are FISCO and IMPACT. Both are used in different regions. One is used for the EMEA region and another one is used for the North America Region. The management has been seeing that the following are the outputs.

The management of the company is looking to either switch the system into one or use one system for one type of product. You are required to advise the management as to 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 either Bond or Repos when compared with FISCO as it takes lesser time.

In order to determine the comparative advantage, we shall determine the opportunity cost of booking Bond and Repo for both the web-based system.

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 in comparison to 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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