An entity has comparative advantage in a product or service when it produces that product or service at a lower opportunity cost than another entity. In means that the entity with a comparative advantage in Product A has to forgo less of another product, say product B, to produce more of Product A.
The principle of comparative advantage is the basis on which international trade is encouraged. It proposes that countries should specialize in producing products and services in which they have comparative advantage because this will increase the total world production of all goods and services and increase the standard of life.
The concept of comparative advantage can also be applied to businesses and individuals.
Example 1: Eastern Furnishing (EF) and Western Furnishers (WF) are two businesses engaged in production of chairs and tables. Both have 20 carpenters half specializing in producing chairs and half in producing tables. EF produces 20 tables and 40 chair per day while WF produces 25 tables and 45 chairs per day.
WF has clear absolute advantage because it produces more tables and more chairs as compared to EF using the same amount of resources (carpenters). EF produces 2 tables and 4 chairs per carpenter, while WF produces 2.5 tables and 4.5 chairs per carpenter. Current production is 45 tables and 85 chairs.
If EF decides to produce 1 more table, it has to forego 2 chairs (4 chairs produced for 2 tables). On the other hand, if WF decides to produce 1 more table, it has to forego 1.8 chairs (4.5 chairs produced for 2.5 tables). WF has lower opportunity cost in producing chairs, which suggests it has comparative advantage in production of chairs. EF on the other hand, has lower opportunity cost in producing tables and comparative advantage in production of tables. EF should specialize in producing tables and WF should specialize in producing chairs. After specialization, the world production of tables would be 50 (= 25 × 2) and production of chairs would be 90 (= 45 × 2). Specialization has resulted in production of 5 more tables (= 50 − 45) and 5 more chairs (= 90 − 85).
** Example 2:** Katarina Neuhausova and Veronika Katocsova are partners in a professional consultancy firm engaged in providing audit and tax services. Currently, both of them stay abreast with changes affecting both audit and tax business and earn $4,000 per day. Katarina spends 4 hours on audit earning $800 and 4 hours on tax earning $1,600. Veronika earns $600 from audit work of 4 hours per day and $1,000 from tax work in the rest of the 4 hours.
Veronika suggested that they should specialize as it will reduce the cost that go into updating skills relevant to both segments. They pulled out some data and did some analysis, a summary of which is given below:
|Revenue per Hour|
|Audit Services||Tax Services|
Veronika is worried to know that Katarina has absolute advantage in both audit and tax. She thinks specialization will not be helpful.
Though it is true that Katarina has absolute advantage, they can still benefit from specialization. In order to earn one more dollar of audit revenue, Veronika has to forego 1.67 dollar of tax revenue (= $250 ÷ $150). In order to earn one more dollar of audit revenue Katarina, on the other hand has to forego 2 dollar of tax revenue (= $400 ÷ $200). This tells that Veronika has comparative advantage in tax and Katarina has absolute advantage in audit. Veronika should specialize in tax and Katarina in audit. After specialization their revenue should would be $4,400 (= 8 × 400 + 8 × 150). Specialization due to the principle of comparative advantage has resulted in increase in revenue by $400 per day.
Written by Obaidullah Jan, ACA, CFA and last modified on