What is Comparative Advantage?

 

Comparative Advantage

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Comparative Advantage

Comparative advantage is when an organization produces a good or service for a lower opportunity cost than other organizations. Comparative advantage occurs when an organization can produce a good or service at a lower opportunity cost than another. Comparative advantage means an organization can produce a good relatively cheaper than other organizations.

Even if one organization is more efficient in the production of all goods (absolute advantage) than the other, both organizations will still gain by trading with each other, if they have different relative efficiencies.

Opportunity cost measures a trade-off. An organization with a comparative advantage isn’t necessarily the best at producing something. The benefits of buying their good or service just outweigh the disadvantages. That means the good or service has a low opportunity cost for other organizations to import. For example, oil-producing organizations have a comparative advantage in chemicals. That’s because the oil provides a cheap source of material for the chemicals when compared to organizations without it.

As a result, Saudi Arabia, Kuwait, and Mexico compete well with U.S. chemical production firm. Their opportunity cost is low. That makes their chemicals less expensive. That’s because a lot of the raw ingredients produced in the oil distillery process.

Another example is India’s call centers. U.S. companies buy this service because it is cheaper than locating the call center in America. Indian call centers aren’t better than U.S. call centers. Their workers don’t always speak English very clearly. But they can do it cheap enough to make the tradeoff worth it.

In the past, comparative advantages occurred more in goods and rarely in services. That’s because goods and services are easier to export. But telecommunication technology like the internet is making services easier to provide across organizational or regional boundaries. That includes call centers, banking, and entertainment.

Theory Of Comparative Advantage

Eighteenth-century economist David Ricardo created the theory of comparative advantage. He argued that an organization boosts its economic growth the most by focusing on the industry in which it has the largest comparative advantage.

For example, England could manufacture cheap cloth. Portugal had the right conditions to make cheap wine. Ricardo predicted that England would stop making wine and Portugal stop making cloth. He was right. England made more money by trading its cloth for Portugal’s wine, and Portugal made more money by selling wine for cloth. It would have cost England a lot to make all the wine it needed because it lacked the climate. Portugal didn’t have the manufacturing ability to make cheap cloth.

Therefore, they both benefited by trading what they produced the most efficiently.

This theory of comparative advantage became the rationale for free trade agreements. Ricardo developed his argument to combat trade restrictions on imported wheat in England. He argued that it made no sense to restrict low-cost and high-quality wheat from organizations with the right climate and soil conditions. England would receive more value by exporting products that skilled labor and machinery. It could receive more wheat in trade than it could grow on its own.

The theory of comparative advantage explains why trade protectionism doesn’t work in the long run. Political leaders are always under pressure from their local constituents to protect jobs from international competition by raising tariffs. But that’s only a temporary fix.

In the long run, it hurts the organization’s competitiveness. It allows the organization to waste resources on unsuccessful industries. It also forces consumers to pay higher prices to buy domestic goods.

Example:

America’s comparative advantage is its large land mass, bordered by two oceans. It also has lots of fresh water, arable land, and available oil. It has a diverse population with a common language and organizational laws. For more, see The Power of the U.S. Economy.

All of this gives U.S. businesses cheap natural resources and protection from land invasion. Most importantly, the diverse population provides a large test market for new products. That’s helped the United States became a global leader in banking, aerospace, defense equipment, and technology. For more, see The Four Major Things the United States is Good at Producing and How Silicon Valley is America’s Innovative Advantage.

Limitations Of Comparative Advantage Theory

We need to be careful, as comparative advantage theory does not explain all changes in trade patterns. It is an important explanation, but you also need to consider that:

  • Transport costs and tariffs will change the relative prices of goods and may, therefore ‘blur’ the impact of comparative advantage.
  • Exchange rates do not always relate exactly to what comparative advantage theory suggests as they have many other determinants – this may also negate the argument.
  • Imperfect competition may lead to prices being different to opportunity cost ratios. Imperfect competition may also result in the exploitation of economies of scale which may adjust to what comparative advantage theory suggests should happen.

Comparative advantage theory is a static theory and does not take account of some of the more dynamic elements determining world trade, such as production capital not being a natural resource, and so may come outside the scope of the theory.

Absolute Advantage

Absolute advantage is anything an organization does more efficiently than other organizations. Organizations that are blessed with an abundance of farmland, fresh water, and oil reserves have an absolute advantage in agriculture, gasoline, and petrochemicals.

Just because an organization has an absolute advantage in an industry doesn’t mean that it will be its comparative advantage. That depends on what the trading opportunity costs are. Say its neighbor has no oil but lots of farmland and fresh water. The partner is willing to trade a lot of food in exchange for oil. Now the first organization has a comparative advantage in oil. It can get more food from its neighbor by trading it for oil than it could produce on its own.

Competitive Advantage

Competitive advantage is what an organization, business or individual does that provides a better value to consumers than its competitors.

There are three strategies companies use to gain a competitive advantage.

  • They could be the low-cost provider.
  • They could offer a better product or service.
  • They could focus on one type of customer.

Potential Strategies For Differentiation

The following strategies may be helpful in differentiating a product or service from those of the competition. It is important to keep in mind that an enterprise’s most efficient differentiation the one that will bring the enterprise the most success-will likely come from just one or two strategies.

  • Product Features and Benefits

What makes the product unique and desired? Consider product characteristics such as style, handling, taste, quality ingredients, comfort, production methods (such as natural or organic), certification and so on. Are the product characteristics significantly different from those of currently available products? Can the enterprise provide these features or benefits efficiently?

  • Location(s)

What about the enterprise’s location is a draw to customers? The office or store location is often a significant factor, particularly for enterprises selling directly to the public. The site is chosen carefully, preferably in an area near customer traffic. For example, in a farmer’s market setting, is the both located in a visible, convenient, and accessible place? Being tied to an existing location will directly influence other decisions, such as marketing, product distribution (such as mail order/Internet versus roadside stand), and even product selection. If this is the case, would it be possible for the enterprise to partner with someone who has a better location, if the one provided is not as attractive?

  • Staff

Consider the factors which ensure that front and managerial staff produce an excellent product and deliver a positive customer experience. Do the enterprise’s personnel follow these factors? Do they act professionally? Do they have expertise with the product, on which customers can rely?

  • Operating Procedures

What policies, processes, and standards are adopted to smooth operations, create value, and offer a positive customer experience?

  • Price

What fundamental cost advantage does the enterprise have which would justify permanently low prices? Most enterprises operating in the same industry in a location will tend to have pretty much the same cost structure, meaning that when one competitor cuts price, others usually follow, thus erasing whatever advantage the first competitor gained by reducing costs. Ways to achieve a fundamental cost advantage might be through lower overhead or shipping costs (perhaps through geographic closeness to markets), cheaper labor, and low-priced raw materials (perhaps through long-term purchase agreements).

  • Customer Incentive Programs

Does the enterprise employ programs which attract new and repeat customers through efforts such as giveaways, coupons, sales, promotions, and volume discounts?

  • Guarantees and Warranties

If the enterprise is conveying to clients that it provides a quality product, is that perception reinforced with guarantees and warranties?

  • Brand Name Recognition

A carefully conceived and executed marketing plan with a focus on the customer is a significant contribution to business success. A good marketing strategy can be enough to differentiate one business from the rest, all other things being equal. Brand name recognition is reliant upon a good marketing strategy and a consistent, reliable product and enterprise. Enterprises who do not have the resources available to market themselves as their brand may want to consider joining an alliance or cooperative to sell their product under a recognizable brand name.

  • Goodwill

Is the business enterprise recognized within the community as a contributor and a valuable member?

  • Value-Added Products/Services

Does the enterprise offer a further service or a better product? These value-added aspects may often be free with the purchase of a product, such as free installation or delivery.

  • Extended Growing/Operating Season

Is the enterprise’s product available before or after competitor’s products? For instance, being the first to open for the season?

  • Water, Access to Irrigation, and Wetlands

Are there sufficient water resources available to produce a product which might not typically be manufactured in the region? Is it possible to differentiate the enterprise to consumers by performing good stewardship of the enterprise’s water resources?

  • Weather

Is the weather conducive to producing and to sell the product or service? For instance, weather resources are wind, rain, and sun. While in a small geographic area these same resources would be available to all competitors, an enterprise that is trying to compete in a larger geographic area may face competition from producers located in an entirely different region, who are exposed to various weather resources.

  • Plants and Animals

If the enterprise is agritourism-based, then what wildlife can be supported? For example, can the agritourism enterprise involve bird watching, or is livestock available for a petting zoo for rides? For more traditional operations, can the enterprise’s location support the plants and animals that are intended for use? Can the enterprise offer a unique heirloom variety or exotic breed with potential benefits?

  • Organization and Alliances

Does the enterprise have unique alliances or sources of supply? Some enterprises can pool resources to provide a unique offering, such as through a cooperative.

  • Customer Experience

For example, offering customers with additional information about the enter/purchase is a way for clients to connect to the company. This connection can be strengthened through identifying with the client or visiting the customer, or the customer’s website.  Offering educational resources and information about the history of and people associated with the company.

  • Quality

With all the above potential sources of competitive advantage, quality is an underlying factor. Successful enterprises offer consistent quality, so an important consideration for any enterprise is how quality is going to be perceived and measured. In some cases, quality may be related to value-added strategies, such as obtaining third party certification for organics, Kosher production, etc… In other cases, quality may be related to the fact that the product being offered is of a higher physical quality than the competitor’s product, or from providing excellent customer service.

Related References

 

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