Unit 4: Comparative Advantage

Comparative advantage is a dynamic concept meaning that it can and does change over time. For a country, the following factors are important in determining the relative unit costs of production:




1. The quantity and quality of factors of production available for example some countries have an abundant supply of good quality farmland, oil and gas, fossil fuels. Climate and geography have key roles in creating differences in comparative advantage.

2. Different proportions of factors of production – some countries have abundant low-cost labour suitable for volume production of manufacturing products.

3. Increasing returns to scale and the division of labour – increasing returns occur when output grows more than proportionate to inputs. Rising demand in the markets where trade takes place helps to encourage specialisation, higher productivity and internal and external economies of scale. These long-run scale economies give regions and countries a significant advantage.

4. Investment in research & development which can drive innovation and invention

5. Fluctuations in the exchange rate, which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers.

6. Import controls such as tariffs, export subsidies and quotas – these can be used to create an artificial comparative advantage for a country's domestic producers.

7. The non-price competitiveness of producers - covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support. Many countries are now building comparative advantage in high-knowledge industries and specializing in specific knowledge sectors – an example here is the division of knowledge in the medical industry, some countries specialize in heart surgery, others in pharmaceuticals.

8. Institutions – these are important for comparative advantage and important for growth too. Banking systems are needed to provide capital for investment and export credits, legal systems help to enforce contracts, political institutions and the stability of democracy is a key factor behind decisions about where international capital flows.

Comparative advantage is often a self-reinforcing process.



Entrepreneurs in a country develop a new comparative advantage in a product either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets

Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on

The expansion of an industry leads to external economies of scale.