Comparative Advantage

Written By
Paul Tracy
Updated November 4, 2020

What is Comparative Advantage?

A firm's comparative advantage is its ability to produce a good or service at a lower opportunity cost than another entity.

How Does Comparative Advantage Work?

Famed economist David Ricardo first coined the term "comparative advantage" in the early 1800s.

Let's look at an example of the concept:

Assume that Company XYZ and Company ABC both make wood chips. Company XYZ is located in Oregon, where lumber is abundant; Company ABC is located in Death Valley, California, where lumber is not abundant.

Company ABC must spend more money than Company XYZ to make wood chips because it has to bring wood in from other states. Due to its location and resources, Company XYZ has a comparative advantage to Company ABC.

It is important to note that Company XYZ may not run its business any better than Company ABC; that is, it may not make the actual wood chips more efficiently than Company ABC (that's called "absolute advantage"). The competitive advantage come from Company XYZ's access to cheaper raw materials.

Value investors, including the great Warren Buffett, often call a company's comparative advantage a "moat." This moat should protect the firm's profitability during difficult conditions.

Why Does Comparative Advantage Matter?

Comparative advantage is a theory based on relativity. If a country or company is relatively better at making a product, it should make that product and not something else. As such, comparative advantage is an important concept in global trade, and it's the reason many countries concentrate on trying to produce certain goods or services more efficiently than other countries.

Characteristics of an economy, like the amount of fertile land, a specialized workforce, the presence of natural resources, or an advanced infrastructure, influence which comparative advantages countries have. This notion supports the idea that every country has something to gain from engaging in trade.

Activate your free account to unlock our most valuable savings and money-making tips
  • 100% FREE
  • Exclusive money-making tips before we post them to the live site
  • Weekly insights and analysis from our financial experts
  • Free Report - 25 Ways to Save Hundreds on Your Monthly Expenses
  • Free Report - Eliminate Credit Card Debt with these 10 Simple Tricks
Ask an Expert
All of our content is verified for accuracy by Paul Tracy and our team of certified financial experts. We pride ourselves on quality, research, and transparency, and we value your feedback. Below you'll find answers to some of the most common reader questions about Comparative Advantage.
Be the first to ask a question

If you have a question about Comparative Advantage, then please ask Paul.

Ask a question

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

If you have a question about Comparative Advantage, then please ask Paul.

Ask a question Read more from Paul
Paul Tracy - profile
Ask an Expert about Comparative Advantage

By submitting this form you agree with our Privacy Policy

Don't Know a Financial Term?
Search our library of 4,000+ terms