What it is:
A firm's comparative advantage is its ability to produce a good or service at a lower opportunity cost than another entity.
How it works/Example:
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. Click here to learn How Buffett Made a +362,000% Gain by finding companies with sustainable comparative advantages.
Why it matters:
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.