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Competitive Advantage: Definition & Importance in Trade

Competitive Advantage: Definition & Importance in Trade

Competitive advantage in production is the ability of an individual, a company or a country to manufacture products, commodities with a lower opportunity cost compared to other competitors.

What is a comparative advantage (competitive advantage)?


Comparative advantage in manufacturing activity of an individual, a company or a nation is the ability to manufacture a product or perform a service with a lower opportunity cost compared to others. This means that in the certain time taken to produce one unit of any product, the benefits that they have to trade off (including health, time, and incomes from other jobs) are fewer than their competitors; therefore, they can work on this job at a lower cost. This also means that their goods and services will be priced lower than those of  their competitors, and it results in higher sales revenue.

The law of comparative advantage is said to have been discovered by the British political - economist David Ricardo in “On the Principles of Political Economy and Taxation”, written in 1817, and by James Mill, his mentor.


How to understand the Competitive Advantage


Comparative advantage is one of the important concepts proving that: any country or individual, business, at any time, can mutually benefit from the increased cooperation and trade activities. To comprehend comparative advantage, we need to understand the definition of opportunity cost. Opportunity cost represents the potential benefits that a person must dispose of when choosing one alternative while giving up others. The smaller the opportunity cost is, the greater the competitive advantage is.


For example


Michael Jordan is a basketball star who is exceptionally physically superior compared to other athletes. Supposedly, Michael can finish painting in 8 hours due to his physical strength and height. However, for the same 8 hours, he can shoot commercial ads for $50,000 because he is a basketball superstar.


In contrast, neighbor Joe could paint the same house in 8 hours. However, in the same amount of time, if Joe doesn’t paint the house, with his current high school degree, he can only run the table for a wage of $100, which is due to the fact that he has no special talent.

Thus, in this case, Joe has a comparative advantage over Michael Jordan. This is because while they both paint the house in 8 hours, Joe's opportunity cost is much lower, just $100 wage compared to Michael's $50,000 compensation from commercial ads.


The best deal right now is that Michael shoots the commercial ads and in the meantime pays Joe to paint the house. With this arrangement, Michael Jordan and Joe will get the best outcome. Michael spends 8 hours shooting commercials to earn $50,000, then pays Joe $100 or more to hire him to paint the house.


What is the difference between competitive advantage and absolute advantage?


Comparative advantage is the opposite of Absolute advantage. Absolute advantage refers to the ability to produce in greater quantities and better quality than others. In contrast, comparative advantage is the ability to produce at a lower opportunity cost, not necessarily superior in quantity or quality. Comparative advantage helps small and undeveloped countries to gain a competitive edge in trade despite having no advantage in massive production or product quality. Thanks to low opportunity costs & cheap labor, underdeveloped countries can better produce simple items such as clothes, shoes, food, etc. Meanwhile, the developed countries with advanced science and technology will have more time and resources to produce more advanced products.


Example


(1) A lawyer will provide better legal services, type and organize faster than a secretary. In this case, the lawyer has an absolute advantage in providing both legal services and related tasks of the secretary. However, both parties benefit from an exchange based on comparative advantages. A lawyer makes $175/hour in legal services and $25/hour in secretarial work. Secretaries make $0/hour for legal services and $20/hour for secretarial work.


To fulfill the secretarial work, the lawyer will lose $150, a significant opportunity cost, for not doing legal services. Thus, it will be more profitable for a lawyer to do full time legal service and hire a secretary to type and arrange other secretarial work. Secretary literally has little to lose, which means that the opportunity cost per person is now much lower. This is how comparative advantage works.


(2) Australia possesses very modern agricultural technologies (greenhouse farming, farming management A.I system) that can bring about higher crop yield and better quality than Vietnam. However, in Australia, the salary expenses are expensive and research-investment expenses for these technological machines are also not cheap. Australia can use that time to invest in research in other higher-value industries such as aerospace, which is much more valuable and yield higher investment return. Therefore, although Australia has an absolute advantage, Vietnam should be the one to focus on agriculture as they have a comparative advantage over Australia thanks to cheap labor costs and abundant resources.