In previous article #7 we looked at the competitive advantage of comparative advantage. I wanted to explore comparative advantage further, and give an example that can apply to any combination of trade deals, be they intercompany departments, companies interacting with one another, regions and even countries trading with each other.
Comparative advantage is the relative, but not absolute advantage in one economic activity that one entity enjoys in comparison with other entities (Peng 2011). It is also defined as the law of association. This association has the ability to increase wealth, or the worth of those trading (or exchanging) those items that each is really good at. In essence, parties that specialize in what they are good at generally, the cost of their production is better than anyone else’s. Knowing this can put you in a position to evaluate your opportunity costs for producing similar or the same type of goods, or even other goods and services you may need. It also allows you to look at goods or services that you specialize in and supply, in opportunity cost terms.
What do we mean by opportunity cost? Opportunity cost is the cost of pursuing one activity at the expense of another activity, given that the alternatives may yield other opportunities (Peng 2011). In other words if you concentrate on producing/delivering what you are really good at, then you can gain an advantage by trading with another entity for goods or services that they are really good at, that you need.
In Article #7 I gave an example of trade between the UK and France. The UK, in this case was making both textiles and wine. Yes, for those that may not know, wine is made in the south of England. Likewise France makes wine and textiles also. However the UK is better known for making textiles than France, and France is better known for making wines than textiles.
Opportunity cost can be measured in the time it takes to produce. In this hypothetical example we will look at the time it takes the UK and France to make both products. Lets assume that in the time it takes to produce 10 bottles of wine, the UK can manufacture 100 shirts. France on the other hand can either produce 100 bottles of wine; or in the same time, produce 100 shirts.
Because the UK can produce 100 shirts or 10 bottles of wine it produces, its opportunity cost is 1 bottle of wine or 10 shirts. France’s opportunity cost is 1 bottle of wine or 1 shirt. If they traded with themselves, this is their respective opportunity cost. Recall, opportunity cost is the cost of pursuing one activity at the expense of another activity.
Another way of looking at this is, if we split each countries time available at producing both shirts and wine, the total production of goods between the two countries is, 100 shirts and 55 bottles of wine.
Because France and the UK are good at producing wine and shirts respectively, France and the UK can see that if they trade with each other, they can be more productive for each other and reduce their opportunity costs. So if the UK spends its time just producing shirts and making no wine, and France spends its time just making wine and no shirts, the total production will increase to 100 shirts and 100 bottles of wine, a gain of 45 bottles of wine, between the two countries with no extra effort or cost.
Now when the UK and France trade with each other, the UK can keep 5 shirts and trade with France 5 shirts for 1 bottle of wine. The opportunity cost to both countries has now reduced. Whereas the UK’s cost was 10 shirts or 1 bottle of wine, they now trade 5 shirts with France for 1 bottle of wine, or 10 shirts for 2 bottles of wine. France that had an opportunity cost of 1 shirt or 1 bottle of wine, now can get 5 shirts for trading 1 bottle of wine with the UK.
In summary, there is a lot of good news in specialising and trading. A) If you specialize at what you do then just producing what you are good at takes no extra effort or cost. B) It also gains you an advantage, as you don’t waste time on producing goods and services that you are not the best at. C) The two countries collectively produce more if they concentrate on what they are good at. D) That should make each country more efficient at producing their specialisation, which E) may increase their output further, hence more to trade with. And F) in this case, this would improve the trade between the two countries, and most probably reduce their opportunity costs further. The final piece of good news about this scenario, G) is that this can be applied across all products and services, in companies both internally and externally, regions and as we can see here, by countries.
References: Peng, M. W. (2011) “Global Business” 2nd Edition South Western Cengage Learning.
‘Strategic Global Group (SGG) establishes your Competitive Advantage’.
Phil Wilton has worked in MNC’s as well as developing start-ups and business expansion for SME’s. He received his MBA in International Business, Strategy, Marketing and Emerging Markets from the University of Liverpool. He also completed Business Strategy – Achieving Competitive Advantage at Cornel University.
Feel free to contact Phil (SGG) for a no obligation discussion on how he can help your firm.