In a competitive marketplace, businesses need to know their advantage over others. Is it lower prices? A differentiated product? A service that targets a particular type of customer? This is the theory of competitive advantage. To win in business, developing and using that competitive advantage is critical.
While this notion works in the world of business, commerce between nations has been built on the concept of comparative advantage. First set out by the English economist David Ricardo in the 19th century, comparative advantage demonstrates that even if one country is better at producing all goods than another, they both still benefit from trade. Ricardo’s textbook example shows a simplified world economy consisting of two countries (England and Portugal) producing wine and cloth. In Ricardo’s example, Portugal could produce both more efficiently than England could. However, Portugal was superior to England at producing wine, so it made sense for England to produce cloth and trade it for Portuguese wine. If each country focused on producing the good for which it had a comparative advantage, then overall production of both wine and cloth would go up, leaving both countries better off as a result.
The critical difference between competitive advantage and comparative advantage is this: competitive advantage increases wealth (wins) by outperforming others; comparative advantage increases wealth (wins) by working with others. One is a zero-sum game; the other offers the chance for both parties to prosper.
Ricardo’s new ideas came at the ideal time in world history. Mercantilism had been the predominant economic model of the prior two centuries, advocating for trade surpluses with all nations. The fallout from the Napoleonic Wars had turned the geopolitical landscape of Europe upside down. And the Industrial Revolution was rapidly reshaping national economies.
More recently, comparative advantage has had a real-world impact over the course of the last century.
- The formation of the European Union over the past 70 years has removed barriers to trade and created an integrated economic environment that has allowed for increased specialization and mutual benefit.
- Large agricultural export countries like Brazil, the U.S., Argentina, Australia, and Ukraine have helped increase nutritional standards the world over.
- Starting in the 1990s, American technology companies began focusing on design and consumer tastes, outsourcing manufacturing to China, leading to most Americans having powerful technology in their pockets.
In the current discourse on trade and tariffs, competitive and comparative advantages are being confused. Countries are not the same as companies – international trade is not a zero-sum game.
It is important, of course, for one’s own country to increase wealth. Greater wealth provides opportunities for economic mobility. Economic mobility provides hope for the future. Countries that build comparative advantage in critical growth industries – for example, artificial intelligence, robotics, medical innovations, and services for aging populations – provide that hope and will succeed over the long term. The countries that invest considerable capital in R&D, scientific and engineering talent, and ecosystems that support entrepreneurialism will maintain their comparative advantage, even if other countries also benefit.
For companies, competitive advantage can manifest in the form of a price war, driving profits down for all parties. At the end of the day, one of those businesses may be the “winner” – having put most of their competitors out of business. They may have won, but they only won because the others lost – all parties have weakened their businesses and their future prospects. When a disruption or new entrant comes along, the “winning” business is unlikely to stay a winner for long.
Countries can do the same with a trade war, like the one taking shape today. While other countries may lose out, when trade and wealth decline across the board – comparative advantage in reverse – we have a “lose-lose” outcome. Each country still has to make the goods it needs, but they are less efficient at making them because of a new lack of supply. That diverts resources from building for the future and lessens the chance that the next generation will be better off than the last.
It should go without saying that short-term gain for long-term pain is not a good strategy. Good long-term capital strategies for countries to follow are investments in scientific research, education, critical infrastructure, and building effective savings and investment systems for retirement and education needs.
Two hundred years ago, David Ricardo put forth the idea that trade can be a win-win for countries of varying skills and specializations. It’s critical that we do not forget that lesson now. Global trade in goods, services, and capital can increase wealth for all – done right, it is a win-win, not a compromise.
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