In business, everyone talks about their competitive advantage. What do we do best? How do we leverage on that to be profitable? How do we improve and innovate to get ahead and stay ahead of the competition? There’s absolutely nothing wrong with this approach, as it’s proven to be successful and an indispensable part of a vibrant market system.
But economists also talk about comparative advantage, which while it sounds similar is really quite different. Anyone looking around the real world will notice some striking anomalies when looking at different countries.
How can businesses which appear at first glance to be uncompetitive – whether through higher costs or inferior products – survive competition? More puzzlingly, why is it that industries in some countries thrive, despite being less productive and efficient than the same industry in another country? And more puzzlingly still, why do countries trade similar products with each other? For example, Germany has a far more efficient and cost effective auto industry, yet the Germans export autos and auto parts to France and Italy, yet at the same time imports cars and parts from those very same countries.
The answer to that lies in comparative advantage. With the more usual competitive advantage, the aim is to beat the competition, gain market share, and grab the lion’s share of profits. Whoever manages to do this, management gets bonuses, shareholders gets dividends, investors see their share price go up, workers see their wages increase, and everyone’s happy – except for those who’ve lost out to the winner.
Comparative advantage on the other hand takes into account two things – different productivity levels, and scarce resources of land, labour and capital. It’s probably best illustrated with an example. Let’s take an industry – for example steel making – and assume there’s two countries. Country A is hyper efficient, with a high technological level and can make steel at $X per tonne. Country B is less efficient, with low productivity and a lower level of technological advancement. It can only make steel at $2X per tonne – about half as productive as Country A. From a competitive standpoint it’s no contest – Country A would beat Country B hands down and dominate the steel industry.
But now assume that we have another industry – say software development – which both countries can pursue. In Country A, software development costs $Y but in Country B they can only produce it at $4Y because of the lower skill level of its workforce, an even worse case than in steel making.
If we believe in competitive advantage, Country B is in a hopeless situation – they simply can’t compete with Country A at any level, or in any industry. But taking the principle of comparative advantage, there’s a way for both countries to actually benefit.
Because Country A is so much better at software development than it is at steel making, it can maximise the return on its use of resources by concentrating on software development at the expense of steel making. Country B on the other hand can utilise what it resources it has to make steel where it has a “comparative advantage”. The countries then can trade their production of the respective goods – both countries benefit as they’ve utilized their scarce resources to maximum benefit, despite Country B being relatively less efficient and less productive at everything.
So here we have the basis for globalization and trade – and the reason why developing countries such as China and Indonesia continue to attract FDI, and particularly labour intensive FDI. It’s not just because of low wages – low wages are a sign of low productivity – but because the labour in the countries that chose to invest here and in other developing countries such as Malaysia, are so much better at doing something else more valuable.
Theoretically, comparative advantage implies gains from trade, even if embarking on a particular industry doesn’t appear to make any sense from a competitive standpoint. Malaysia’s national auto industry can be taken as an example of this kind of effort, even if the result often leaves much to be desired. The principle was sound, even if the execution was less than ideal.
Comparative advantage also means we as Malaysians shouldn’t be afraid to embark on new industries, even if other countries appear to be so much better placed competitively. It would be nice to be on the more productive side of the trade equation (though that too has costs, as US manufacturing firms and American blue collar labour have discovered), but that’s not a necessary condition for reaping the benefits from trade.
Click here for our report on “Turning comparative advantages into competitive advantages”
*HishamH blogs for Economics Malaysia and is an applied and practicing economist in the Malaysian financial sector.
The views expressed here are the personal opinion of the columnist.
**Photo of workers in a Guangzhou factory courtesy of Edwin Lee