What is comparative advantage and how does it help small business owners?

With 101 new businesses being launched every hour, the small business sector is as competitive as ever.

As an entrepreneur, you’re always striving to get ahead—to gain an advantage over your competitors.

One of the easiest ways to do this is to focus on doing what your business does best (and avoid doing what your business doesn’t excel in).

When you do this, you can increase the efficiency and profitability of your business without even breaking a sweat. Welcome to comparative advantage 101.

In this article, we’ll define comparative advantage and explain how to calculate it. We’ll also compare it to other types of advantage and map out its benefits and challenges.

What is a comparative advantage?

To understand the economic theory of comparative advantage (or CA as we’ll call it for short), it’s equally important to understand its sister concept, opportunity cost.

Opportunity cost is the potential benefit your business misses out on when it chooses one option instead of another.

The rule of thumb is: the company with the lower opportunity cost has a CA.

Putting this all together, CA refers to your company’s ability to produce goods or services at a lower opportunity cost than another company.

How to calculate comparative advantage

Consider 2 small businesses: Kathy’s Coffee and Patsy’s Pastries.

Both shops have coffee and pastry-making capabilities.

Kathy’s Coffee can produce 200 cups of coffee or 80 pastries a day whereas Patsy’s Pastries can produce 150 cups of coffee or 75 pastries in the same timeframe.

For Kathy’s Coffee, the formula for calculating the opportunity cost of producing:

1 cup of coffee is:

80 pastries / 200 cups of coffee = 0.4 pastries

1 pastry is:

200 cups of coffee / 80 pastries = 2.5 cups of coffee

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For Patsy’s Pastries, the formula for working out the opportunity cost of producing:

1 cup of coffee is:

75 pastries / 150 cups of coffee = 0.5 pastries

1 pastry is:

150 cups of coffee / 75 pastries = 2 cups of coffee

Kathy’s Coffee has a CA in producing coffee because its opportunity cost (0.4 pastries) is lower than Patsy’s Pastries (0.5 pastries).

On the other hand, Patsy’s Pastries has a CA in producing pastries because its opportunity cost (2 cups of coffee) is lower than Kathy’s Coffee (2.5 cups of coffee).

If Kathy’s Coffee specialises in producing coffee and Patsy’s Pastries specialises in producing pastries, they can potentially become trade partners: trading coffee for pastries and vice versa.

When Kathy’s Coffee and Patsy’s Pastries trade together based on their CAs, they can operate more efficiently and profitably than if they produced both products individually.

What are absolute advantage and competitive advantage?

CA shouldn’t be confused with absolute advantage, which is your company’s ability to produce goods or services more efficiently than another company.

This means your business can deliver the same amount of goods using less resources or, alternatively, it can produce more goods with the same resources.

For instance, if Adam’s Autos can produce 10 cars using the same amount of resources that Brian’s Bangers uses to produce 5 cars, Adam’s Autos has an absolute advantage in car production.

CA should also be contrasted with competitive advantage, which is when your business has the capacity to produce goods or services that are of better value to consumers than another business.

It’s a bit more challenging and time-consuming to secure a competitive advantage than it is a CA.

This is because your business can only really gain a competitive advantage by conducting extensive market research in order to find out what other businesses are doing and how they’re doing it.

There are 3 main ways your company can gain a competitive advantage:

1. Produce superior goods or services
   
2. Offer the lowest-priced goods or services
   
3. Deliver goods or services for a niche market
   

Benefits and challenges of comparative advantage

CA can benefit small businesses in several ways:

1. Produces higher quality products or services. When your business plays to its strengths, it can often produce better quality products or services. The byproduct of this is a stronger business reputation, which can draw in more customers.
   
2. Increases efficiency. Similarly, when your business specialises in producing certain goods or services—rather than being a “Jack (or Jill) of all trades”—it often uses its time, money, and labour more effectively, which leads to higher levels of productivity.
   
3. Reduces costs. When you focus your business on producing goods or services where it has a CA, this can reduce its production costs. This may, in turn, result in a win-win situation—lower prices for your customers and higher profit margins for your business.
   
4. Spurs innovation. Product or service specialisation can lead you to invest in improving the main drivers of your business offering. This innovation can lead to an uptick in new and improved goods or services.
   
5. Expands trade opportunities. CA prompts trade between businesses, giving your business access to a broader range of products or services than it could produce alone.
   

On the flip side, CA has a number of drawbacks for small businesses, primarily the potential for over-dependence on other businesses for complementary goods or services.

If, for example, one of your trading partners experiences supply chain disruption or quality control issues, their problems can quickly become your problems, which adversely affect your business.

Another challenge of CA is that it can increase competition.

By choosing to specialise, your business may face stiff competition from larger businesses that can typically produce goods or services at a significantly lower cost due to economies of scale.

Economies of scale are cost savings that are derived when your business increases its production volume and becomes more efficient, resulting in a lower cost per unit.

For example, when your business buys goods in large quantities (buying in bulk), suppliers often offer discounts, which reduce the cost of the goods per unit.

Final thoughts

When your business produces specialist goods or services at a lower opportunity cost and gains a CA, it can capitalise on its strengths by forming effective, mutually beneficial trade partnerships.

This can lead to better products or services, lower prices, stronger sales margins and ultimately, increased profitability.

CA has its risks, too, but your business can minimise them by, for example, building robust relationships with multiple trade partners and diversifying its product or service offerings.

The good news is, your business doesn’t need an unfair advantage to get ahead. CA will do.