In economics, comparative advantage refers to the ability of a person or a country to produce a particular good at a lower opportunity cost than another person or country. It can be contrasted with absolute advantage which refers to the ability of a person or a country to produce a particular good at a lower absolute cost than another.
Comparative advantage explains how trade can create value for both parties even when one can produce all goods with less resources than the other. The net benefits of such an outcome are called gains from trade.
Origins of the theory
Comparative advantage was first described by Robert Torrens in 1815 in an essay on the Corn Laws. He concluded it was England's advantage to trade with Poland in return for grain, even though it might be possible to produce that grain more cheaply in England than Poland.
However the term is usually attributed to David Ricardo who explained it in his 1817 book On the Principles of Political Economy and Taxation in an example involving England and Portugal. In Portugal it is possible to produce both wine and cloth with less labor than it would take to produce the same quantities in England. However the relative costs of producing those two goods are different in the two countries. In England it is very hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore while it is cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth. Conversely England benefits from this trade because its cost for producing cloth has not changed but it can now get wine at a lower price, closer to the cost of cloth. The conclusion drawn is that each country can gain by specializing in the good that it has comparative advantage in and trading that good for the other.
Limits of Applicability
Free mobility of capital in a globalized world
Ricardo explicitly bases his argument on an assumed immobility of capital:
" ... if capital freely flowed towards those countries where it could be most profitably employed, there could be no difference in the rate of profit, and no other difference in the real or labour price of commodities, than the additional quantity of labour required to convey them to the various markets where they were to be sold."
He even explains why from his point of view (anno 1817) this is a reasonable assumption:
"Experience, however, shews, that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connexions, and intrust himself with all his habits fixed, to a strange government and new laws, checks the emigration of capital."
In the 21st century however, capital is much more free to move internationally than Ricardo could possibly have imagined. An indication of that is "the fact that about one third of the $6.1 trillion total for world trade in goods and services in 1995 was trade within companies - for example between subsidiaries in different countries or between a subsidiary and its headquarters" and a further reduction of barriers against transnational investments is actively pursued by the WTO.
Consequently, Ricardo's original idea in its pure form does not apply to the modern world and neither do more modern versions of models for international trade that are based on the idea of comparative advantage, like the Heckscher-Ohlin model. "International trade (governed by comparative advantage) becomes, with the introduction of free capital mobility, interregional trade (governed by absolute advantage)."
This limit of applicability has been prominently voiced by renowned economist Herman Daly.
In Kicking Away the Ladder: Development in Historical Perspective and Bad Samaritans: The Myth of Free Trade and the Secret History of Capitalism , Ha-Joon Chang argues that the principle of comparative advantage was used by advanced industrial countries to keep undeveloped countries on agriculture instead of developing their own manufactures (which would have made them competition for the industrialized nations). Similar to the way that those individuals who have accumulated much capital support a free contract between themselves and wage-laborers, in order to employ them for labor and then sell the products of their labor and the owner's capital after taking a profit, those countries which have already industrialized prefer "free" trade between nations, in order to maintain a similar type of dependence of the undeveloped world upon the already developed world: with developed world capital employing the labor of citizens of undeveloped nations, then selling the products of their labor back to them through international trade (after taking a profit).