With 101 new companies are created every hourThe small business sector is as competitive as ever.
As an entrepreneur, you are always striving to get ahead – to gain an advantage over your competitors.
One of the easiest ways to do this is to focus on what your company does best (and avoid doing things your company isn’t particularly good at).
If you do this, you can increase the efficiency and profitability of your business without breaking a sweat. Welcome to Comparative Advantage 101.
In this article, we define comparative advantage and explain how it is calculated. We also compare it to other types of benefits and highlight its advantages and challenges.
What is comparative advantage?
To understand the economic theory of comparative advantage (or CA, as we call it for short), it is equally important to understand its sister concept, opportunity cost.
Opportunity cost is the potential benefit your company misses out on by choosing one option instead of another.
As a rule of thumb: the company with the lower opportunity cost has a CA.
All in all, 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 two small businesses: Kathy’s Coffee and Patsy’s Pastries.
Both shops sell coffee and pastries.
Kathy’s Coffee can produce 200 cups of coffee or 80 pastries per day, while Patsy’s Pastries can produce 150 cups of coffee or 75 pastries in the same period.
For Kathy’s Coffee, the formula for calculating the opportunity cost of production applies:
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
For Patsy’s Pastries, the formula for calculating the opportunity cost of production is:
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 coffee production because its opportunity cost (0.4 units) is lower than that of Patsy’s Pastries (0.5 units).
On the other hand, Patsy’s Pastries has a CA in producing pastries because its opportunity cost (2 cups of coffee) is lower than that of Kathy’s Coffee (2.5 cups of coffee).
If Kathy’s Coffee specializes in making coffee and Patsy’s Pastries specializes in making pastries, they may be able to become trading partners: exchanging coffee for pastries and vice versa.
When Kathy’s Coffee and Patsy’s Pastries work together based on their CAs, they can operate more efficiently and profitably than if they manufactured both products separately.
What are absolute advantages and competitive advantages?
CA should not 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 with fewer resources or, alternatively, produce more goods with the same resources.
For example, if Adam’s Autos can produce 10 cars with 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 compared to competitive advantage, where your company is able to produce goods or services that have greater value to consumers than another company.
Securing a competitive advantage is a little more demanding and time-consuming than a certification body.
Because only through comprehensive market research can your company truly gain a competitive advantage to find out what other companies are doing and how they do it.
There are three main ways your company can gain a competitive advantage:
- Produce high quality goods or services
- Offer the cheapest goods or services
- Supply goods or services to a niche market
Advantages and Challenges of Comparative Advantage
CA can benefit small businesses in several ways:
- 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 better company reputation, which can attract more customers.
- Increases efficiency. When your company specializes in producing specific goods or services rather than being a “jack of all trades,” it often uses its time, money, and labor more effectively, resulting in higher productivity.
- Reduces costs. Focusing your company on producing goods or services where it has a certification body can reduce production costs. This, in turn, can lead to a win-win situation – lower prices for your customers and higher profit margins for your business.
- Promotes innovation. Specializing in products or services can lead to investing in improving the key drivers of your business offering. This innovation can lead to an increase in new and improved goods or services.
- Expands trading opportunities. CA promotes trade between companies and gives your company access to a wider range of products or services than it could produce on its own.
On the other hand, CA has a number of disadvantages for small businesses, primarily the possibility of excessive dependence on other businesses for complementary goods or services.
For example, if one of your trading partners experiences a supply chain disruption or quality control issue, their problems can quickly become your problems, negatively impacting your business.
Another challenge of CA is that it can increase competition.
If you choose to specialize, your business could face strong competition from larger companies that can typically produce goods or services at significantly lower costs due to economies of scale.
Economies of scale are cost savings that occur when your company increases its production volume and becomes more efficient, resulting in a lower cost per unit.
For example, if your company purchases goods in large quantities (bulk buying), suppliers often offer discounts that reduce the per unit cost of the goods.
Final thoughts
If your company produces specialized goods or services at a lower opportunity cost and receives a CA, it can leverage its strengths by building effective, mutually beneficial trading partnerships.
This can lead to better products or services, lower prices, higher sales margins and ultimately higher profitability.
CA also carries risks, but your company can minimize these by, for example, building solid relationships with multiple trading partners and diversifying its product or service offerings.
The good news is that your business doesn’t need an unfair advantage to get ahead. CA is enough.
