Comparative advantage is when a country can produce one thing more efficiently than it can produce another thing. The idea is straightforward enough: if Germany is better at making beer than it is at making pizzas it has a comparative advantage in brewing. But economists get really excited about the idea of comparative advantage because of what it implies about international trade.
To start, it’s helpful to explain a related idea: absolute advantage. A country has an absolute advantage if it can produce something more efficiently than another country. Germany is better than making beers than Italy, so it has an absolute advantage in brewing. Italy is better at making pizzas than Germany, so it has an absolute advantage in pizza making. In this situation, it’s not hard to see why the Germans and Italians might want to get together to swap beer for pizza. If they both stick to making only what they’re better at, there should be more beer and more pizza to go around.
But what would happen if the Italians, after years of studying and investing in new breweries, got a lot better at making beer? So much better that they could actually make quality beer more efficiently than the Germans?! Italy would have an absolute advantage in both brewing and pizza making (compared to Germany).
What should the countries do now that Italy’s top dog at both brewing and pizza making? They could stop trading, and both go back to making their own pizza and their own beer. But Italy is still relatively better at making pizza than it is at making beer—it’s slightly better than Germany at brewing, but way better than Germany at making pizza. In this situation the two countries could still have more beer and more pizza if they stuck to making what they are comparatively better at, and then trading.
Not every country is the best at producing something. But every country is comparatively better at producing some things than others. This implies that if every country were to specialize and produce what it has a comparative advantage in and then trade, the entire world could be better off.
Since this theory came on the scene in the early 1800s, it has been one of the most popular and important arguments for free trade. But not everyone is convinced the theory translates so well into real life (as the difficulties of shipping pizzas across Europe might indicate).
It’s also worth pointing out that the theory of comparative advantage only claims that with trade, the world can produce more than without it. Whether that’s a good idea or not is a much messier and complicated issue.