Emerging Markets & Comparative Advantage

This post explains comparative advantage, country risk, and how businesses can assess emerging markets.

Q1. How does opportunity cost relate to comparative advantage?

Comparative advantage is the ability to produce a good or service at a lower opportunity cost than another producer. Opportunity cost is the value of the best alternative given up when a choice is made. It is not simply the money or labor cost of production.

Absolute advantage means being able to produce more with the same resources. A producer can have an absolute advantage in every good and still have a comparative advantage in only some of them. Comparative advantage depends on comparing opportunity costs.

Example: Suppose two countries produce only guns and butter. If all resources are used for one product, Country A can produce 12 guns or 8 units of butter. Country B can produce 8 guns or 4 units of butter.

• In Country A, producing 1 gun means giving up about two-thirds of a unit of butter. Producing 1 unit of butter means giving up 1.5 guns.
• In Country B, producing 1 gun means giving up half a unit of butter. Producing 1 unit of butter means giving up 2 guns.

Country A has an absolute advantage in producing both goods because it can produce more of each. But Country B has the comparative advantage in guns because its opportunity cost for producing a gun is lower. Country A has the comparative advantage in butter because its opportunity cost for producing butter is lower. Specializing according to comparative advantage can allow both countries to gain from trade.

Q2. What is country risk, and how do political and legal systems contribute to it?

Country risk is the possibility that political, economic, or legal conditions in a country will cause losses or disrupt a business or investment. A government defaulting on its debt is one example, but country risk also includes events such as sudden policy changes, political instability, trade restrictions, or difficulty enforcing contracts.

Political system: The institutions and processes through which a country is governed and political decisions are made. These may include the executive branch, legislature, political parties, elections, and other groups that influence policy.

Legal system: The laws, courts, and procedures used to interpret and enforce rules. A country’s legal system affects matters such as contracts, property rights, employment, taxes, business permits, and intellectual property.

Political and legal risks are related, but they are different. For example, a government may decide to impose trade sanctions as a political action. Those restrictions then affect businesses through laws and regulations. The United States maintains sanctions programs involving Iran and North Korea; the exact restrictions can change, so companies must check the rules that apply to their activities.

Legal-system risk can also arise when a company has difficulty understanding local regulations or enforcing a contract. A company entering a new market should learn which permits it needs, how disputes are resolved, and whether its contracts and intellectual property will receive legal protection.

A historical example of political and social opposition to globalization occurred in Millau, France, in 1999. French farmers dismantled a McDonald’s restaurant that was under construction as part of a protest connected to agricultural and trade disputes. The event shows how public opposition to government and trade policies can affect a company’s operations and reputation.

Q3. What difficulties can businesses face in emerging markets, and how should they choose a market?

Emerging markets can offer businesses opportunities for growth, but conditions vary widely from one country—and one city—to another. Potential difficulties include political instability, corruption, economic uncertainty, changing regulations, complex bureaucracy, currency risk, logistics problems, and differences in consumer behavior. A strategy that works in one emerging market may not work in another.

A business should compare potential markets systematically before expanding. It can assess:

• Customer demand: Which customers need the product, how many can afford it, and how do they prefer to buy?
• Competition: Which local and international businesses already serve those customers?
• Political and legal conditions: What rules, permits, taxes, trade restrictions, and protections apply?
• Economic and financial conditions: How stable are prices and exchange rates, and how easily can customers make payments?
• Operating conditions: Can the business find suitable staff, suppliers, transport, technology, and local partners?

For example, an education company comparing two emerging markets could estimate demand for its courses, study local competitors, check education and data-protection rules, and examine how customers make payments. It should compare cities as well as countries, since infrastructure, customer needs, and costs may differ within the same country.

After comparing the options, the company could test its service in one city or customer segment before investing heavily. Local legal and business advisers can help it understand regulations and operating practices. The company should set clear measures for the pilot—such as customer sign-ups, course completion, costs, and repeat purchases—and expand only if the results support doing so.

Sources: OpenStax: Absolute and Comparative Advantage; U.S. Treasury: Sanctions Programs and Country Information; INA: The Millau McDonald’s protest.