Comparative Advantage

Introduction

Specialization and trade between countries pays huge dividends to the participant countries, but the problem is that this is not obvious to people.  The benefit of specialization for individual workers is exceedingly clear.  If we were to try to be self-sufficient we would all have very meager lifestyles.  We would be opting to be “cavemen”, in effect.  We readily accept the thought that if I am a baker, and you are a brewer, etc., we can all live better.   It has been much harder for people to see that specialization pays off for countries, too.  The topic of comparative advantage brings out the benefits that countries can get from sticking to the production of those items at which they are relatively good, and leaving the production of other items to other countries.

 

A situation of comparative advantage arises when you have two countries, and one of them is better at the production of both of two items they both want.  The superior country would seem to be well advised to say, “who needs those other guys, we can do it better ourselves – we’ll just be self-sufficient.”  They would be wrong, however.  The superior country should use its valuable time to make the thing where they have the most pronounced superiority over the other country (the thing where they are “more better”), and leave the production of the other item to other country (the are worse at both things, but “less worse” at one of the two).  That way the superior country will not waste time doing something that somebody else could do nearly as well as they could do.  It will turn out that both countries will be able to find a trading ratio (terms of trade) whereby the superior country and the other country both end up with better outcomes than if they try to be self-sufficient.

 

That’s it in a nutshell, but it needs to be proven.

 

 

Application.

Two countries, US and Them, each produce two products: Food and Manufactured Goods

The production possibilities tables for the countries are:

 

US			Them
Food	Mfg.		Food	Mfg.
100	0		50	0
0	60		0	50

Assume straight line production possibilities curves (although this is contrary to what we learned in this subject, it is a simplification which saves lots of work and trouble)

The US is the superior producer – better at both.

The US has a Comparative Advantage in food because we are “more better” there (our ability relative to theirs is, in the ratio sense, greatest for food). The US should produce only or mostly food.

“Them” has a comparative advantage in manufactured goods, because their ability more nearly matches ours in that product  (in the ratio sense). They are “less worse” in that.

Them produces all or mostly manufactured goods.

The US will only be motivated to specialize in food if we can get as good, or actually a better trade off of mfg. for food  by trading with them, compared to what we can do on our own.. On our own we gain six mfg for every 10 food we don’t produce (i.e., if we switch our resources from food to mfg). So, that sets the lower limit to what we would accept.We would definitely accept 8 mfg in exchange for 10 food given up.

Them would look to get at least 10 food for 10 mfg given up in trade.That is because, their own internal trade off is 1 for 1.

The above mentioned combo (10 food provided by the US for 8 mfg provided by Them) is acceptable to both, so it is a possible basis for trade.

 

Using that combo, have the US produce only food (100) and give up 50 food to get back 40 mfg (the 10 for 8 ratio).After the trade, the US has 50 food and 40 mfg. This is outside of our production possibilities curve – for the US, acting by itself, 50 food only allows for 30 mfg to be made.

Them produces only mfg., yielding them 50 units. Them gives up 40 mfg, leaving them 10 mfg. They get 50 food in return for the 40 mfg, leaving them with a combination of 10 mfg and 50 food. This is outside their pp curve –if they produced 10 mfg, they would only be able to make 40 food, on their own.

 

Both countries have benefited. The superior producer (US) would not be justified to say: ”Why should we bother trading with Them, since we are better than they are at both kinds of production.” Specialization pays off for everybody! Furthermore, it would be counterproductive for the either country to set up laws and rules which interfere with trade, as in tariffs or other forms of “protectionism”.
 

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