The division of labor facilitates production of a given good, but how do individuals or groups determine which specific goods or services to produce? The maximum potential gains from trade tend to be realized if you specialize in that activity which you can do at the lowest cost relative to other people’s costs. In 1817, David Ricardo, an influential early economist, focused on international trade when he generalized this idea into an economic law.

The law of comparative advantage: Mutually beneficial exchange is possible whenever relative production costs differ prior to trade.

This law applies to all exchanges, whether between individuals or nations.

Opportunity cost is the key to comparative advantage: Individuals and nations gain by producing goods at relatively low costs and exchanging their outputs for different goods produced by others at relatively low cost. All potential trading partners can gain enormously through appropriate specialization and exchange.

Oranges are grown at lower cost in Florida than in Iowa, for example, while Iowa excels in producing corn. Floridians and Iowans share gains from exchange according to comparative advantage by trading Florida oranges for Iowa corn. Similar gains are realized when Americans trade with foreigners—efficiency requires using all the world’s resources in the relatively most productive ways.

Suppose Brazilians can grow coffee more easily than they can catch salmon, while Alaskans find it relatively easier to catch salmon than to grow coffee. Alaskans have a comparative advantage in salmon fishing, and Brazilians, in coffee production. Trading Alaskan salmon for Brazilian coffee clearly benefits both groups. The table below shows how both parties to a trade can gain whenever their opportunity costs differ. If Alaskans and Brazilians each specialize in their areas of comparative advantage, and if 1 pound of salmon trades for, say, 1 pound of coffee, then Alaskans can consume an extra 4 pounds of coffee daily while Brazilians can consume an additional 4 pounds of salmon. Note that the Alaskan opportunity cost of producing 1 pound of coffee is 5 pounds of salmon before trade, while each pound of coffee costs Brazilians only 1/5 of a pound of salmon.

Opportunity Costs and Efficiency

Before Specialization

Hours Worked

Production and Consumption

Alaskan

4

4

5 pounds of salmon

1 pound of coffee

 Brazilian

4

4

1 pound of salmon

5 pounds of coffee

After Specialization

Hours Worked

Production

Consumption

Alaskan

8

10 pounds of salmon

5 pounds of salmon

5 pounds of coffee

 Brazilian

8

10 pounds of coffee

5 pounds of coffee

5 pounds of salmon

Trade enables each Alaskan to consume an additional 4 pounds of coffee per day, and each Brazilian to consume an extra 4 pounds of fish per day. Each group specializes in the form of production in which it enjoys a comparative advantage, and Alaskans and Brazilians both gain from trade.

A party has an absolute advantage if producing a good absorbs fewer resources than another party would require to produce the good.

But what if Alaskans had absolute advantages in everything–if they could do every task faster and easier than Brazilians? You might think that Alaskans must lose if Brazilians gain from trade but, surprisingly, both sides can gain. Suppose, for example, that a lawyer whose fees run $250 an hour types twice as fast as her secretary, whose wage is $12 hourly. She still gains by hiring the secretary. Despite her absolute advantage in typing, the lawyer’s comparative advantage lies in practicing law. Similarly, many professional athletes probably have absolute advantages in lifting and carrying compared to most furniture movers. Nevertheless, few pro athletes move their furniture when traded between teams. Athletes and movers both gain by concentrating in their own areas of comparative advantage.

It is important to notice that, in these last two examples, absolute advantages do not translate into comparative advantages. Indeed, the lawyer’s absolute advantage in typing still yields a comparative disadvantage in secretarial work, and, although furniture movers have absolute disadvantages at both athletics and furniture moving, their absolute disadvantage is relatively the least in moving furniture, so this is an area of comparative advantage for them.

U.S. exports have recently been swamped by imports, and many industries once dominated by U.S. firms have been invaded by aggressive foreign exporters. Does this mean that we are losing all of our comparative advantages? No! Being comparatively disadvantaged in all areas is impossible because relative magnitudes determine comparative advantage. Would you like to read a Focus that identifies a few of the many areas in which U.S. producers continue to enjoy a substantial competitive edge?

Roots of Comparative Advantage

Relative resource abundance is often cited as driving comparative advantage. It seems natural for fertile soil to yield advantages in agriculture, for vast oil reserves to give the Middle East an edge in oil, and for China’s low-wage workers to yield advantages in labor-intensive goods. But why is Argentina with all its natural resources relatively poor, while Switzerland, with few natural resources, enjoys one of the world’s highest standards of living? And why is Pakistan’s economy stagnant while Singapore thrives despite greater population density and fewer natural resources?

The key to such riddles is that how resources are combined is as crucial as the mix of resources available. Comparative advantage is also molded by: (a) climate and location, (b) institutional and cultural factors, (c) government policies, (d) the skills and education of the populace, (e) the vigor of internal competition and size of domestic markets, and (f) the ability of domestic entrepreneurs to innovate and cultivate global markets.

Comparative advantage is only one of several potential sources of gains from trade. If you would like to find out more about the ways trade can be beneficial, open this link to the gains from trade.