The division of labor facilitates production of a given good, but how do individuals or groups determine the specific goods or services they will produce? All potential gains are realized if you specialize in that 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.

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. Table 2 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.

A party has an absolute advantage in a good if it can produce the good using fewer resources than another party would require to produce the good.

 

Table 2 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 Alaskans to consume an additional 4 pounds of coffee per day, and Brazilians 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 virtually everyone ultimately gains through this process of trade.

 

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. [1] Suppose, for example, that a lawyer whose fees run $300 an hour types twice as fast as her secretary, whose wage is $18 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 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 their area of comparative advantage.

 

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. Focus 1 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.

 

A detailed multinational study by Michael Porter, a professor at the Harvard Business School, concludes that government policies intended to promote targeted domestic industries (e.g., export subsidies or tariffs on imports) fail as often as they succeed.[2] In this view, government cannot accurately pick industries that are "winners." Porter argues that government policy should be broadly limited to: (a) encouraging domestic rivalry (which rewards success in lowering costs and improving quality), (b) investing in human resource skills that enhance productivity, and (c) emphasizing quality as a national priority. The shapes of production possibilities frontiers (graphs of the limits to productive capacity) help show how comparative advantages differ internationally.

 

Focus : Is the United States at a Comparative Disadvantage?

The U.S. economy was the world's undisputed heavyweight champion from World War II into the 1960s. Almost everything we produced found ready export markets, e.g. steel, cars, planes, and construction equipment. Today, one out of every three new cars Americans buy is foreign. U.S. imports exceeded exports each year from 1982 through 2005. We now import shiploads of oil and steel, and most of our clothes and shoes. Such facts dismay people who believe we are losing our ability to compete in world markets. First, ongoing internationalization is one major explanation for concern that the United States has lost its ability to compete. Almost all countries are both exporting and importing record shares of their output and income—so most societies have an increasingly international flavor, alarming traditionalists who fear "foreign influence." Second, some countries' exports have grown faster than our exports, in part because changing comparative advantages force technologies and resource usage to adjust. Signs are emerging, however, that rates of gain are shrinking for countries that played "catch-up" in recent decades. For example, our average labor productivity growth lagged behind that of Japan and parts of Western Europe during much of 1950--1980.[3] This pattern reversed after 1985, while wages in those countries grew faster than U.S. wages. Consequently, average U.S. labor costs per unit of output, which formerly exceeded those in other major industrial powers, had fallen to roughly average by the 1990s. Third, the international value of the dollar rose in the 1980s. Foreign suppliers sought high prices and profits by exporting goods to the U.S., while foreign buyers were discouraged from buying high-priced U.S. exports, partially accounting for huge imbalances of trade during 1983-1990. During 1990-1996, however, the dollar fell relative to other major currencies. Coupled with the relative decline in U.S. labor costs, this drop in the value of the dollar helped bolster U.S. exports and restrain imports in the 1990s. Thus, our trade imbalance continued to shrink into the late 1990s. Germany briefly displaced the U.S. as "the world's greatest exporter" in 1989-1991, but we regained that title by 1992. If we are the world's biggest exporter, why have deficits in our balance of trade continued? Answer(:)? We also hold the title of "the world's biggest importer." Voracious national consumption means that we sometimes import even goods at which we excel as producers. For example, the United States is the world's #2 steel producer, but we still import steel. Robust international competition has made it easy to forget that the U.S. remains the world’s largest producer across many major industries, including aircraft, aluminum, computers, education (we "export" the degrees foreign students earn), entertainment, financial services (e.g., credit cards), paper, petrochemicals, plastics, scientific instruments, and semiconductors. We continue to be the world's biggest "high-tech" exporter, and dominate exports of films, music, software, and agricultural products. (Our farmers’ topsoil and the technology they use are the envy of the rest of the world.) And even our auto industry is the #3 exporter in world markets. If you are in another country and see a new "foreign" car, chances are 1 in 12 that it was "Made in the USA."

 

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