Comparative advantage and specialisation

Comparative advantage is where one person – or country – is relatively more efficient at producing a good or service than another person or country.  Given that this is filed in the Macroeconomics section, I’m going to be talking about countries from here.

If two countries specialise in goods that they have a comparative advantage in producing, both are likely to be better off.  This is the case even where one country is better at producing both goods.  Consider a theoretical example – the two countries are Australia and Japan, and the goods are TVs and cars.  An example might help.So, if cars and TVs are the two goods we’re comparing, let’s consider the following example:

As can be seen, Australia builds a car in less time than Japan does, but takes more time to build a TV.  The opportunity cost of one car for Australia is three TVs.  Japan’s opportunity cost for one car is eight TVs.  In one period of 120 hours, each country – working by itself – could produce according to the following graph:

Production - Cars vs TVs

This gives a total of between 7 cars and 0 TVs, or 36 TVs and no cars.  Given a total economy-wide requirement for four cars, Australia might choose 2 cars and 6 TVs, and Japan might choose 2 cars and 16 TVs.  However, if both countries engaged in trade, Australia could produce all four cars required, and Japan could produce nothing but TVs.  Australia could sell two cars to Japan for 8 TVs.  This leaves Australia 2 TVs better off than they would have been otherwise, and leaves Japan one car better off than they would have been, given the 120 hour period of work.  In Australia, one car is worth 3 TVs.  In Japan, 8 TVs is worth one car.  If both countries trade, both are better off.

This holds true even if – as is more likely in this example, Japan is more productive in both cars and TVs.  The opportunity cost is still real – there are still only 120 hours of production time.  Even if Australia took 40 hours to produce a car, and Japan took 30, both countries are still better off trading.  This absolute advantage in production still means one car costs Japan 6 TVs, while one car only costs Australia four TVs.  Assuming the Australian workers can’t just pick up and move to Japan (either physically or in adopting Japanese production methods), Australia is still better off producing cars and Japan TVs.

Where this falls over

This is clearly a basic example.  The problem is that life isn’t this simple.  Firstly, no national economies survive on two goods only.  Secondly, no mention has been made of transportation costs, or social or political benefits of maintaining production locally. Ethical considerations – fair work laws and environmental regulations in particular – have been ignored.  Not everyone wins from free trade – the countries as a whole do, but countries don’t exist as separate identities from their citizens.  And comparative advantages can change over time – taken to an extreme, every national economy would only produce a small number of goods or services, and free trade would lead to oligopolies in national trade.  And we know how they work out.

Where this works

Trade does work.  Conventional thought indicates that putting up trade barriers will harm your economy.  Perhaps if every other country did not put up trade barriers, the one that did would be advantaged.  This example of the free rider problem is what international treaties seek to avoid.  One country can’t bar trade from others without them retaliating in some way.  Comparative advantages are also real.  Australia has a comparative advantage in natural resources, skilled labour, and education as compared with many other national economies.