Comparative advantage

In economics, the theory of comparative advantage explains why it can be beneficial for two countries to trade, even though one of them may be able to produce every kind of item more cheaply than the other.

Example 2

Suppose there are two countries, Northland and Southland. Both have a wine-making industry and a clothing industry.

Related Topics:
Wine - Clothing

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• In Northland, it takes a worker:
• 3 days to make a suit of clothes
• 5 days to make a bottle of wine.
• Southland is more efficient in both industries – a Southlander can make a suit of clothes in 1 day or a bottle of wine in 1 day.

Tabulated:

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Absolute cost in days

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Production capabilities per day

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Southland has an "absolute advantage" in both industries – it is more productive at making both wine and clothes. However, it is 5 times more productive than Northland in wine making and only 3 times more productive than Northland in Clothes making. That is, it has a comparative advantage in wine making. While Northland is worse at making either kind of goods, it is least deficient at making clothes.

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In a competitive market, the price of goods reflects the cost of making them, so it is likely that in Northland, a bottle of wine (taking 5 days for a Northlander to produce) costs more than a suit of clothes (made in 3 days). As the Southlanders can make either wine or clothes at the same production cost, it is rational to export wine to Northland, and take the higher profit. Ultimately, Northland must pay for this imported wine somehow, and since clothing can be produced relatively more easily, clothes will be exported back to Southland.

Related Topics:
Competitive - Price - Cost - Import - Export

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Wine will be a more profitable export than clothes for Southland as this comparative advantage in productivity is maintained, so it would be rational for Southlanders to deploy more resources into the wine industry at the expense of the clothes industry.

Related Topics:
Profit - Rational

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This can be illustrated as follow. Suppose Northland and Southland do not trade with each other. In a work week (let us say 5 working days) where 1 day is used to produce wine and 4 days is used to produce clothes. The total production will then be as follow:

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Suppose the Countries start using their Comparative advantage and do trade with each other. Southland produces wine in all 5 days and Northland produce clothes all 5 days.

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When Northland and Southland do trade and specialize they produce 30 units instead of 22 units if each country tries to be self sufficient. A analogous example appears in the German version .

Related Topics:
Specialize - Self sufficient - German

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Suppose that the Southland clothes industry now collapses due to a labour (or capital) shortage caused by the boom in the wine industry. This might not worry the Southland Treasury – the Northlanders should be willing to pay more for wine than for clothes: until the price rises above 5:3, it will not be economic to reopen the Northland vineyards. Therefore a Southland worker can make wine, buy clothes and still be in profit. Provided the profit margin is enough, it is worth Southland trading wine for clothes with Northland, even though Southland imports goods that it could manufacture more efficiently itself. If Northland's clothes were to rise to more than the price fetched by wine, it would be time to re-open the Southland clothes factories.

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This theoretical model omits several factors that sometimes apply in the real world: Workers and capital may not be painlessly transferable between industries. The clothing industry (in Southland) and wine-making industry (in Northland) may therefore exert political pressure (through industry associations and trades unions) to protect their industries. Governments also sometimes decide to provide subsidies or to erect import barriers to preserve domestic industries. Reasons other than political include national prestige, or the wish to avoid being dependent on imports in case trade is disrupted – for example by war.

Related Topics:
Workers - Capital - Trades union - Protect - Subsidies - Political - Dependent

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