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  1. The next step in the analysis is to assume that trade between countries is suddenly liberalized and made free.
  2. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more.
  3. For example, at the time, England was able to manufacture cheap cloth.
  4. This desire leads the shoemakers to lobby for, say, special tax breaks for their products and/or extra duties (or even outright bans) on foreign footwear.
  5. Some companies may have customers who experience miscommunications due to language barriers when they’re speaking with representatives at Indian call centers.

Countries like China and South Korea have made major productivity gains by specializing their economies in certain export-focused industries, where they had a comparative advantage. For many products, there are advantages in producing on a large scale; costs become lower as more is produced. Thus, for example, automobiles can be made more cheaply in a factory producing 100,000 units than in a small factory producing only 1,000 units. This means that countries have an incentive to specialize in order to reduce costs. To sell a large volume of output, they may have to look to export markets.

Finally, we characterize the patterns of our estimated productivity along the cross-section as well as in its evolution over time. We find that, for the entire sample of countries (first column of Table 1), both domestic innovation and the distance to the technology frontier have a positive and statistically significant effect on productivity growth. In this section we study the role of these two sources of productivity growth in two ways. First, we regress the growth rate of our measure of country-industry productivity obtained from the gravity analysis on a measure of both domestic innovation and the potential for technology transfer. As it turned out, specialization in any good would not suffice to guarantee the improvement in world output. Ricardo showed that the specialization good in each country should be that good in which the country had a comparative advantage in production.

What Is Comparative Advantage?

Testing the Ricardian model for instance involves looking at the relationship between relative labor productivity and international trade patterns. A country that is relatively efficient in producing shoes tends to export shoes. The next step in the analysis is to assume that trade between countries is suddenly liberalized and made free. The initial differences in relative prices of the goods between countries in autarky will stimulate trade between the countries.

Sources of Competitive Advantage to Drive Growth

However, Ricardo demonstrated numerically that if England specialized in producing one of the two goods and if Portugal produced the other, then total world output of both goods could rise! If an appropriate terms of trade (i.e., amount of one good traded for another) were then chosen, both countries could end up with more of both goods after specialization and free trade than they each had before trade. This means that England may nevertheless benefit from free trade even though it is assumed to be technologically inferior to Portugal in the production of everything. Following Eaton and Kortum (2002), is the contribution to trade costs of the distance between country and falling into the interval (in miles), defined as [0, 350], [350, 750], [750, 1,500], [1,500, 3,000], [3,000, 6,000], [6,000, maximum]. The other control variables between country and country include common border effect , common official language effect , and colonial relationship effect . We include an exporter fixed effect, , to fit the patterns in both country incomes and observed price levels as shown in Waugh (2010).

How does comparative advantage benefit the United States?

Deardorff argues that the insights of comparative advantage remain valid if the theory is restated in terms of averages across all commodities. His models provide multiple insights on the correlations between vectors of trade and vectors with relative-autarky-price measures of comparative advantage. “Deardorff’s general law of comparative advantage” is a model incorporating multiple goods which takes into account tariffs, transportation costs, and other obstacles to trade. In a famous example, Ricardo considers a world economy consisting of two countries, Portugal and England, each producing two goods of identical quality. In Portugal, the a priori more efficient country, it is possible to produce wine and cloth with less labor than it would take to produce the same quantities in England. However, the relative costs or ranking of cost of producing those two goods differ between the countries.

The country may not be the best at producing something, but the good or service has a low opportunity cost for other countries to import. Comparative advantage is usually measured in opportunity costs, or the value of the goods that could be produced sources of comparative advantage with the same resources. If competitor factory B, can make three belts with the resources it takes to make one pair of shoes, then factory A has a comparative advantage in making belts, and factory B has a comparative advantage in making shoes.

Where it does not have a comparative advantage, it benefits by paying less for those goods and services through trade than it would cost to produce them domestically. David Ricardo famously showed how England and Portugal both benefit by specializing and trading according to their comparative advantages. In this case, Portugal was able to make wine at a low cost, while England was able to cheaply manufacture cloth. Ricardo predicted that each country would eventually recognize these facts and stop attempting to make the product that was more costly to generate. The theory of comparative advantage supports free trade and specialization among countries.

In France, the country specializes in wine and produces 1,000 barrels. Recall that the opportunity cost of 1 barrel of wine in the United States is 1 piece of cloth. Therefore, the United States would be open to accepting a trade of 1 wine for up to 1 piece of cloth. It is important to note that the United States enjoys an absolute advantage in the production of cloth and wine.

Suppose, as before, that Portugal is more productive than England in the production of both cloth and wine. If Portugal is twice as productive in cloth production relative to England but three times as productive in wine, then Portugal’s comparative advantage is in wine, the good in which its productivity advantage is greatest. Similarly, England’s comparative advantage good is cloth, the good in which its productivity disadvantage is least. This implies that to benefit from specialization and free trade, Portugal should specialize in and trade the good that it is “most better” at producing, while England should specialize in and trade the good that it is “least worse” at producing. A country is said to have a comparative advantage in the production of a good (say, cloth) if it can produce it at a lower opportunity cost than another country.

Suppose the attorney produces $175 per hour in legal services and $25 per hour in secretarial duties. The secretary can produce $0 in legal services and $20 in secretarial duties in an hour. Wider gaps in opportunity costs allow for higher levels of value production by organizing labor more efficiently.

The concept of comparative advantage was developed in the early 1800s by the economist David Ricardo. He argued that a country boosts its economic growth the most by focusing on the industry in which it has the most substantial comparative advantage. It was originally applied to international trade, but it can be applied to any level of business.

Comparative advantage is the ability of a country to produce a good or service for a lower opportunity cost than other countries. In the United States, the country specializes in cloth and produces 2,000 pieces. Recall that the opportunity cost of 1 piece of cloth in France is 2 barrels of wine. Therefore, France would be open to accepting a trade of 1 cloth for up to 2 barrels of wine.

In the long run, trade protectionism hurts the nation’s competitiveness because it isn’t efficient. The theory of comparative advantage argues that trade protectionism doesn’t work over time. Political leaders are always under pressure from their local constituents to protect jobs from international competition by raising tariffs. Ricardo developed his approach to combat trade restrictions on imported wheat in England. He argued that it made no sense to restrict low-cost and high-quality wheat from countries with the right climate and soil conditions. England would receive more value by exporting products that required skilled labor and machinery.

One critique of the textbook model of comparative advantage is that there are only two goods. Dornbusch et al. (1977)[43] generalized the theory to allow for such a large number of goods as to form a smooth continuum. Based in part on these generalizations of the model, Davis (1995)[44] provides a more recent view of the Ricardian approach to explain trade between countries with similar resources. This is because you’ll make more money as a plumber because an hour of babysitting services costs far less than you would make doing an hour of plumbing. Every hour you spend babysitting is an hour’s worth of lost revenue you could have gotten on a plumbing job. This desire leads the shoemakers to lobby for, say, special tax breaks for their products and/or extra duties (or even outright bans) on foreign footwear.