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Sources of Comparative Advantage

January 13, 2012

The fundamental purpose of an economy is to give people as many goods as possible for as little effort as possible and to allocate resources to their highest value use. Trade is perhaps the most effective human institution to achieve these goals. Creation can be destructive, as people face costs of switching from one industry to another, but in the long run the benefits from trade are very large. Trade is based on differences between people, both differences in production and preferences. The more different people are from one another, the more they will gain from trading.

If each person makes what they are best at and trades for the rest, no one will have to make anything they are relatively poor at. What someone is best at is determined not by how good they are relative to other people, but by the relative values of the goods they can produce.

Natural Resources
Perhaps the easiest example of comparative advantage arrises out of differences in natural resources. If one country has a lot of copper ore, they will probably have a comparative advantage in copper production. If one country has fantastic weather for mangos, they will probably have a comparative advantage in mango production.

When people are born, they are all fairly similar in their capacities to make economic goods. It is only by acquiring skills and knowledge that they distinguish themselves. Without trade, we would each have to learn thousands of skills to survive. Each person would need to build their own shelter, weave their own clothes, hunt and farm their own food. Each person could only be passingly familiar with the best ways to make each type of object. With trade, each person can work on one tiny step in the production process of one good, and develop high levels of skill at it. It is easy to forget just how many people it takes to produce even the simplest of consumer goods. Such high levels of specialization are rewarded by high comparative advantage and productivity.

An “economy of scale” exists whenever large scale production is more efficient than small scale production. Sometimes this occurs because a firm can spread fixed costs over a larger amount of production. Sometimes it occurs because the larger scale allows firms to have more specialized workers and capital. Increasing the size of the web of trade allows for increasingly larger firms and more specialization.

If two countries with monopolies trade, the result is an oligopoly. Even if there were no efficiency gains from trade at all, countries would still gain because open trade forces firms to compete more intensely.

This is just a partial list of things which can cause one country to have a comparative advantage. Anything that causes one firm to have a different relative cost of production than another gives rise to a comparative advantage.

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