Comparative advantage, specialization

The theory of comparative advantage explains why, for example, Argentina specializes in raising cattle whereas Germany makes cars. An example might be the easiest way to explain the logic.

Let’s say that in Germany it takes $90,000 worth of resources (wages, capital, land, etc) to raise 30 cows and $30,000 to produce a car. If the Germans decide to raise more cattle, they can make fewer cars. Similarly, making more cars means less cattle.

If Germany decides to raise 30 cows, they give up producing $90,000 / $30,000 = 3 cars. If they decide to make one more car they give us producing ($30,000 / $90,000) * 30 cows = 10 cows.

In Argentina, it takes $40,000 to raise 30 cows and $20,000 to make a car. Then, to raise 30 cows in Argentina, they give up producing $40,000 / $20,000 = 2 cars. To make an additional car, they give up ($20,000 / $40,000) * 30 cows = 15 cows.

Based on that, cars should be made in Germany. There we give up less cattle (10 instead of 15) in order to produce one more car. Similarly, cattle are raised more efficiently in Argentina where we give up fewer cars.

In general, a product will be produced in the country where the opportunity cost of making that product is the lowest. That is, in the country where the alternative use of resources is less appealing. The country with the lower opportunity cost is considered to have comparative advantage in the production of that product.

On the chart. Notice that tourism generates more than 70 percent of the exports of Croatia and Jamaica (two countries on the coast with warm climate) whereas it generates only about 25 percent of the exports in Estonia and about 16 percent of the exports in Sweden (two countries also on the coast but with cold climate).

The comparative advantage of countries depends on a number of factors:

Natural resources. For example, Kuwait specializes in the production of petrol.

Geographical situation. For example, countries with sea borders specialize in transport logistics and ship building. A good example is South Korea.

Abundant and relatively cheap labor. For example, Vietnam specializes in textile production that requires many workers.

Abundant land. The U.S. is an important producer of grains.

Traditions developed over time. For example, the Swiss have perfected watch making over the centuries. In essence, they have worked to develop their comparative advantage.

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