Study notes

Specialisation and the Gains from Trade

This study note looks at comparative advantage and the gains from specialisation and trade

First introduced by David Ricardo (pictured) in 1817, comparative advantage exists when a country has a 'margin of superiority' in the supply of a product i.e. the cost of production is lower.

Countries will usually specialise in and export products, which use intensively the factors inputs, which they are most abundantly endowed. For example the Canadian economy which is rich in low cost land is able to exploit this by specializing in agricultural production. The dynamic Asian economies including China has focused their resources in exporting low-cost manufactured goods which take advantage of much lower labour costs. This is now changing as China looks to move from a middle-income country by specializing in industries that use higher levels of knowledge and technology.

In the richest advanced countries, the comparative advantage is mainly in specializing in producing and exporting high-value and high-technology goods and high-knowledge services.

Output of X Output of Y
Country A 180 90
Country B 200 150

In this example, country B has an absolute advantage in both products. Absolute advantage occurs when a country or region can create more of a product with the same factor inputs. But Country A has a comparative advantage in the production of good X. It is 9/10ths as efficient at producing good X but it is only 3/5ths as efficient at producing good Y.

Comparative advantage exists when a country has lower opportunity cost, i.e., it gives up less of one product to obtain more of another product. In our example above, for country A, every extra unit of good Y produced involves an opportunity cost of 2 unit of good X. For country B, an additional unit of good Y involves a sacrifice of only 4.3 units of good X.

There are gains to be had from country A specializing in the supply of good X and country B allocating more of their resources into the production of good Y.

Another example of comparative advantage

Consider two countries producing two products – digital cameras and vacuum cleaners.

Pre-specialisation Digital Cameras Vacuum Cleaners
UK 600 600
United States 2400 1000
Total 3000 1600

Were the UK to shift more resources into higher output of vacuum cleaners, the opportunity cost of each cleaner is one digital television. For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners.

If the UK chose to reallocate resources to digital cameras the opportunity cost of one extra camera is still one vacuum cleaner. But for the United States the opportunity cost is only 5/12ths of a vacuum cleaner. Thus the United States has a comparative advantage in producing digital cameras.

Digital Cameras Vacuum Cleaners
UK 0 (-600) 1200 (+600)
United States 3360 (+960) 600 (-400)
Total 3360 1800
  • The UK specializes totally in producing vacuum cleaners – doubling its output to 1200.
  • The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners.
  • Output of both products has increased - representing a gain in economic welfare.

Exam Tip: Iit is useful to learn a numerical example to illustrate comparative advantage for use in an exam

For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. There are gains from trade between the two countries. If the two countries trade at a rate of exchange of 2 digital cameras for one vacuum cleaner, the post-trade position will be as follows:

  • The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras
  • The USA exports 840 digital cameras and imports 420 vacuum cleaners
Digital Cameras Vacuum Cleaners
UK 840 780
United States 2520 1020
Total 3360 1800

Compared with the pre-specialisation output levels, consumers in both countries now have an increased supply of both goods to choose from.

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