It can be argued that world output would increase when the principle of comparative advantage is applied by countries to determine what goods and services they should specialise in producing. Comparative advantage is a term associated with 19th Century English economist David Ricardo.
Ricardo considered what goods and services countries should produce, and suggested that they should specialise by allocating their scarce resources to produce goods and services for which they have a comparative cost advantage. There are two types of cost advantage – absolute, and comparative.
Absolute advantage means being more productive or cost-efficient than another country whereas comparative advantage relates to how much productive or cost efficient one country is than another.
In order to understand how the concept of comparative advantage might be applied to the real world, we can consider the simple example of two countries producing only two goods - motor cars and commercial trucks.
Using all its resources, country A can produce 30m cars or 6m trucks, and country B can produce 35m cars or 21m trucks. This can be summarised in a table.
In this case, country B has the absolute advantage in producing both products, but it has a comparative advantage in trucks because it is relatively better at producing them. Country B is 3.5 times better at trucks, and only 1.17 times better at cars.
However, the greatest advantage - and the widest gap - lies with truck production, hence Country B should specialise in producing trucks, leaving Country A to produce cars.
Economic theory suggests that, if countries apply the principle of comparative advantage, combined output will be increased in comparison with the output that would be produced if the two countries tried to become self-sufficient and allocate resources towards production of both goods. Taking this example, if countries A and B allocate resources evenly to both goods combined output is: Cars = 15 + 15 = 30; Trucks = 12 + 3 = 15, therefore world output is 45 m units.
Opportunity cost ratios
It is being able to produce goods by using fewer resources, at a lower opportunity cost, that gives countries a comparative advantage.
The gradient of a PPF reflects the opportunity cost of production. Increasing the production of one good means that less of another can be produced. The gradient reflects the lost output of Y as a result of increasing the output of X.
Having a comparative advantage in X, Country A sacrifices less of Y than Country B. In terms of two countries producing two goods, different PPF gradients mean different opportunity costs ratios, and hence specialisation and trade will increase world output.
Only when the gradients are different will a country have a comparative advantage, and only then will trade be beneficial.
If PPF gradients are identical, then no country has a comparative advantage, and opportunity cost ratios are identical. In this case, international trade does not confer any advantage.
It may overstate the benefits of specialisation by ignoring a number of costs. These costs include transport costs and any external costs associated with trade, such as air and sea pollution.
The theory also assumes perfect mobility of factors without any diminishing returns. The reality may be very different. Output from factor inputs is likely to be subject to diminishing returns. This will make the PPF for each country non-linear and bowed outwards.
If this is the case, complete specialisation might not generate the level of benefits that would be derived from linear PPFs. In other words, there is an increasing opportunity cost associated with increasing specialisation. For example, it may be that the maximum output of cars produced by country A is only 20 million (compared with 30), and the maximum output of trucks produced by country B might only be 16 million instead of 21 million. Hence, the combined output from trade might only be 46 million units (instead of the 51 million units initially predicted).
Complete specialisation might create structural unemployment as some workers cannot transfer from one sector to another.
Relative prices and exchange rates are not taken into account in the simple theory of comparative advantage. For example if the price of X rises relative to Y, the benefit of increasing output of X increases.
Comparative advantage is not a static concept - it may change over time. For example, nonrenewable resources can slowly run out, increasing the costs of production, and reducing the gains from trade.
Many countries strive for food security, meaning that even if they should specialise in non-food products, they still prefer to keep a minimum level of food production.
Finally, the principle of comparative advantage is derived from a simple two good/two country model. The real world is far more complex, with countries exporting and importing many different goods and services.
However, the principle of comparative advantage clearly does ‘shape’ the pattern of world trade, although most countries do try to spread their risks by diversifying into a range of goods and services, even when they do not have a clear comparative advantage.