How comparative advantage leads to specialization

Absolute and comparative advantage.

• A producer has an absolute advantage in a good when it can produce more of it than another producer with its resources; a country may have it because of more labour, better technology or richer natural resources.
• A producer has a comparative advantage in a good when it can produce that good at a lower opportunity cost, that is, by giving up less of the other good for each unit; the idea is David Ricardo's.
• The two are different. A producer can have an absolute advantage in both goods, yet it cannot have the lower opportunity cost in both: if its opportunity cost of the first good is lower, its opportunity cost of the second good, which is the reciprocal, must be higher.

Why comparative advantage leads to specialization. Judged by absolute advantage alone, a producer that is better at everything would seem to have no reason to trade. But when opportunity costs differ, each producer should specialise in the good whose opportunity cost is lower for it, even if one of them has an absolute advantage in both. Producing each good where it costs least in forgone output raises total output, and each side then trades part of its output for the other good, so both can gain. Trade lets each party concentrate on what it does best and buy from others what it is less suited to produce.

Example: two farmers in Punjab. Our own figures. In a season Gurpreet can grow either 60 quintals of wheat or 30 quintals of potatoes on his land; Harjeet can grow either 20 quintals of wheat or 20 quintals of potatoes on his.

• Advantages. Gurpreet has the absolute advantage in both crops. But wheat costs him only half a quintal of potatoes against one for Harjeet, so Gurpreet's comparative advantage is in wheat; potatoes cost Harjeet one quintal of wheat against two for Gurpreet, so Harjeet's comparative advantage is in potatoes.
• Without specialization. Each puts half his land under each crop. Gurpreet grows 30 wheat and 15 potatoes; Harjeet grows 10 wheat and 10 potatoes. Total: 40 wheat and 25 potatoes.
• With specialization. Harjeet grows only potatoes (20). Gurpreet puts 70% of his land under wheat (42) and 30% under potatoes (9). Total: 42 wheat and 29 potatoes, more of both crops from the same land.
• The trade. Harjeet gives Gurpreet 7 quintals of potatoes for 11 quintals of wheat, a rate of about 1.57 quintals of wheat per quintal of potatoes. This lies between Harjeet's opportunity cost (1) and Gurpreet's (2), so each pays less than it would cost him to grow the crop himself.

Each farmer ends with more of both crops than he could have had alone, although Gurpreet is the better grower of both.

The condition behind the gain. The gain comes from the difference in opportunity costs. If the two farmers gave up the same amount of one crop for the other, neither would have a comparative advantage, and specialising would add nothing to total output. The rate of exchange must also lie between the two opportunity costs; outside that range one side would do better growing the crop himself.

Conclusion. Comparative advantage, the lower opportunity cost, tells each producer which good to specialise in. Because opportunity costs differ, specialising this way raises total output, and trading at a rate between the two opportunity costs lets every party end up better off.