The most important principle in explaining regional specialization is
the concept of comparative advantage, first formulated by the British
economist David Ricardo. The key word in "comparative advantage" is
"comparative." A region specializes in those products in which its
productive capabilities in comparison to those of its potential trading
partners are comparatively better than those of the other products. To
illustrate this let us consider the example used by Ricardo.
England and Portugal can both produce cloth and wine. Suppose that one
worker in England working one year can produce 10 yards of cloth or 5 gallons
of wine. On the other hand, one worker in Portugal can produce 6 yards of
cloth or 4 gallons of wine. In this example, the English workers are
more productive in producing both cloth and wine than the Portuguese workers.
In actuality, the English might be more productive in producing cloth and the
Portuguese more productive in producing wine. In such a case, England would
be said to have an absolute advantage in producing cloth and Portugal in
producing wine. But there is no challenge in explaining specialization if
each trading partner has an absolute advantage in its specialization. The
challenge is to explain specialization for the case of a country, in this
example Portugal, that does not have an absolute advantage in any product.
Consider first the situation without trade. Suppose there are one million
workers in England and one million workers in Portugal. In England the
combinations of cloth and wine that can be produced, the so-called
production-possibilities curve is as shown below.
The English worker/consumers must choose a combination of cloth and
wine that they can produce and which is the most desirable given their
tastes for cloth and wine. If one more gallon of wine is produced the
production of cloth must be cut by 2 yards. The prices of cloth and wine
must reflect this trade-off. If the price of a yard of cloth is one pound
sterling then a gallon of wine must sell for 2 pounds sterling. The income
of the English workers is 10 million pounds sterling and this is also their
level of consumer expenditure. Suppose that without trade England produces
and consumes 6 million yards of cloth and 2 million gallons of wine.
The production possibilities curve for Portugal is shown below.
Now let us suppose trade is allowed and an exchange rate of 8 escudos
per pound sterling develops, but that temporarily the prices of cloth and
wine in the two countries remains the sames as before trade. In Portugal
someone will recognize that if they produces one more gallon of wine and
sell it in England for two pound sterling they can buy two yards of cloth.
Therefore the increased production of wine, which required a cutback in
production of cloth in Portugal of 1.5 yards, ultimately allowed the
Portuguese to consume 2 more yards of cloth. Likewise in England someone
will recognize that if one more yard of cloth is produced it can be taken
to Portugal and sold for 10 escudos and those 10 escudos traded for
two-thirds of a gallon of wine. Thus the cutback in production of wine in
England of one half gallon ultimately led to an increase in consumption of
wine by two-thirds of a gallon.
Therefore Portugal would expand production of wine and the cloth industry
would disappear, while in England no more wine would be produced and all labor
would go into the production of cloth. With extensive trade the relative prices of cloth and wine in England and
Portugal would change and ultimately become the same. The situation would
be as shown below.
The condition for equilibrium is that the relative price of cloth and
wine would have to such that the export of cloth from England is equal to
the amount of cloth Portugal wants to import and the amount of wine exported
from Portugal would have to be equal to the amount of wine England wants to
import.
Comparative advantage is not a static matter. As the set of trading
partners changes so would any nations comparative advantage.