Theory of Comparative Advantage Historically, nations have traded with each other for hundreds of years for profit or because they did not have enough resources (land, labor, and capital) to satisfy all needs of countries. consumers. For example, Japan has a highly skilled workforce that uses technologically advanced equipment to produce automobiles and electrical equipment; however, it does not have its own oil fields. Saudi Arabia has large oil reserves but lacks the capital to produce cars and electrical equipment. Trade between Saudi Arabia and Japan will allow both countries to obtain goods and services that they cannot produce on their own. Specialization and trade can therefore ensure higher standards of living for all countries as resources are used more efficiently. Definition of Comparative Advantage To illustrate the concept of comparative advantage you need at least two goods and at least two places where each good could be produced with scarce resources in each place. The example here is from Ehrenberg and Smith (1997), page 136. Suppose that the two goods are food and clothing, and that "the price of food in the United States is 0.50 units of clothing and the price of 'clothing is 2 units of clothing.' [Suppose further that] the price of food in China is 1.67 units of clothing and the price of clothing is 0.60 units of food. So we can say that “the United States has a comparative advantage in food production and China has a comparative advantage in clothing production. It follows that in a trading relationship the United States should allocate at least some of its scarce resources to food production and China should allocate at least some of its scarce resources to clothing production, because this is the most efficient allocation of scarce resources and allows the price of food and clothing to be as low as possible. Theory of Comparative Advantage Adam Smith's theory of absolute advantage is a simple explanation of the benefits of international trade. However, if a country has an absolute advantage in producing all goods, there can be benefits from trade. In 1817, David Ricardo, a classical economist, developed the principle of comparative advantage to explain this situation. The principle is based on relative efficiencies of production where each country has a comparative advantage in producing the good in which it has the lowest opportunity cost. Opportunity costs are what you have to give up to consume or produce another good.