Monday, June 23, 2008

Comparative Advantage & Its Sources

A country has a comparative advantage in producing a good if the opportunity cost of producing the good is lower for that country than for other countries.

There are 3 main sources of comparative advantage:

(a) Differences in climate
(b) Differences in factor endowment (factors of production such as land, labour and capital are of different levels of abundance in different countries)
(c) Differences in technology

The causes of differences in technology are somewhat mysterious. Sometimes they seem to be based on knowledge accumulated through experience. Sometimes, they are a result of set of innovations that for some reason occur in one country but not in others.

Note: Technological advancement is also often transitory. For example, Europe's aircraft industry has closed the gap with that of the US. China's level of technology is also advancing rapidly as a result of technological transfer from the large volume of foreign direct investments into the country, as well as huge funding for R&D from the government as well as private enterprise. At any given point in time, differences in technology are a major source of comparative advantage for any country.

Differences in factor endowment (through differences in the distribution of resources, both quantity and quality) will also affect the cost of production, hence accounting for the differences in opportunity costs. For example, China's abundance of labour, both skilled and unskilled, have allowed her to produce at lower opportunity costs due to the cheap labour, hence giving China a comparative advantage in the labour-intensive industries.

Lastly, climatic differences between countries can play a major role in determining the costs at which different countries produce a good, specifically agricultural produce. For example, certain regions of France have climatic conditions that are highly favourable to the growing of grapes for producing champagne, giving these regions a comparative advantage in production of champagne. On the other hand, the arid climate in many parts of the Australian continent does not favour the growing of agricultural goods such as rice, which requires a lot of water for the paddy fields. In order to supply sufficient water to these crops, complex irrigation networks have been set up and maintained at high cost, which reflects that Australia clearly does not have a comparative advantage in the production of rice.

(Link: Ricegrowers' Association of Australia - Australia's rice is more highly priced; NY Times Article: A Drought in Australia, a Global Shortage of Rice & Article: The Australian Rice Industry and Water)

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