What is the theory of comparative advantage? Many theories apply to international trade. The most popular theory is the theory of comparative advantage, which states that specialization and trade between countries benefit all who are involved. If this method is practiced, each nation will have a greater quantity and variety of higher-quality products to consume at lower prices.

For this mutually beneficial system to work, each country must specialize in the production of those products for which it possesses a comparative ­advantage—that is, produce the goods and services it can produce relatively more efficiently compared to other countries. A comparative advantage should not be confused with an absolute advantage, which is the ability to produce more of a good or a service than any other country. Just because a large country can produce more of a good than a small country can doesn’t necessarily mean it is relatively more efficient at producing that good. What matters is relative efficiency, or comparative advantage—not absolute advantage.

When all countries focus on producing products for which they have a comparative advantage, collectively they all have more production to share. This, in turn, creates higher standards of living for these countries. As you’ve probably guessed, countries export products for which they have a comparative advantage and import products for which they do not have a comparative advantage.

What can a country do to have an edge in world markets? Governments often focus on improving their nations’ competitiveness by improving their resources—natural resources, labor, capital (plant, equipment, and infrastructure), technology, innovation, and entrepreneurialism. A nation can only do so much to improve its natural resources, however; it has to work with the natural resources with which it is endowed. Nations with abundant natural resources will likely have a comparative advantage in the production of goods that require these raw materials. For example, big-leaf mahogany trees are found in only a few countries, including Mexico and Belize. So, these countries have a comparative advantage in the production of mahogany furniture and musical instruments made from mahogany.

However, governments can and do invest in health, education, and training designed to increase the productivity of their labor forces. All international businesses are constantly looking for good workers, and each country wants to attract businesses to enhance the employment opportunities for its citizens. Investing in education programs, entrepreneurial classes as well as vocational training and apprenticeships develops an attractive workforce. As well, countries compete to attract foreign students, many of whom choose to stay in the country where they finish their education.

Many governments try to create incentives to attract the investments made by private companies, such as investments in plant and equipment. One way to do this is for a government to try to keep interest rates low so that private companies will invest in the latest state-of-the-art equipment, thereby giving them an edge over foreign competition. Governments also invest in public capital, which is sometimes called infrastructure. Infrastructure includes roads, bridges, dams, electric grid lines, and telecommunication satellites that enhance productivity.

Governments also try to promote technological advances to give their nations a competitive edge. This can include investments in basic and applied research at state-funded higher-educational institutions. Finally, governments also promote innovation and entrepreneurialism. In countries like Korea, France, and Norway, there are few women entrepreneurs.4 To close the gap in Norway, the government there created an action plan to increase grant accessibility for female entrepreneurs. The objective is to have women own at least 40 percent of entrepreneurial businesses.5 On the flip side, sometimes governments use trade restrictions and added tariffs on goods from other countries to create an artificial competitive advantage. We’ll discuss these practices later in the chapter.

What can businesses do to be more competitive? To be competitive, businesses must grapple with many of the same issues nations trying to be more competitive do. That is, successful companies try to gain access to cheap raw materials, invest in their workers’ training and productivity, and purchase state-of-the-art plants and equipment that will give them an edge. Successful companies also invest in cutting-edge technology in their research-and-development departments. Finally, they promote innovativeness throughout their organizations.

Conversely, if a company, an entire industry, or even a nation has lost its competitive advantage, then it probably failed in one or more of these areas. For example, at one time, the U.S. steel and textile industries had a competitive advantage in the world. Today, however, those industries have fallen behind their international competitors. It is the joint job of government and private businesses to determine the ways to improve to compete more effectively.

What are the benefits and costs of international trade? The theory of comparative advantage indicates that countries that participate in international trade will experience higher standards of living because of the greater quantity and variety of higher-quality products offered at lower prices. These results stem from the increased competition associated with more open trade. But these benefits are not without their costs.

The costs of international trade are borne by those businesses and their workers whose livelihoods are threatened by foreign competition. Some domestic businesses may lose market share to foreign companies, stunting their profitability and ability to create jobs. Other firms may face so much foreign competition that they’re driven out of business entirely.

Do the benefits of international trade outweigh the costs? This is a difficult question to answer. The costs of increased international trade—including lost jobs to foreign competitors—are often easy to identify. The benefits are not always easily seen, however, as they are spread out among millions of consumers. One measure used to quantify a country’s international trade is the balance of payments (BOP). The BOP summarizes all of the transactions—payments, financial aid, and gifts—that take place between residents of a country and the external world.

However, one number does not express the complexities of international trade. For example, a greater quantity and variety of higher-quality products to purchase may not be easily traced to increased international trade because these benefits are often slow and subtle. Price reductions may save people only a nickel here and a dime there. But the sum of these lower prices for the public as a whole can be dramatic—especially over time. As we’ll see in the next section, governments play a large role in determining how much international trade they will support, for example, by choosing to impose restrictions on the quantity and types of goods that can cross their nations’ borders.