“I can’t do everything!”

How many times have you thought or said that when frustrated that you had too many demands on your life and not enough time or resources? We all have to set life priorities according to what we can do best and need to do most. Our economy has the same frustrations and has to set priorities according to “comparative advantage.”

Comparative advantage, as it relates to a nation’s production possibilities, just means that we must produce what we are best at producing and need most. This takes into consideration such things as domestic resources, skills, labor availability, transportation options, and levels of demand. Because our wants will always exceed our abilities to produce, we have to decide what goods and services we want most and can produce most efficiently. Then, we sacrifice those less desired and least efficiently produced goods and services to other sources.

Looking at production decisions from a national perspective, we must determine what we can do more efficiently and economically than other nations. Then we allow other nations to produce what they can more efficiently and economically than we can. I use the following illustration with my students to simplify this concept.

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A country can produce both guns and butter. A gun is valued the same as a pound of butter. According to the graph, the country can produce 1000 pounds of butter if it produces no guns. Or, it can produce 200 guns if it produces no butter. Therefore, it sacrifices the production of five pounds of butter for each gun it produces. So, it is obviously better at producing butter than guns. It takes the same amount of resources to produce one gun as it does to produce five pounds of butter. This is perhaps due to more agricultural capability and resources than manufacturing capability and resources. The country can produce a mix of both guns and butter anywhere along the red curve. It’s always a five to one trade-off. For instance, it can produce 180 guns if it produces only 100 pounds of butter (giving up 900 pounds of butter). But, it can produce only 20 guns if it produces 900 pounds of butter (giving up 100 pounds of butter). I hope you can see that, no matter what mix of production the country chooses, it loses more proportionally when it produces guns than when it produces butter. So, the country’s comparative advantage is in producing butter. The country now has to determine how much it needs guns to be produced domestically and how many guns it could import from another country that has a comparative advantage in producing guns. It might do well to produce most of the world’s butter and let other countries produce its demand for guns. Although oversimplified, that is the concept that drives international trade.

America’s industries rely on this concept when deciding what to produce. Think about what our national comparative advantages include. We are the predominant builder of the world’s aircraft. We build most of the world’s heavy equipment. We produce most of the world’s movies, music, and other entertainment. That is because we have the raw materials, labor, technology, and infrastructure to produce these things more efficiently. In doing so, we have sacrificed the production of other things. Not long ago, we produced the most automobiles, but not any more. Once, we were the breadbasket of the world producing the most food, but China and India now have a slight advantage overall. Over a period of time, industrial leaders decided that we needed to concentrate on building more jetliners and let other countries build most of the home appliances.

America has in recent years transitioned toward a service economy in its comparative advantage. We have become the “go-to” nation for financial, business, and professional services around the world. Our educated and technology-savvy workforce has become better at advisory and solution services than at actually making things.

I know you hear a lot about America losing its commerce to foreign countries. There are lots of reasons for that, but the main reason is that other countries have made gains over us in several areas of comparative advantage. However, just bringing certain production back into our country won’t necessarily change the comparative advantage. Unless we gain back that advantage–more economical labor, resources, technology, etc.–the economy will not sustain reinstated domestic production in the long term. We are partners in a global economy whether we like it or not. The future of America’s economy will largely depend on maintaining vital raw materials, ensuring reasonable labor costs, advancing technology, and upgrading our nation’s infrastructure. Watch with interest as these factors are debated in this election year.

Next week, we will look at the fundamentals of how prices are determined by demand and supply. Click “Follow” on this page to ensure that you don’t miss the next post.