What is Competitive Advantage?

So if we are not using Tariffs to artificially boost our competitiveness, how are we meant to make money with international trade?

Competitive advantage is the principle that a country will produce something it better at producing than anyone else. It could be a pricing advantage. Maybe the country has low wages and can make goods cheaply. It could be a technological advantage. The country could have advanced technologies that other countries do not know how to use as well.

In the Perfect Capital Market, a place with no taxes, government and free trade (thinkĀ  Capitalist), countries produce what they have a competitive advantage in. The country will sell some of those goods as exports to other countries. The other countries will trade goods that they have a competitive advantage in.

For example, imagine a world of only two countries. They are called the United States and Australia. The United States is really good at making computers. The United States makes the best, most advanced computers in the world. Far better than what Australia can make. The United States has a competitive advantage in computers. Australia has a competitive advantage in solar panels. Australia’s solar panels are the most efficient in the world.

Australia produces solar panels at a cost of $10 and exports them to the United States. The solar Panels are sold to the United States for $20. The United States uses those solar panels to make it’s computers at a cost of $10. The United States exports it’s computers to Australia who buys them for $20. Australia in turn designs even better solar panels. Both countries are trading where they have a competitive advantage. Both countries benefit. In this case they benefit equally. Each country makes $10 profit.

What if there was a third good? Wheat. Both the United States and Australia are good at producing wheat. Australia is really efficient at producing wheat. The United States wants to trade it’s wheat with Australia instead of computers. Australia has cheap wheat because it is so efficient at producing wheat. Wheat costs $5 to produce in Australia and is sold for $10 in Australian shops. Australia will only pay the United States $10 for it’s wheat.

Wheat in the United States costs $6 to produce. The United States will only make $4 profit in Australia but Australia will make $5 profit. Australia has a competitive advantage for wheat. But it is small. The United States can try to sell it’s wheat to Australia, but it will never make as much money selling wheat as Australia. Eventually Australia will be ahead as all those dollars start to add up.

What would the United States be better off producing to make the most possible profit? Computers. Because that’s where the United States has a competitive advantage.