Comparative Advantage: The Island and the Continent
The principle of "Comparative Advantage" states that even if one nation can produce every single good more efficiently than another nation, they can still both benefit from trading with each other. If you have trouble wrapping your head around that, don't worry! Here is an example that will help you to visualize the process.
On the island a worker will produce in a given time one bushel of widgets or two cases of gadgets, while on the continent the same amount of labor, in the same time, will produce two bushels of widgets or ten cases of gadgets. Therefore, both products are cheaper on the continent than on the island.
At first thought it might appear that the continentals cannot possibly profit by importing anything from the island and that if there is to be any trading it must be all one way. Protectionists will recommend that the islanders adopt a tariff, for unless they have one the island will be flooded with the cheap goods of the continent; their home industries will be out-competed; their workers will be unemployed.
Here is the production of widgets and gadgets in the two countries with 3,000 workers employed in each, using the productivity figures stated above. No foreign trading is contemplated:
In time, it dawns on entrepreneurs on the island that they are not so very efficient at making gadgets. They set aside their ill-advised effort to compete in the gadget market. Instead, 250 workers are added to those producing widgets for home consumption, and 750 workers produce widgets for export.
Meanwhile, on the continent, entrepreneurs realize there's a lot more profit in gadgets than in widgets. So, 250 workers are shifted from the widget mills to state-of-the-art gadget factories. Of these, 225 workers produce gadgets for export.
Now, each country has employed the same 3000 workers, but instead of making the mistake of producing everything "here at home," each did the sensible thing and produced more of their more profitable item and less of their less profitable item and traded their surplus. Both the islanders and the continentals have 250 more bushels of widgets and 250 more cases of gadgets than they would have had with the same amount of labor, had there been no trading!
Suppose the islanders decided to devote some of their public revenue to subsidizing their gadget-making industry, to improve its productivity. In which scenario would they be more able to do so?