An economy can focus on producing all of the goods and services it needs to function, but, this may lead to an inefficient allocation of resources and hinder future growth. By using specialization, a country, instead of dividing up its resources, could concentrate on the production of the one thing that, relative to itself, it can do the best.
For example, let’s look a hypothetical world that has only two countries (Country A and Country B) and two products (cars and cotton). Each country can make cars and/or cotton. Now, suppose that country A has very little fertile land and an abundance of steel for car production. Country B, on the other hand, has an abundance of fertile land but very little steel. If country A were to try to produce both cars and cotton, it would need to divide up its resources. Because it requires lots of effort to produce cotton via irrigation of land, country A would have to sacrifice producing cars. The opportunity cost of producing both cars and cotton is high in country A, who will have to give up a lot of capital in order to produce both. Similarly, for country B, the opportunity cost of producing both products is high because the effort required to produce cars is greater than that of producing cotton.
So, each country can produce one of the products more efficiently (at less cost) than the other. Country A, who has an abundance of steel, would need to give up more cars than country B would to produce the same amount of cotton. Country B would need to give up more cotton than country A would to produce the same amount of cars. Thus, country A has a comparative advantage over country B in the production of cars, and country B has a comparative advantage over country A in the production of cotton.
Now say the countries specialize in producing the goods with which they have a comparative advantage. If they trade goods, they produce for those goods in which they don’t have a comparative advantage; both countries will be able to enjoy both products at a lower opportunity cost. Furthermore, each country will be exchanging the best product it can make for another good or service that is the best the other country can produce. Specialization and trade works also between many different countries. For example, if country C specializes in the production of corn, it in turn can trade its corn for cars from country A, and cotton from country B.
Determining how countries exchange goods produced by a comparative advantage (the best for the best) is the backbone of international trade theory. This method of exchange is considered an optimal allocation of resources, whereby economies, in theory, would no longer be lacking any of their needs. Like opportunity cost, specialization and comparative advantage apply also to the way in which individuals interact within an economy.