Comparative Advantage

Comparative Advantage Graph

Figure 1 below illustrates the comparative advantage graph.

Fig 1. - Comparative Advantage

We have two countries, A and B, where country A can produce 200 units of wine and 1000 units of computers and country B can produce 800 units of wine and 150 units of computers.

The curve in Figure 1 above shows the Production Possibility Curve for each of the two countries. None of these countries can consume and produce above the production possibility curve.

The opportunity cost for country A, if it decided to focus only on producing computers, is 200/1000=2/10=1/5 of a bottle of wine not made. The opportunity cost of country B focusing only on computers is 800/150=16/3, meaning they lose a lot of wine if they decide to focus only on producing computers.

From the calculation above it is clear that country A has a comparative advantage over Country B in computer production, whereas country B has a comparative advantage over country A in wine production. Note that country A has an absolute advantage over Country B as it can produce more units of both wine and computers combined than country B.

The absolute advantage would suggest that country A doesn’t have to trade with country B, but that is not the case.

Comparative advantage suggests that country A will be trading with country B as the opportunity cost of trading with country B is lower than the opportunity cost country A would face if it spends time in wine production. That is to say, country A is incentivized to trade with country B as it benefits more. The same goes for country B.

Gains from Trade and Comparative Advantage

If country A and country B decided to trade with one another they both would benefit from this trade.

Fig 2.- Gains from trade and comparative advantage, StudySmarter Original

Figure 2 shows what happens when there is trade between these two countries. Country A can increase its consumption of wine from 200 to 250, and country B can increase its consumption of computers from 150 to 200.

This is known as gains from trade and it refers to the gains two countries receive from focusing on what they have a comparative advantage in and trading it for the good the other country has a comparative advantage in.

Another important concept that you should be aware of here is terms of trade - this refers to the price of one good in terms of the other that two individuals or countries agree to trade on. Whenever you have an individual or a country receiving a good that comes at a lower price than their opportunity cost for producing it, you have beneficial terms of trade.

Comparative Advantage and International Trade

When countries focus on specializing their production in one particular good, and they have a comparative advantage over another country, and vice-versa, both these countries could benefit from trading with one another.

The benefit of comparative advantage in international trade is that it allows countries to achieve consumption levels of certain goods that they otherwise would not be able to. The reason for that is that they lower the opportunity cost of focusing on a specific good by trading it for the good the other country is specialized in.

Think about it, if you are good at growing apples and not so good at growing oranges, why wouldn't you focus on growing apples and exchange some of the apples for oranges produced by another guy who is good at growing them? Keep in mind that the cost you pay to exchange your apples for oranges is lower than the opportunity cost of you making apples and oranges together.

Comparative Advantage Example

A comparative advantage example from today's world. Think about China and the United States. China's comparative advantage over the United States comes in the form of cheap labor, which the United States cannot match. Chinese employees create basic consumer items at a lower opportunity cost than their counterparts in the United States. The reason for that is that China has a larger portion of unskilled labor compared to the US. That's why using this labor in the production of basic customer items doesn't create much opportunity cost for China.

On the other hand, a specialized, high-skilled workforce is where the United States has a comparative advantage. American employees generate sophisticated items or investment possibilities at lower opportunity costs than their counterparts in China. Specializing and trading in this manner are beneficial to both parties: the US and China.

Comparative Advantage Formula

To determine the comparative advantage, we must know how many commodities are produced per unit of labor. The labor unit may be whatever you choose, with the most popular ones being: working days and the number of employees.

The comparative advantage formula is as follows:

$Comparativeadvantage=\frac{OutputA}{OutputB}$

Theory of Comparative Advantage

The theory of comparative advantage was developed by the 19th-century British economist David Ricardo¹, who attributed the causes of international trade to differences countries have in their relative opportunity cost in producing the same commodity.

The comparative advantage theory suggests that the opportunity cost of producing a certain good should be considered when a country chooses which good or service to focus on making. By specializing and trading in accordance with their comparative advantages, David Ricardo demonstrated how both England and Portugal gained from this strategy.

During the time Ricardo was developing the theory of comparative advantage, England could produce clothes at a low cost while Portugal was able to produce wine at a low cost. Ricardo anticipated that each nation would finally come to terms with these realities and abandon attempts to manufacture the product that was more expensive to produce.

Indeed, as time progressed, England ceased to produce wine, and Portugal ceased to manufacture fabric.

Both nations realized that it was in their best interests to abandon their attempts to produce these things domestically and instead trade with one another in order to get them.