Comparative advantage
Why do countries trade, even when one could make everything more cheaply? David Ricardo's principle of comparative advantage answers this.
Absolute advantage
A producer has an absolute advantage in a good if it can make more of it with the same resources. Adam Smith argued that countries gain by specialising in goods where they have an absolute advantage and trading for the rest.
Comparative advantage
A producer has a comparative advantage in a good if it has a lower opportunity cost of producing it. David Ricardo showed in 1817 that even if one country is better at producing everything, both countries gain by specialising according to comparative advantage and trading.
Worked example
In one day, Country A can make 10 cars or 20 tonnes of wheat; Country B can make 2 cars or 10 tonnes of wheat. A has an absolute advantage in both. A's opportunity cost of a car is 2 tonnes of wheat; B's is 5 tonnes. So A has a comparative advantage in cars, and B in wheat (B gives up 0.2 cars per tonne versus A's 0.5).
Gains from trade
In that example, if A specialises in cars and B in wheat, and they trade at a rate between their opportunity costs, say 1 car for 3 tonnes of wheat, both can consume combinations outside their own production possibilities. A receives 3 tonnes of wheat for each car, more than the 2 tonnes it would sacrifice to grow the wheat itself; B pays only 3 tonnes for a car that would cost it 5 tonnes to make. Both are better off.
Sources of comparative advantage
Comparative advantage arises from differences in climate and natural resources (Brazil and coffee), in the abundance of labour or capital (labour-abundant countries specialise in labour-intensive goods), in technology and skills, and from economies of scale and accumulated know-how in particular industries.
Specialisation in daily life
Comparative advantage applies to people too. A top lawyer may type faster than her assistant, but her opportunity cost of typing is very high, so it makes sense for the assistant to type and the lawyer to practise law. Trade between people, regions, and countries rests on the same logic.
Terms of trade
The terms of trade are the rate at which a country's exports exchange for imports. For both sides to gain, the terms must lie between the two countries' opportunity costs. If the price of a country's exports rises relative to its imports, its terms of trade improve.
Winners and losers
Trade increases total output, but not everyone gains. Workers and firms in industries facing new import competition may lose jobs or income, while consumers and exporting industries gain. Economists generally argue the gains are large enough that winners could compensate losers, though in practice compensation is often limited.
Key takeaways
Absolute advantage means producing more with the same resources; comparative advantage means a lower opportunity cost. Ricardo showed both countries gain by specialising in their comparative advantage and trading at terms between their opportunity costs. Comparative advantage comes from resources, factor abundance, technology, and scale. Trade creates both winners and losers.
Flashcard
Producing more with the same resources
Check your understanding
Country X can produce 6 shirts or 3 phones per worker; Country Y can produce 4 shirts or 1 phone. Which has the comparative advantage in phones?