1.4 Comparative Advantage and Trade

Key Terms

• Absolute Advantage—the ability to produce more of a good or service with a given amount of resources than someone else.

• Comparative Advantage—the ability to produce a good at the lowest opportunity cost.

• Terms of Trade—the rate at which one good can be exchanged for another.

Introduction

The concepts of absolute advantage and comparative advantage illustrate how individual countries or entities interact and trade with each other. For example, countries can specialize in what they are good at producing and then trade for goods and services that they are not as efficient at.

There are two types of problems within these concepts:

• Output problems focus on how much can be produced given a set amount of resources.

• Input problems focus on how much of a resource is needed to produce one unit of a particular good or service.

Output Problems

The rules for these problems are:

• To determine the absolute advantage you are simply looking for which country can produce a higher amount of the good or service.

• To determine comparative advantage you have to calculate per unit opportunity cost using the formula give up/gain (the amount of good you are giving up divided by the amount of good you are gaining). Once you have calculated per unit opportunity cost, the country with the lowest one has a comparative advantage.

• If the two countries can both make the same amount of the good, then we say neither country has an absolute advantage.

• Countries export what they have a comparative advantage in and import what they don't have a comparative advantage in.

Determining Absolute Advantage

Using the table above, we would determine that Japan has absolute advantage in steel (1200 > 1000) and Canada has absolute advantage in coal (500 > 300).

Determining Comparative Advantage

The per unit opportunity cost for 1 unit of steel in Canada is 1/2 unit of coal (500/1000)

The per unit opportunity cost for 1 unit of steel in Japan is 1/4 unit of coal (300/1200)

Since 1/4 is less than 1/2, Japan has the comparative advantage in steel.

The per unit opportunity cost for 1 unit of coal in Canada is 2 units of steel (1000/500)

The per unit of opportunity cost for 1 unit of coal in Japan is 4 units of steel (1200/300)

Since 2 is less than 4, Canada has the comparative advantage in coal.

Therefore, Japan will export steel to Canada and import coal from Canada.

Terms of Trade

Terms of trade are determined by looking at the two opportunity costs and choosing a number that falls between the opportunity costs in order for it to be beneficial to both countries.

Acceptable terms of trade for this situation would be:

• 1 unit of coal for 3 units of steel

• 1 unit of steel for 1/3 units of coal

Input Problems

The rules for these problems are:

• To determine absolute advantage, you are looking for the country that uses the least amount of resources (i.e. the lower number)

• To determine comparative advantage, you have to calculate the per unit opportunity cost using the formula gain/give up. Once you have calculated the per unit opportunity cost, the country with the lowest one has a comparative advantage.

• If the two countries both can make one unit of the good with the same amount of resources, then we say neither country has an absolute advantage.

• Countries export what they have a comparative advantage in and import what they don't have a comparative advantage in.


Determining Absolute Advantage

Using the table, we would determine that Brazil has an absolute advantage in the production of cars (2 hours < 3 hours). Brazil also has an absolute advantage in the production of trucks (2 hours < 6 hours).

Determining Comparative Advantage

The per unit opportunity cost for 1 car in the United States is 1/2 a truck (3 divided by 6).

The per unit opportunity cost for 1 car in Brazil is 1 truck (2 divided by 2).

Since 1/2 is less than 1, the United States has a comparative advantage in the production of cars.

The per unit opportunity cost for 1 truck in the United States is 2 cars (6 divided by 3).

The per unit opportunity cost for 1 truck in Brazil is 1 car (2 divided by 2).

Since 1 is less than 2, Brazil has comparative advantage in the production of trucks.

Therefore, the United States will export cars to Brazil and import trucks from Brazil.

Terms of Trade

Terms of trade are determined by looking at the two opportunity costs and choosing a number that falls between the opportunity costs in order for it to be beneficial to both countries.

Acceptable terms of trade for this situation would be:

• 1 truck for 1.5 cars
• 1 car for 3/4 of a truck