Comparative Advantage and International Trade
Production Costs and Comparative Advantage
Comparative advantage is determined by opportunity cost, not by who can produce something most cheaply in absolute terms. A country has a comparative advantage in a good if it gives up less of other goods to produce it than another country does.
This distinction matters because a country can have an absolute advantage in every single good and still benefit from trade. Here's why: even if Country A is better at producing both wheat and cloth, it's probably relatively better at one of them. The opportunity costs within each country will still differ across goods, which creates room for specialization.
For example, suppose Country A can produce both bananas and coffee more efficiently than Country B. If Country A's opportunity cost of producing bananas (in terms of coffee foregone) is lower than Country B's, then Country A has the comparative advantage in bananas. Country B, by default, has the comparative advantage in coffee. Both countries gain by specializing and trading.
Mutual Benefits of Trade
Trade creates mutual benefits when each country specializes in the good where it has the lower opportunity cost:
- Each country exports the good(s) in which it has a comparative advantage (e.g., the US exports aircraft, China exports textiles).
- Each country imports the good(s) in which it has a comparative disadvantage.
Even a country with an absolute advantage in all goods benefits from this arrangement. By focusing production on its comparative-advantage goods, it produces more efficiently. It then trades for its comparative-disadvantage goods, obtaining them at a lower opportunity cost than producing them domestically.
The key result: specialization and trade allow both countries to consume beyond their own production possibilities frontier (PPF). The US can consume more textiles than it could produce alone, and China can consume more aircraft, because each is leveraging the other's relative strength.
Opportunity Costs and Advantageous Trade
Opportunity costs determine the relative prices of goods within a country. The relative price of good X in terms of good Y is:
When relative prices differ between two countries, there's an opportunity for advantageous trade. A country will export the good that has a lower relative price domestically and import the good with a higher relative price domestically. For instance, if soybeans are relatively cheap to produce in the US and cars are relatively cheap to produce in Japan, the US exports soybeans and Japan exports cars.
The degree of specialization depends on how opportunity costs behave as production shifts:
- Complete specialization occurs when opportunity costs are constant (a straight-line PPF). Each country devotes all resources to its comparative-advantage good.
- Partial specialization occurs when opportunity costs increase as more of a good is produced (a bowed-out PPF). At some point, shifting more resources yields diminishing returns, so countries produce some of both goods.
With trade, a country's consumption possibilities frontier expands beyond its PPF. The exact position of that new frontier depends on the terms of trade, which is the rate at which exported goods exchange for imported goods. As long as the terms of trade fall between the two countries' domestic opportunity costs, both sides come out ahead.