Int'l Trade: Comparative Advantage

The Principle of Comparative Advantage There are mutual gains from international trade, which means that, on average, citizens in all trading nations gain from exchanging goods in international markets. A simplified example can be used to illustrate the underlying basis for international trade. Suppose two nations both have the capability of producing bananas and wheat. Both nations have the same quantity of natural resources, labor, and capital. The table in Box 4 shows the production possibilities in the two nations when they devote all of their resources to producing either bananas or wheat. Nation A has the opportunity to produce 20 tons of wheat or 20 tons of bananas per year if it specializes in one or the other. Nation B can produce 5 tons of wheat or 10 tons of bananas per year by specializing in production of one item or the other. Notice that with the same resources nation A can produce more wheat when it specializes in that good than can nation B. Similarly, nation A can produce more bananas when it specializes in production of that item than can nation B. With the same resources nation A can therefore produce more than nation B no matter how it specializes. A nation has an absolute advantage over other nations in the production of an item if it can produce more of the item over a certain period with a given amount of resources than the other nations can. Nation A has an absolute advantage in the production of wheat over nation B in this example, because, with the same resources, nation A can produce more wheat by specializing in wheat production than can nation B. In this example nation A also has the absolute advantage in the production of bananas because with the same resources as are available in nation B it can produce more bananas than can nation B. Another way of interpreting nation A's absolute advantage over nation B in both wheat and banana production is to point out that in nation A each unit of either wheat or bananas can be produced with less input than it can be produced in nation B. For example, suppose that the only inputs used to produce wheat are land and labor. Suppose both nations A and B have 2,000 labor hours available per year and the same amount of land. When nation A specializes in wheat production it can produce 20 tons per year with its 2,000 labor hours. The labor cost per ton will be The labor cost per ton of wheat in nation B when nation B specializes in wheat production will be Given the same quantity of land in both nations, wheat is four times as expensive in terms of labor required per ton in nation B as it is nation A. Similarly, just by looking at labor cost you can see that nation A's absolute advantage over nation B in banana production means it can produce bananas with fewer labor hours per ton than can nation B. The labor cost per ton of bananas in nation A is In nation B the labor cost per ton of bananas is Bananas therefore cost twice as much in terms of labor input per ton in nation B compared to nation A. We can show that nation A's absolute advantage over nation B in both items means that each ton requires less land in A than it does in B. In general, when a nation has an absolute advantage, it can produce the specific item with fewer inputs per unit than other nations. Despite the fact that nation A has an absolute advantage over nation B, we can easily demonstrate that the citizens of nation A can gain by specializing in one of the goods and then trading with nation B to obtain the other. This remarkable conclusion stems from the fact that the gains possible from trade are determined by the opportunity cost of each unit of one good in terms of the other rather than by the input cost. To see this, begin by calculating the opportunity cost per unit of each of the commodities in each nation. To simplify the analysis, suppose that each ton of each commodity involves the sacrifice of a constant amount of the other commodity in each nation. Because nation A can produce either 20 tons of wheat or 20 tons of bananas, it will give up the opportunity to produce 20 tons of bananas if it chooses to specialize in the production of wheat. The opportunity cost of each ton of wheat is the sacrifice of bananas associated with each extra ton of wheat produced per year. Assuming constant costs per ton of wheat, the opportunity cost of each ton of wheat in nation A is 1 ton of bananas. A similar calculation can be performed for nation B. Because nation B can produce either 5 tons of wheat or 10 tons of bananas, it follows that it gives up 2 tons of bananas for each extra ton of wheat, assuming constant costs. The opportunity cost of producing a ton of wheat is therefore 2 tons of bananas for nation B. The opportunity cost of bananas for each of the two nations is calculated in the same way. The table in Box 4 shows that the opportunity cost of bananas is 1 ton of wheat in nation A and ½ ton of wheat in nation B, assuming constant costs. The graphs in Box 5 show the production possibilities curves for these two goods in each of the two nations, A and B. The curves have been drawn under the assumption that there is a constant rate in each nation at which bananas are sacrificed for more wheat as resources are allocated from banana production to wheat production. This implies constant opportunity costs per unit, meaning that the opportunity cost of each unit of one of the goods in terms of the other is constant, as was assumed in the calculation of Box 4. The main point of the analysis also holds for the case of increasing costs, but the argument for that case is considerably more complicated. Note that the slope of each production possibilities curve represents the opportunity cost of bananas in terms of wheat multiplied by -1. The slope of the production possibilities curve for nation A is -1, which means each extra ton of bananas produced per year involves the sacrifice of 1 ton of wheat per year. The slope of the production possibilities curve for nation B is -0.5, which means each extra ton of bananas produced per year involves the sacrifice of ½ ton of wheat. A nation has a comparative advantage over a trading partner in the production of an item if it produces that item at lower opportunity cost per unit than its partner does. The gains possible from international trade stem from the decrease in opportunity cost per unit of output that is possible when nations specialize in goods in whose production they enjoy a comparative advantage. By specializing, a nation uses its resources to produce items for which it enjoys a comparative advantage. It then exports some of its annual output in exchange for other goods that can be obtained at lower opportunity cost per unit when they are produced by other nations. A theory of comparative advantage was one of the many contributions to economic thought of the 19th-century British economist David Ricardo (see the Economic Thinkers box). The graphs in Box 6 plot the opportunity cost of each ton of wheat in each of the nations in this example. It's clear that nation A has the comparative advantage in production of wheat over nation B because it can produce each ton of wheat at half the opportunity cost (in terms of bananas forgone) than is possible in nation B. It's also easy to show that nation B has a comparative advantage in bananas, assuming its only possible trading partner is A. To see this, note that the opportunity cost of additional bananas for A is 1 ton of wheat. For each extra ton of bananas produced by A, the resources diverted from wheat production will result in a loss of 1 ton of wheat. In nation B, however, you can see, by looking at the production possibilities curve in Box 5 that each ton of bananas produced involves the loss of only ½ ton of wheat. Thus if resources were reallocated in nation B to produce 2 more tons of bananas, the sacrifice would be only 1 ton of wheat. The graphs in Box 7 show the opportunity cost of bananas in terms of wheat in each nation. Note that nation B has the comparative advantage in bananas, because it can produce the bananas at half the opportunity cost of A. Despite its absolute advantage in both goods, nation A is relatively more efficient in the production of wheat only compared to nation B. Nation A gives up only 1 ton of bananas for each ton of wheat while nation B must give up 2 tons of bananas for each ton of wheat. Nation A, however, is relatively less efficient in the production of bananas compared to nation B, because it must give up a ton of wheat for each ton of bananas if it produces bananas, but nation B has to give up only ½ ton of wheat.