Comparative advantage in a good is attributed to the low opportunity cost producer of that good.
To understand the concept of comparative advantage, you must therefore understand the concept of opportunity cost -- the notion that in choosing any course of action, we give up the opportunity to pursue another course of action.
The opportunity cost of producing one more unit of a good is the number of units of another good that could have been produced with the same resources. For a more complete review of this concept in a production context, see the pages on the Production Possibility Frontier .
The central thesis of this document is that moving towards specialization along lines of comparative advantage will lead to mutual gains from trade.
This is not an all an obvious proposition: the mercantilists regarded trade as a zero-sum game, where nations either won or lost, and the winnings of the winners were the same in amount as the losses of the losers (so that, giving losses a minus sign and summing up winnings and losses, the answer would be zero).
While the mercantilist school was convincingly refuted by David Hume and Adam Smith, Hume and Smith argued the easy case that it pays a country to specialize in what it has an absolute advantage in. That is, if we are absolutely more productive in coffee than anyone else, we should export coffee; if we are absolutely more productive in oil than anyone else, we should specialize in exporting oil.
But what if our international competitors are more productive than us in all goods? Is it to our advantage to trade with them, or will we be "exploited" -- taken advantage of -- if we enter into trade? This is hardly a purely theoretical problem; recent US fears of growing Japanese and European productivity have led many people to be quite concerned about whether an open trading system is still in our interests. Many developing countries have surrounded themselves with high tariff walls because of precisely this concern that only the most efficient really benefit from international trade.
In the early 19th century, Thomas Malthus, arguing that Britain should retain its protection of grain (the "Corn Laws", which set high tariffs or taxes on all imported grain-- not just corn), gave powerful expression to this concern. He admitted that Britain was -- for the moment -- more efficient at the production of industrial goods than anyone else, but argued that this absolute advantage was unlikely to last. The plans for machinery and factories were easily exportable, and in fact, despite legal prohibitions, were being exported. As France and the United States industrialized, they might well prove as efficient or more efficient at the production of manufactured goods. They were already more efficient than Britain at the production of grain. In such a situation, was it really beneficial for Britain to stake her economic future on international trade? Malthus said no, and recommended turning away from the world market and protecting British agriculture.
Malthus' argument was convincingly refuted by David Ricardo. whose Principles of Political Economy and Taxation (1819) was at least as important as Smith's Wealth of Nations in the development of economics. Ricardo's refutation of Malthus turned on the notion of comparative advantage .
In particular, you should be familiar with the notions that:
We will carry out the demonstration with the aid of a simple example.
Given two countries,with country A (say Austria for concreteness) more productive in both goods than country B (say Bulgaria), we have to show that failure to trade leads to inefficiency, and trade leads to mutual gains.
The two countries differ in both their production functions (Austria has better machinery and more productive soil) and in population. Specifically, let us assume that these are:
Austria has a total labor force of 50 million.
Bulgaria has a total labor force of 200 million.
The numbers are of course arbitrary, but they do show that Bulgaria is less productive in both goods: One Austrian worker produces 6 units of good X (say machinery) while a Bulgarian worker produces only 1/2 unit. One Austrian worker produces 4 units of good Y (say wheat), while a Bulgarian worker produces only 2 units.
Austria has an absolute advantage in both goods, since absolute advantage always goes to the country with the higher labor productivity.
The diagrams below translate the situation into Production Possibility Frontiers:
One possibility is that both countries produce X only; another possibility is that both countries produce Y only. The outcomes here are calculated to give us the intercept points on the graph; neither is likely to be actually chosen.
The row labelled "Specialize" shows the results of both A and B devoting all their resources to the good in which they have a comparative advantage. Austria would produce 300 units of X and Bulgaria would produce 400 units of Y.
Compare the results if each country divides its labor force equally.
The last row, labelled "Autarky" shows that this would lead to a world total of 200 units of X and 300 units of Y -- that is, less Y and less X than could have been obtained by specialization.
| Possibility | Austria's output | Bulgaria's output | World output | |||
|---|---|---|---|---|---|---|
| -- | Qx | Qy | Qx | Qy | Qx | Qy |
| All X | 300 | 0 | 100 | 0 | 400 | 0 |
| All Y | 0 | 200 | 0 | 400 | 0 | 600 |
| Specialize | 300 | 0 | 0 | 400 | 300 | 400 |
| Autarky | 150 | 100 | 50 | 200 | 200 | 300 |
Graphically, the World Production Possibility Frontier would be:
i. Does our assumption that labor forces are divided equally between goods make a difference?
Answer: not much of one. Try any alternative division you please, say 1/4 of the labor force of each country in good X and the other 3/4 in good Y. Plot the resulting production point and you will find that it will be inside the world PPF. For some divisions of the labor force, autarky may result in more of good X or of good Y than specialization, but the critical point is that the autarky point will always be inside the world PPF.
ii. Does the relative size of the countries make much of a difference?
Answer: Again, not much of one. If you made both countries the same size (Austria and Bulgaria both have about 8 million people) you would find that the autarky point did not involve less of both goods; but it would still plot as a point inside the world PPF.
iii. Does this show that both countries gain from trade?
Answer: No, it shows only that the world gains from trade. It is certainly therefore possible that both countries gain, but we must do a bit more work to show that both countries do in fact gain from trade.
My trading possibility frontier would therefore go from 200 units on the X axis to 500 units on the Y axis; it would have a slope reflecting relative prices:
-500/200 = 2.5 (looking at the TPF and goods X and Y) or
Px/Py = $5/$2 = 2.5 (looking at the prices of the goods).
To construct a TPF in our example, we need to know -- or to make a reasonable assumption about -- what relative prices are before and after trade.
The "before trade" part is simple -- relative prices reflect opportunity costs or the slope of the PPF. This means that in Austria, relative prices will be
Px/Py = 2/3
and in Bulgaria, relative prices will be
Px/Py = 4
It may help to compute this in money terms. Let us assume that the wage in Austria is 12 schillings per unit of labor. Since the activity requirement for good X is 1/6, this means the price of good X will be (1/6) 12 = 2 schillings; since the activity requirement for good Y is 1/4, the price of good Y will be (1/4) 12 = 3 schillings. Hence, as claimed, the relative price is Px/Py = 2/3.
In Bulgaria, assume the wage is 30 levs per unit of labor. The price of good X, which has an activity requirement of 2, will therefore be 60 levs; the price of good Y, with an activity requirement of 1/2, will be 15 levs. Relative prices will be Px/Py = 60/15 = 4.
We cannot yet compute world relative prices after trade. We know only that relative prices must be somewhere between Austrian and Bulgarian autarky prices. Consider: in Austria, if Austria exports good X, there must be less of it available to supply the domestic market, and its price will therefore rise. At the same time, imports of good Y will drive down the price of good Y on the Austrian market, and Py will therefore rise in Austria. With Px rising and Py falling, Px/Py must rise in Austria -- to more than 2/3
At the same time, Bulgaria is importing good X. The price of good X will therefore fall in Bulgaria, since there is more of it on the market. It is exporting good Y, and since there is less of good Y on the Bulgarian market, its price will necessarily rise in Bulgaria. With Px falling and Py rising, Px/Py will necessarily fall in Bulgaria -- to less than 4.
The above reasoning shows only that the after-trade relative prices must be somewhere between 2/3 and 4; to establish exactly where would require that we bring demand as well as supply into the picture. Rather than introduce that complication, let me simply assume that after trade the relative prices settle down to Px/Py = 2, or good X will then be worth twice as much as good Y.
Both countries will face the same price ratio; can both countries gain from it?
The answer is an easily demonstrated YES. If Austria specializes in good X, she can produce 300 units of good X, which would at that price ratio trade for up to 600 units of good Y. Her trading possibility frontier is shown below. Note the similiarity here to what happens when labor productivity increases due to a technological improvement.
What about Bulgaria? If Bulgaria specializes in good Y, she will produce 400 units of good Y. It is true that good Y is (at our assumed world price ratio) only half as valuable as good X, but still, Bulgaria can trade for up to 200 units of good Y at the assumed world prices. This is more than the 100 units of Y she could produce on her own, so the Bulgarian TPF also shifts outward.
