for kim woods

Comparative Advantage

Comparative advantage is often misunderstood. When engaging in trade, countries maximize their gains when they specialize in the goods or services in which they have the greatest comparative advantage. Comparative advantage occurs when a country has a lower opportunity cost of producing a good or service. This is different from having an absolute advantage.

Absolute advantage is straightforward. When a country can produce a good more efficiently than another country (i.e. it consumes fewer resources to produce), it has an absolute advantage. When a country can produce a good more efficiently than it can produce other goods, it has comparative advantage.

The law of comparative advantage states that two countries can gain from trade when each concentrates on the production of that good in which it has the greatest comparative advantage.

Example: Assume we have two countries: Country A and Country B. They both are capable of producing wine and cheese. The relative prices and required hours to produce each good are summarized in the following table:

			Country A	Country B
Prices:	Wine	$/gallon	12	12
	cheese	$/lb	12	12
Hrs to make:	Wine	hrs/gallon	2	3
	cheese	hrs/pound	1	6

If we assume for simplicity that the only input is labor (1200 hours/year) and there is no trade between the countries, we can calculate the wages paid in each country in each industry.

Wine Wages in Country A = ($12/gallon)*(gallon/2 hrs) = $6/hr

We can repeat this calculation for each industry and country:

Country A Country B

Wages	wine workers	6	$/hr		4	$/hr
	cheese workers	12	$/hr		2	$/hr

What we know at this point is that wages are lower in each industry in Country B. We also see that Country A has an absolute advantage in manufacturing wine (uses only 2 hours/gallon) and in manufacturing cheese (requires 3-hrs/gallon).

If we were to open up the borders and allow free trade – which country would gain? You might say Country A would gain because they would have an absolute advantage in both goods. You might feel that Country B would gain more because they are a low wage country and would get all the jobs.

The answer is that both countries would benefit from trade. Low wages are not enough to take away jobs – the workers must also be efficient in those jobs.

To see why both countries gain, we must look at their comparative advantages. First, we calculate the opportunity costs. The opportunity cost is what they give up in order to produce the good. For example, to produce wine, they must give up the opportunity to make cheese. We state the opportunity cost of wine in terms of the amount of cheese foregone.

Wine in Country A requires 2-hrs/gallon. Cheese requires 1 hr/pound. Therefore, making 1 gallon of wine (2 hrs) = giving up the opportunity to make 2 pounds of cheese. The opportunity cost of a gallon of wine is = 2 pounds of cheese. We can repeat this for all products:

Country A Country B

What is the opportunity cost of?
	wine		2	lbs of cheese		0.5	lbs of cheese
	cheese		0.5	gallons of wine		2	gallons of wine

Now we can see that while Country A had an absolute advantage in both goods, it only has a comparative advantage in cheese. Country B has the comparative advantage in wine. Mathematically, a country will always have a comparative advantage in something, or will be relatively better at producing something.

Now let’s see how this allows both countries to gain from trade. We start by assuming that both countries have closed borders (no trade) and spend about half of their resources producing wine (600 hrs) and half producing cheese (600 hrs). We calculate the total output and the total revenue in each country.

Case 1: Two protectionist countries - Each uses ½ their resources for cheese and for wine
How much can each country produce?	Country A	Country B	Total
	wine	gallons/yr	300	200	500
	cheese	pounds/yr	600	100	700
What is total revenue?
	wine ind.	$/yr	3600	2400	6000
	cheese ind.	$/yr	7200	1200	8400
	total		10800	3600	14400

Now we assume that the countries allow free trade. Each country specializes in the good in which they have the comparative advantage.

Case 2: Two free trade countries - Each specializes
How much can each country produce?	Country A	Country B	Total
	wine	gallons/yr	0	400	400
	cheese	pounds/yr	1200	0	1200
What is total revenue?
	wine ind.	$/yr	0	4800	4800
	cheese ind.	$/yr	14400	0	14400
	total		14400	4800	19200

The total amount of revenue has risen from $14,400 to $19,200. Country A’s revenue increased from $10,800 to $14,400 and Country B’s increased from $3,600 to $4,800. Both countries are better off. Note that when the countries specialize and trade, wages are maximized in each country (workers shift to higher wage industries). More goods are being consumed in each country. The fact that Country B has lower wages did not mean that they got all the jobs. In general, free trade appears to be better than protectionism. However, while the overall economies are better off, the downsides are that wine workers in Country A will lose their jobs, need to be re-trained to make cheese, and may have to relocate.

You could argue that this case is extreme – each country is completely specializing and giving up the other industry. Also, there is less total wine being produced. You can also show that even if they want to maintain a minimum wine production, they will still gain. Here is an example:

BUT LESS WINE IS MADE?
How much can each country produce?	Country A	Country B	Total
	wine	gallons/yr	100	400	500
	cheese	pounds/yr	1000	0	1000
What is total revenue?
	wine ind.	$/yr	1200	4800	6000
	cheese ind.	$/yr	12000	0	12000
total	13200	4800	18000

While the world income is lower than complete specialization, wine production is maintained and both countries are still better off trading.

Revised 10/2011 Pg 1 of 2