Comparative advantage is a fundamental concept in economics, especially when discussing international trade. It explains why countries and even individuals can benefit from trading with each other, even if one party is better at producing everything. Understanding How To Figure Out Comparative Advantage is crucial for grasping the dynamics of global markets and making informed economic decisions. This guide will walk you through the concept, providing clear examples and a step-by-step method to identify comparative advantage.
Understanding Absolute and Comparative Advantage
Before diving into how to figure out comparative advantage, it’s important to distinguish it from absolute advantage. These two concepts are related but distinct, and understanding their differences is key to grasping the power of comparative advantage.
Absolute Advantage
Absolute advantage refers to the ability of a country, individual, or company to produce a greater quantity of a good, product, or service than competitors, using the same amount of resources. Essentially, it’s about who is simply better at producing something.
Consider the example of the United States and Mexico producing shoes and refrigerators. Let’s look at the resources, in this case, labor, needed to produce 1,000 units of each good, as shown in Table 1.
Table 1. Resources Needed to Produce Shoes and Refrigerators
| Country | Number of Workers needed to produce 1,000 units — Shoes | Number of Workers needed to produce 1,000 units — Refrigerators |
|—|—|—|
| United States | 4 workers | 1 worker |
| Mexico | 5 workers | 4 workers |
As you can see from Table 1, the United States requires fewer workers to produce both 1,000 pairs of shoes (4 workers) and 1,000 refrigerators (1 worker) compared to Mexico (5 workers for shoes and 4 workers for refrigerators). In this scenario, the United States has an absolute advantage in producing both shoes and refrigerators. They are simply more productive in both industries when we look at the amount of labor required.
Comparative Advantage
Comparative advantage, however, is a more nuanced concept. It focuses on the opportunity cost of production. Instead of looking at who is simply more productive, comparative advantage asks: At what relative cost can a country produce a particular good? Opportunity cost is what you give up to produce something else. In the context of countries and trade, it’s about what a country sacrifices to produce more of one good in terms of forgone production of another good.
To find comparative advantage, we don’t just compare the input (like workers) needed; we compare the opportunity costs. Let’s revisit the US and Mexico example.
The United States can produce 1,000 shoes using 4 workers or 1,000 refrigerators using only 1 worker. For shoes, the US uses four-fifths the workers Mexico does (4 vs. 5). For refrigerators, the US uses only one-quarter the workers Mexico does (1 vs. 4). While the US has an absolute advantage in both, its advantage is relatively larger in refrigerators. Conversely, Mexico’s absolute disadvantage is relatively smaller in shoes.
Therefore, the United States has a comparative advantage in refrigerators, where its absolute productivity advantage is greatest. Mexico, on the other hand, has a comparative advantage in shoes, where its absolute productivity disadvantage is least.
The key takeaway is that comparative advantage is not about being the best at something; it’s about being relatively better at producing something compared to other goods or countries. It’s about identifying where your opportunity cost is lower.
Mutually Beneficial Trade with Comparative Advantage
The power of comparative advantage lies in its ability to create mutually beneficial trade opportunities. When countries specialize in producing goods where they have a comparative advantage and trade with each other, overall production and consumption can increase, making both countries better off. The production possibilities frontier (PPF) is a useful tool to visualize this.
Recall that a production possibilities frontier illustrates the maximum combinations of two goods a country can produce with its given resources. Let’s assume both the United States and Mexico each have 40 workers.
Table 2 shows the production possibilities if each country dedicates all 40 workers to producing either shoes or refrigerators.
Table 2. Production Possibilities before Trade
| Country | Shoe Production — using 40 workers | Refrigerator Production — using 40 workers |
|—|—|—|
| United States | 10,000 shoes | or | 40,000 refrigerators |
| Mexico | 8,000 shoes | or | 10,000 refrigerators |
For the United States, with 40 workers, they can produce 10,000 shoes (since 4 workers make 1,000 shoes, 40 workers will make 10,000) or 40,000 refrigerators (since 1 worker makes 1,000 refrigerators, 40 workers make 40,000). Similarly, for Mexico, 40 workers can produce 8,000 shoes or 10,000 refrigerators.
The slope of the PPF represents the opportunity cost. In this case, it’s the opportunity cost of producing one refrigerator in terms of shoes forgone.
Figure 1. Production Possibility Frontiers. (a) With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources. Point A on both graphs is where the countries start producing and consuming before trade. Point B is where they end up after trade.
Let’s assume before trade, both countries choose to produce and consume at point A on their PPFs, representing a mix of shoes and refrigerators. Table 3 shows the production at point A for each country and the total combined production.
Table 3. Production at Point A before Trade
| Country | Current Shoe Production | Current Refrigerator Production |
|—|—|—|
| United States | 5,000 | 20,000 |
| Mexico | 4,000 | 5,000 |
| Total | 9,000 | 25,000 |
Now, let’s see what happens when both countries specialize based on their comparative advantage. The United States shifts some labor towards refrigerators (their comparative advantage), and Mexico shifts labor towards shoes (their comparative advantage).
Suppose the United States moves 6 workers from shoe production to refrigerator production. Shoe production decreases by 1,500 pairs (6/4 × 1,000), and refrigerator production increases by 6,000 (6/1 × 1,000). Mexico, shifting 10 workers from refrigerators to shoes, decreases refrigerator production by 2,500 (10/4 × 1,000) and increases shoe production by 2,000 (10/5 × 1,000).
Table 4 shows the resulting production after this shift towards comparative advantage. Notice that the combined production of both shoes and refrigerators has increased!
Table 4. Shifting Production Toward Comparative Advantage Raises Total Output
| Country | Shoe Production | Refrigerator Production |
|—|—|—|
| United States | 3,500 | 26,000 |
| Mexico | 6,000 | 2,500 |
| Total | 9,500 | 28,500 |
This example illustrates a crucial insight: even if a country has an absolute advantage in everything (like the US in this example), specializing in comparative advantage and trading leads to higher overall output and potential gains for all trading partners. The United States, despite being better at producing both goods, benefits from specializing in refrigerators and importing shoes from Mexico, and vice versa.
Can a production possibility frontier be straight?
In many introductory economics models, production possibility frontiers are depicted as curves bending outwards. This curvature reflects the principle of increasing opportunity costs, where shifting resources becomes less and less efficient as you specialize. However, for simplicity and to clearly demonstrate concepts like absolute and comparative advantage, economists often use straight-line PPFs. Straight-line PPFs imply constant opportunity costs, meaning the trade-off between producing two goods remains constant regardless of the production level. While less realistic, this simplification helps focus on the core principles of comparative advantage.
How Opportunity Cost Sets the Boundaries of Trade
Opportunity costs define the boundaries within which trade becomes mutually beneficial. Let’s look at the opportunity costs in our example to understand the possible range of beneficial trades between the US and Mexico.
Before specialization, Mexico produced 4,000 shoes and 5,000 refrigerators. After specializing, Mexico produces 6,000 shoes and 2,500 refrigerators. For Mexico to benefit from trade, it needs to export shoes and import refrigerators in a way that allows it to consume more than its pre-trade consumption of both goods. If Mexico exports no more than 2,000 pairs of shoes (giving up the increase in shoe production from specialization) and imports at least 2,500 refrigerators (gaining back or exceeding the reduction in refrigerator production), it will be better off.
Similarly, the United States, before specialization, produced 5,000 shoes and 20,000 refrigerators. After specializing, it produces 3,500 shoes and 26,000 refrigerators. For the US to gain, it needs to export refrigerators and import shoes such that it consumes more of both than before trade. If the US exports no more than 6,000 refrigerators (the increase in refrigerator production) and imports at least 1,500 pairs of shoes (partially compensating for reduced shoe production), it will also be better off.
Table 5 summarizes the range of mutually beneficial trades. For example, if the US exports 4,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes, both countries would gain.
Table 5. The Range of Trades That Benefit Both the United States and Mexico
| The U.S. economy, after specialization, will benefit if it: | The Mexican economy, after specialization, will benefit if it: |
|—|—|
| Exports fewer than 6,000 refrigerators | Imports at least 2,500 refrigerators |
| Imports at least 1,500 pairs of shoes | Exports no more than 2,000 pairs of shoes |
International trade, guided by comparative advantage, allows countries to access lower opportunity costs. Mexico, wanting more refrigerators without trade, would have to reduce shoe production based on its own domestic opportunity costs. However, by specializing in shoes and trading with the US for refrigerators, Mexico effectively takes advantage of the lower opportunity cost of refrigerator production in the United States. Conversely, the US benefits from Mexico’s lower opportunity cost of shoe production.
The theory of comparative advantage explains the fundamental reason for international trade: differences in comparative advantages. Gains from trade arise from specializing where opportunity costs are lower.
Calculating Absolute and Comparative Advantage: A Step-by-Step Guide
Let’s work through a practical example to illustrate how to calculate absolute and comparative advantage. Consider Canada and Venezuela, producing oil and lumber. The production per worker is shown in Table 6.
| Table 6. Oil and Lumber Production in Canada and Venezuela |
|---|
| Country |
| Canada |
| Venezuela |
Let’s follow these steps to determine absolute and comparative advantage:
Step 1: Set up the production table. Organize the data as in Table 6, showing the output of each good per worker in each country.
Step 2: Determine absolute advantage. For each good, identify which country can produce more with the same amount of resources (one worker in this case).
- Oil: Venezuela produces 60 barrels, Canada produces 20 barrels. Venezuela has absolute advantage in oil.
- Lumber: Canada produces 40 tons, Venezuela produces 30 tons. Canada has absolute advantage in lumber.
Step 3: Calculate comparative advantage for oil. To find comparative advantage, we need to calculate the opportunity cost of producing one unit of each good in each country. Let’s start with oil.
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Canada’s Opportunity Cost of Oil: In Canada, a worker can produce 20 barrels of oil OR 40 tons of lumber. So, 20 barrels of oil is equivalent to 40 tons of lumber. We can write this as: 20 Oil = 40 Lumber. To find the opportunity cost of one barrel of oil, divide both sides by 20: (20/20) Oil = (40/20) Lumber. This simplifies to: 1 Oil = 2 Lumber. So, in Canada, producing one barrel of oil means giving up 2 tons of lumber.
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Venezuela’s Opportunity Cost of Oil: In Venezuela, a worker can produce 60 barrels of oil OR 30 tons of lumber: 60 Oil = 30 Lumber. Divide both sides by 60 to find the opportunity cost of one barrel of oil: (60/60) Oil = (30/60) Lumber. This simplifies to: 1 Oil = 1/2 Lumber. In Venezuela, producing one barrel of oil means giving up 1/2 ton of lumber.
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Comparing Opportunity Costs for Oil: Canada’s opportunity cost of oil is 2 tons of lumber, while Venezuela’s is only 1/2 ton of lumber. Because 1/2 Lumber < 2 Lumber, Venezuela has a lower opportunity cost of producing oil. Therefore, Venezuela has a comparative advantage in oil production.
Step 4: Calculate comparative advantage for lumber. Now, let’s find the comparative advantage in lumber. We calculate the opportunity cost of producing one ton of lumber in each country.
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Canada’s Opportunity Cost of Lumber: From Step 3, we know 40 Lumber = 20 Oil in Canada. Divide both sides by 40: (40/40) Lumber = (20/40) Oil. This simplifies to: 1 Lumber = 1/2 Oil. In Canada, producing one ton of lumber means giving up 1/2 barrel of oil.
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Venezuela’s Opportunity Cost of Lumber: From Step 3, we know 30 Lumber = 60 Oil in Venezuela. Divide both sides by 30: (30/30) Lumber = (60/30) Oil. This simplifies to: 1 Lumber = 2 Oil. In Venezuela, producing one ton of lumber means giving up 2 barrels of oil.
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Comparing Opportunity Costs for Lumber: Canada’s opportunity cost of lumber is 1/2 barrel of oil, while Venezuela’s is 2 barrels of oil. Because 1/2 Oil < 2 Oil, Canada has a lower opportunity cost of producing lumber. Therefore, Canada has a comparative advantage in lumber production.
Step 5: Summarize comparative advantage and specialization.
- Canada has a comparative advantage in lumber.
- Venezuela has a comparative advantage in oil.
Step 6: Determine trade patterns. Countries should specialize in producing the goods where they have a comparative advantage and trade for other goods.
- Canada should specialize in lumber production and export lumber.
- Venezuela should specialize in oil production and export oil.
- Canada will import oil from Venezuela, and Venezuela will import lumber from Canada.
In this example, notice that absolute advantage and comparative advantage are aligned: Canada has both absolute and comparative advantage in lumber, and Venezuela has both in oil. However, this is not always the case. Comparative advantage, determined by opportunity costs, is the true driver of beneficial specialization and trade.
Trade and Incomes
The concept of comparative advantage is deeply linked to income levels. Income in an economy is fundamentally tied to labor productivity. Countries with an absolute advantage in producing certain goods generally have higher labor productivity in those sectors. If a country holds absolute advantage across many industries, it signifies higher average labor productivity, leading to higher average incomes for its workers compared to countries with lower absolute advantages.
However, when considering international trade and maximizing living standards, comparative advantage takes precedence over absolute advantage. By specializing in sectors where they possess a comparative advantage, countries can further boost their average labor productivity. This specialization allows resources to be used more efficiently, leading to increased overall output and, consequently, higher average incomes.
Therefore, for understanding international trade patterns and how countries can maximize their economic well-being through trade, comparative advantage is the more critical concept. It dictates which goods a country should focus on producing and trading to enhance the standard of living for its population.
Watch It
To further solidify your understanding of comparative advantage and its benefits, consider watching this video that visually explains these concepts:
[Link to video about comparative advantage benefits]
For additional numerical examples and practice, this video from ACDC economics provides a helpful review:
[Link to ACDC economics video]
By understanding and applying the concept of comparative advantage, you can gain valuable insights into international trade, specialization, and the factors that contribute to economic prosperity.
