Lesson summary: Comparative advantage and gains from trade
Absolute advantage describes a situation in which an individual, business or country can produce more of a good or service than any other producer with the same quantity of resources.
The United States, for example, has a skilled workforce, abundant natural resources, and advanced technology. Because of these three things, the US can produce many goods more efficiently than potential trading partners, giving it an absolute advantage in the production of goods from corn to computers, to maple syrup and cars. This does not, however, mean that the US does not benefit from trading for these goods with other nations.
Comparative advantage describes a situation in which an individual, business or country can produce a good or service at a lower opportunity cost than another producer.
For example, because it has an abundance of maple trees, Canada can produce maple syrup at a very low opportunity cost in relation to avocados, a fruit for which its climate is less suited.
Mexico, on the other hand, with its ample sunshine and warm climate. can grow avocados at a much lower opportunity cost in terms of maple syrup given up than Canada.
Production specialization according to comparative advantage, not absolute advantage, results in exchange opportunities that lead to consumption opportunities beyond the PPC. Trade between two agents or countries allows the countries to enjoy a higher total output and level of consumption than what would have been possible domestically.
Canada and Mexico can each specialize in the good they have a comparative advantage in and exchange with one another. This lets both countries enjoy more maple syrup and avocados than they could have enjoyed without trade. Mexico will export avocados and import maple syrup; this way Mexicans can enjoy their tasty breakfasts and Canadians will enjoy delicious guacamole!
Comparative advantage and opportunity costs determine the terms of trade for exchange under which mutually beneficial trade can occur.
In order for Canadians to benefit from trade with Mexico, they must be able to import avocados at a lower opportunity cost than it would cost them to grow domestically. Likewise, Mexico must get maple syrup more cheaply (in terms of avocados given up) than it could have produced it for domestically. The terms of trade refer to the trading price agreed upon by two agents, which when beneficial, will allow both countries to enjoy gains from trade.
Term | Definition |
|---|---|
absolute advantage | the ability to produce more of a good than another entity, given the same resources. For example, in a single day, Owen can embroider 10101010 pillows and Penny can embroider 15151515 pillows, so Penny has absolute advantage in embroidering pillows. |
comparative advantage | the ability to produce a good at a lower opportunity cost than another entity. For example, for every pillow Owen embroiders his opportunity cost is 2222 scarves knitted, while Penny must forego 3333 scarves for every pillow she embroiders, so Owen has comparative advantage in embroidering pillows. |
specialization | when an individual or a country allocates most or all of its resources towards the production of a particular good or service. For example, Sal (an individual) specializes in producing educational videos, and Bangladesh (the country) specializes in producing textiles. |
trade | the exchange of goods, services or resources between one economic agent and another |
international trade | the exchange of goods, services, or resources between one country and another |
gains from trade | the ability of two agents to increase their consumption possibilities by specializing in the good in which they have comparative advantage and trading for a good in which they do not have comparative advantage |
terms of trade (also called “trading price”) | the price of one good in terms of the other that two countries agree to trade at; beneficial terms of trade allows a country to import a good at a lower opportunity cost than the cost for them to produce the good domestically, thus the country gains from trade. |
PPCs can be used to determine opportunity costs, comparative advantage, and who should specialize in which good (as in Figure 1).
The gains from trade can be shown in a PPC by drawing a line originating at the point on the axis on which an agent is specializing its production (in the good it has a comparative advantage in) out to a point on the opposite axis beyond what it could have achieved without trade.
Assuming terms of trade are beneficial (e.g. offering each agent a lower opportunity cost than could be achieved without trade) an individual or country will be able to consume at a point beyond its PPC through specialization and trade (as in Figure 2).
A country that has an absolute advantage in producing all goods still stands to benefit from trade with other countries, since the basis of the gains for trade is comparative advantage, not absolute advantage.
It is not possible for an individual or country to have a comparative advantage in all goods. There will be some other individual or country that can produce some things at lower opportunity costs.
"Self-sufficiency" is not necessarily a trait to be strived for in the global economy. Individuals or nations who try to produce everything for themselves are likely to end up poorer than those that engage in specialization and trade.
Absolute advantage describes a situation in which an individual, business or country can produce more of a good or service than any other producer with the same quantity of resources.
The United States, for example, has a skilled workforce, abundant natural resources, and advanced technology. Because of these three things, the US can produce many goods more efficiently than potential trading partners, giving it an absolute advantage in the production of goods from corn to computers, to maple syrup and cars. This does not, however, mean that the US does not benefit from trading for these goods with other nations.
Comparative advantage describes a situation in which an individual, business or country can produce a good or service at a lower opportunity cost than another producer.
For example, because it has an abundance of maple trees, Canada can produce maple syrup at a very low opportunity cost in relation to avocados, a fruit for which its climate is less suited.
Mexico, on the other hand, with its ample sunshine and warm climate. can grow avocados at a much lower opportunity cost in terms of maple syrup given up than Canada.
Production specialization according to comparative advantage, not absolute advantage, results in exchange opportunities that lead to consumption opportunities beyond the PPC. Trade between two agents or countries allows the countries to enjoy a higher total output and level of consumption than what would have been possible domestically.
Canada and Mexico can each specialize in the good they have a comparative advantage in and exchange with one another. This lets both countries enjoy more maple syrup and avocados than they could have enjoyed without trade. Mexico will export avocados and import maple syrup; this way Mexicans can enjoy their tasty breakfasts and Canadians will enjoy delicious guacamole!
Comparative advantage and opportunity costs determine the terms of trade for exchange under which mutually beneficial trade can occur.
In order for Canadians to benefit from trade with Mexico, they must be able to import avocados at a lower opportunity cost than it would cost them to grow domestically. Likewise, Mexico must get maple syrup more cheaply (in terms of avocados given up) than it could have produced it for domestically. The terms of trade refer to the trading price agreed upon by two agents, which when beneficial, will allow both countries to enjoy gains from trade.
Term | Definition |
|---|---|
absolute advantage | the ability to produce more of a good than another entity, given the same resources. For example, in a single day, Owen can embroider 10101010 pillows and Penny can embroider 15151515 pillows, so Penny has absolute advantage in embroidering pillows. |
comparative advantage | the ability to produce a good at a lower opportunity cost than another entity. For example, for every pillow Owen embroiders his opportunity cost is 2222 scarves knitted, while Penny must forego 3333 scarves for every pillow she embroiders, so Owen has comparative advantage in embroidering pillows. |
specialization | when an individual or a country allocates most or all of its resources towards the production of a particular good or service. For example, Sal (an individual) specializes in producing educational videos, and Bangladesh (the country) specializes in producing textiles. |
trade | the exchange of goods, services or resources between one economic agent and another |
international trade | the exchange of goods, services, or resources between one country and another |
gains from trade | the ability of two agents to increase their consumption possibilities by specializing in the good in which they have comparative advantage and trading for a good in which they do not have comparative advantage |
terms of trade (also called “trading price”) | the price of one good in terms of the other that two countries agree to trade at; beneficial terms of trade allows a country to import a good at a lower opportunity cost than the cost for them to produce the good domestically, thus the country gains from trade. |
PPCs can be used to determine opportunity costs, comparative advantage, and who should specialize in which good (as in Figure 1).
The gains from trade can be shown in a PPC by drawing a line originating at the point on the axis on which an agent is specializing its production (in the good it has a comparative advantage in) out to a point on the opposite axis beyond what it could have achieved without trade.
Assuming terms of trade are beneficial (e.g. offering each agent a lower opportunity cost than could be achieved without trade) an individual or country will be able to consume at a point beyond its PPC through specialization and trade (as in Figure 2).
A country that has an absolute advantage in producing all goods still stands to benefit from trade with other countries, since the basis of the gains for trade is comparative advantage, not absolute advantage.
It is not possible for an individual or country to have a comparative advantage in all goods. There will be some other individual or country that can produce some things at lower opportunity costs.
"Self-sufficiency" is not necessarily a trait to be strived for in the global economy. Individuals or nations who try to produce everything for themselves are likely to end up poorer than those that engage in specialization and trade.
