Comparative Advantage and Gains
from Specialization and Trade
Tale of Two Builders
Consider two people, Carl and Sam. Both
are in the construction business.
Carl can build 2 brick houses in a month. But if he
makes frame houses instead, he can build 4 frame
houses in that month.
Sam has ‘two left thumbs’, so he can build only 1 brick
house in a month. If he makes frame houses instead,
he can build only 1 frame house in that month.
Carl has an absolute advantage over
Sam in the production both types of
house, because he can produce more
houses with the same resources.
While it would appear that there
would be no opportunity to trade – as
Carl has the absolute advantage in
both – we need to consider the
opportunity costs for each builder.
Recall: Carl can build 2 brick or 4 frame
houses Sam can build either 1 brick or
1 frame house.
Complete the following table of opportunity costs
Builder Op Cost of Frame
House
Sam
_______ brick hs
Carl
_______ brick hs
Op Cost of Brick
house
_______ frame hs
_______ frame hs
Opportunity Costs for Builders
Builder Op Cost of Frame
House
Op Cost of Brick
house
Sam
1 brick hs
1 frame hs
Carl
1/2 brick hs
2 frame hs
Who has the lowest opportunity costs for
each type of house?
Person A has a comparative advantage
over person B in the production of a good if
person A has a lower opportunity cost of
producing the good.
person
Sam
Carl
comparative advantage
brick
frame
Law of Comparative Advantage:
The total output of a group, an economy, or
a group of nations will be greatest when the
output of each good is produced by the
person (or firm or nation) with the lowest
opportunity cost.
Let’s see how this law applies to Carl and
Sam.
12 Months Production without specialization
Let’s say that the costs/prices of houses are
identical for brick and frame houses, and – just
for the variety – they each produce equal
numbers of frame and brick houses over a
period of 12 months:
Builders
Frame
Brick
Sam
6mths = 6
6mths = 6
Carl
4 mths = 16
8mths = 16
Total
22
22
Sam has an idea 


Sam is tired of working for 12 months of the year; he
wants to work for only 11 months, and have a month’s
holiday. He has a brainwave and approaches Carl to see if
he will trade houses.
If Carl produces some extra frame houses, Sam figures he
can make up the shortfall in brick houses. Will this work?
Recall: Carl can build 4 frame houses/month; hence it takes
5 ½ months to make 22. for another 5 ½ months he can
make 11 brick houses (at 2 per month).
Sam takes all 11 months to make 11 brick houses.
11 Months Production
with Specialization
Carl
Sam
Total
frame
brick
0
11
11 Months Production
with Specialization
Carl
Sam
Total
frame
22
0
brick
11
11
11 Months Production
with Specialization
Carl
Sam
Total
frame
22
0
22
brick
11
11
22
Terms of trade
The terms of trade is the ratio of brick-to-frame that
will be advantageous to both Sam and Carl.
The terms of trade will be between 1 and 2 frame
houses per brick house. It has to be over 1 for Sam,
and under 2 for Carl.
After construction, Carl and Sam have
the
following:
Sam
brick
frame
build
11
0
Carl
brick
frame
11
22
Suppose that Carl and Sam agree to trade
6 frame houses for 5 brick houses. So we
have
Sam
brick
frame
build
11
0
Carl
brick
frame
11
22
trade
-5
+6
+5
-6
The result is:
build
result
Sam brick
frame
Carl
brick
frame
trade
11
0
-5
+6
6
6
11
22
+5
-6
16
16
Now Carl and Sam each have the same
number of houses as before
specialization and trade.
However, they are better off now because they get a
month of vacation.
Alternatively, if they worked a 12-month year, they could
produce more houses than before.
Comment:
It is comparative advantage, not absolute
advantage, that makes gains from trade
possible.
By each party specialising in the area(s) they
have the comparative advantage, total
production is increased. This Gain in
production will be shared out according to the
prices resulting from the trade.