Chapter 64: HL extension – absolute and comparative
advantage (3.1)
HL extensions
• Absolute advantage
• Comparative advantage
• Assumptions and PPFs
• Opportunity cost ratios and possible terms of trade
• The gains from trade – the CPF vs the PPF for each economy
• Calculating opportunity costs using data
• Evaluation of comparative advantage
Absolute and
comparative
advantage
•
Explain the theory of absolute advantage
•
Explain, using a diagram, the gains from trade arising from a country’s
absolute advantage in the production of a good (RL)
•
Explain the theory of comparative advantage
•
Describe the sources of comparative advantage including the
differences between countries in factor endowments and the levels
of technology
•
Draw a diagram to show comparative advantage
•
Calculate opportunity costs from a set of data in order to identify
comparative advantage
•
Draw a diagram to illustrate comparative advantage from a set of data
•
Discuss the real world relevance and limitations of the theory of
comparative advantage, considering factors including the
assumptions on which it rests and the costs and benefits of
specialization (a full discussion must take into account arguments in
favour and against free trade and protection found in the next section)
One of the legends floating around amongst economists is that Nobel laureate Paul Samuelson was once challenged by
the sceptical mathematician Stanislaw Ulam to come up with one single proposition or theory in economics which was
not either trivial or impossible to prove in reality. Samuelson went away, brooded, and came back with his reply;
comparative advantage. "That it is logically true need not be argued before a mathematician; that it is not trivial is
attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for
themselves or to believe it after it was explained to them."1
Nations trade simply because it is more economically efficient to have some goods made abroad and then trade for
1
Defending free trade, Arvind Panagaria, Economic Times November 22, 2000
them. If code for computer programs is increasingly being done in India by American firms rather than in the US, then
it simply means that America is getting it done cheaper than domestically. American consumers gain and India benefits
from higher incomes. America will ultimately have to export other things in order to be able to import, since no one will
sell goods to the US unless they find something worthy of their US dollars.
•
Absolute advantage
When a country can produce goods at a lower cost, i.e. using fewer resources, than another country it has an absolute
advantage. Another way of putting it is that a country has an absolute advantage if the unit of output per unit of input is
higher than another country’s. A simple example using two countries, Mexico and the USA, and two goods, textiles and
agricultural goods gives us figure 64.1:
Figure 64.1 Absolute advantage in one good
Potential output of the two
countries assuming factor
inputs are equal in quantity
Consumption in
autarky (= no
trade)
Consumption in
specialisation and
trade
Agriculture
Textiles
USA
8
4
4A and 2T
4A and 4T
Mexico
4
8
2A and 4T
4A and 4T
6A and 6T
8A and 8T
‘World’ totals
USA’s resources (= factor endowment) enables it to produce 8 units of agricultural goods or 4 units of textiles – in any
combination. With the same quantity of resources Mexico can produce 4 or 8 units respectively. Clearly the US is more
efficient in the production of agricultural goods and Mexico is more efficient in textiles – the US has an absolute
advantage in agriculture and Mexico an absolute advantage in textiles. Assuming autarky (= self-sufficiency and no
trade) and each economy allocates half of the resources for each good, total ‘world’ output and consumption is 6 units
of agricultural goods and 6 units of textiles.
Now assume the US and Mexico open up their economies to trade, specialise 100% in their respective absolute
advantage, and trade half of the output with the other economy on the basis of 1 unit of agricultural good for 1 unit of
textile. The US is producing 8 units of agricultural goods and exporting 4 units – which of course means that US
imports of 4 units of textiles. Mexico produces 8 units of textiles and imports 4 units of agricultural goods. In summa;
both economies are now consuming outside the limits of their own production.
Most of those who insist on opposing trade as a method of increasing overall wellbeing make a classic beginners
mistake by confusing absolute advantage with comparative advantage, commonly phrased along the lines of ‘Well, but
if a country is disadvantaged in both goods then it cannot benefit from trade’. This is a very common statement, but
most erroneous as shall be seen.
•
Comparative advantage2
The concept of absolute advantage is quite straightforward and understandable at an almost intuitive level: Imagine that
you and a classmate are given the task of doing a 15 minute presentation in economics in front of the class. Odds are
you would divide the labour so that each one does what he/she is best at, say illustrations on overheads or writing the
script.
The more challenging issue arises in explaining how both can still benefit from trading if one of you happens to be
better at both tasks. This basically means finding where the other is least disadvantaged – and still divide the labour. In
other words, the one who is worse at both illustrations and writing will at least have a comparative advantage in one of
the two. This simple example is understood by every brother and sister who have been given a set of chores to do
together, and for all the seeming complexity of the coming example it still boils down to the basic issue of the ‘weaker’
partner doing the tasks in which he/she is least disadvantaged.3
Uh oh…looks like I’m both weaker and slower…where’s my comparative advantage?!
The lesson here is that an economy with an absolute advantage in both goods might still benefit from trade if there is a
comparative advantage. The theory of comparative advantage was set down in the early 1800s by the famous English
economist David Ricardo, who understood that while the concept of absolute advantage was very powerful in its
argumentation for free trade, it was too limited to have general applicability and acceptability in the real world. In
reality many countries are better than others in the production of any number of goods, so Ricardo set forth to show that
even one country having an absolute disadvantage in many goods could be mutually beneficial to both countries when
trade takes place.
In our example using the US and Mexico producing agriculture and textiles, we now assume that the US has an absolute
advantage in production of both goods and can produce either 10 units of agricultural goods or 10 units of textiles.
Mexico can produce 4 units of agricultural goods or 8 units of textiles. Mexico in fact actually gives up fewer resources
in the production of textiles than the US does – a unit of textiles ‘costs’ 1 unit of foregone agricultural goods in the US
while the ‘cost’ is only 0.5 units of foregone agricultural goods when Mexico produces textiles. In core economic terms,
2
The last thing I wish to do is confuse you – but since it is on the list, here goes. The year 1048 was...nothing special
really. Pope Damasus II dies, Emperor Henry III names his cousin Bruno the new pope Leo and the Chinese emperor
Shenzong is born. This has absolutely nothing to do with economics…except for the number 1048. See figure 64.
3
All my students get to hear about fighting in the karate finals. If your opponent is stronger than you but slower, you
fight him/her on speed – where you have an absolute advantage. If he/she is faster but weaker, your absolute advantage
is in strength. If he/she is 50% stronger and 10% faster…well, you have a problem. However, I recommend fighting
him/her on speed where you are least disadvantaged – where you have a comparative advantage – and you will thus get
the least beating.
Mexico’s opportunity costs in the production of textiles are lower than the US’. Mexico therefore has a comparative
advantage in the production of textiles.
Definition; Absolute and comparative advantage
If the US can produce more agricultural goods and textiles than Mexico using the same amount
of resources, than the US has an absolute advantage.
If Mexico has a lower opportunity cost (in terms of foregone production of agricultural goods)
in the production of 1 unit of textiles, then Mexico has a comparative advantage in the
production of textiles.
Here is the focus of this example: 1) Set down relevant assumptions and outline production possibilities for two
countries; 2) establish cost ratios and terms of trade, i.e. an exchange rate; 3) and finally, we use the cost ratios to show
how specialisation and trade will allow each country to consume outside its PPF.
•
Assumptions and PPFs for the US and Mexico
So, we assume that there are only two economies, USA and Mexico, and two goods, agricultural goods and textiles.
Again we assume that economies can attain maximum potential output – Pareto optimum – and move along the
production possibility frontier, but that no economies of scale exist. We will also assume that opportunity costs are
constant – this is not absolutely necessary but it makes the example easier to follow. Finally, we assume that neither
trade barriers nor transport costs exist. Diagrams I – III in figure 64.2 show the situation facing the two economies:
•
Initially there is no trade between them, whereby the US produces/consumes 6 units of agricultural goods and
4 units of textiles (point A in diagram I)
•
Mexico produces/consumes 2 units of agricultural goods and 4 units of textiles (point B in diagram II).
•
Diagram III shows each economy’s PPF in relation to the other. Notice how the PPFs are divergent, which is
central to your understanding of comparative advantage.
Figure 64.2 (I – III) PPFs and cost ratios for US and Mexico
I: US’s PPF
II: Mexico’s PPF
Agriculture
III: Diverging PPFs
Agriculture
10
Agriculture
10
10
Possible terms of
trade
A
6
PPFUSA
4
2
4
Textiles
10
4
B
PPFMex
4
8
Textiles
8
10
Textiles
10
•
Opportunity cost ratios and possible terms of trade
The theory of comparative advantage states that, ceteris paribus, if a country has a comparative advantage then there are
gains to be made in trade. Are there comparative advantages shown in diagram III in figure 64.2? Go back and re-read
the definitions of absolute and comparative advantage and apply them to figure 64.3.
Figure 64.3 Opportunity cost ratios for agricultural goods and textiles
Potential output
Opportunity costs (in terms of
the other good; producing 1 unit
of agricultural goods in Mexico
means foregoing 2 units of
textiles)
Agricultural
goods
Textiles
Agricultural
goods
Textiles
USA
10
10
1
1
Mexico
4
8
2
0.5
Clearly the answer is “yes”, since Mexico – which is absolutely disadvantaged since the US can produce more of both
goods – has a lower opportunity cost in the production of textiles than the US. Mexico foregoes 0.5 units of agricultural
goods in producing 1 unit of textiles whereas the US foregoes 1 unit of agricultural goods in producing a unit of textiles.
Mexico has a comparative advantage in textiles.
Figure 64.4 Opportunity cost ratios and terms of trade
I: Cost ratios of 1 unit of textiles
II: Cost ratios of 1 unit of agricultural goods
Agricultural
goods
Agricultural
goods
1
1
US cost ratio
Possible terms of
trade
Mexican
cost ratio
0.5
US cost ratio
Mexican
cost ratio
Textiles
1
Textiles
1
2
The terms of trade (figure 64.4, diagrams I and II) are shown as the orange areas in between the diverging cost ratios.
o
Mexico can trade domestically at a rate of 1 unit of textiles for 0.5 units of agricultural goods and
would therefore be willing to trade with the US if the return – imports! – were more than 0.5 units of
imported agricultural goods for each unit of exported textiles.
•
o
The US in turn pays 1 unit of agricultural goods for each unit of textiles produced domestically, and
would trade if it paid less than 1 unit of exported agricultural goods for each unit of imported textiles.
o
The terms of trade will lie somewhere between 1 unit of textiles trade for between 0.5 and 1 unit of
agricultural goods (diagram I). Alternatively, 1 unit of agricultural goods trades for between 1 and 2
units of textiles (diagram II).
The gains from trade – the CPF vs the PPF for each economy
Let’s assume that both economies specialise 100%, and then look at the issue of trade, terms of trade and the
consequent gains from trade. (I shall look at these issues from the point of view of Mexico in order to stress that even
the country with an absolute disadvantage in both goods can gain from specialisation and trade.)
•
The US now has 10 units of agricultural goods which could have been traded domestically at the ratio of 1 unit
of agricultural goods for each unit of textiles. The trade incentive is that the Americans will trade if they can
get more than one unit of textiles per unit of agricultural goods. (When “trade negotiations” take place the
object is to make it worth the while for citizens of Mexico; they too must gain.)
•
Mexico, having specialised 100% in textiles, has 8 units of textiles where each unit can be traded domestically
for 0.5 units of agricultural goods, i.e. each unit of agricultural goods costs Mexico (as in opportunity costs) 2
units of textiles. If Mexcio can pay less than 2 units of textiles for each unit of agricultural goods there will be
an incentive to trade. Figure 64.5 shows each economy’s menu of alternatives and preferences.
Figure 64.5 Possible terms of trade for US and Mexico
US produces agricultural goods
(receives 1 T for 1 A domestically)
Agric. Textiles
1
1.0
1
1.1
1
1.2
1
1.25
…
…
1
1.9
1
2.0
1
2.1
↓
↓
Better
ToT for
US!
US’ limit!
Mexico’s
limit!
Mexico produces textiles
(pays 2 T for 1 A domestically)
Agric. Textiles
Mexico’s
1
2.0
limit!
1
1.9
…
…
1
1.25
1
1.2
1
1.1
1
1.0
US’ limit!
1
0.9
↓
↓
Better
ToT for
Mexico!
Terms of trade established at
•
1 unit agricultural goods = 1.25 units textiles
Or:
•
1 unit textiles = 0.8 units agricultural goods
The US is completely specialised in agriculture, with domestic trade possible at 1:1 for textiles. If the terms under
which the US can trade agricultural goods for imported textiles – the terms of trade – are better than this ratio, trade
will take place:
•
The more textiles the US receives for each unit of agricultural goods, the better the terms of trade are for the
US. This is shown in the blue column/arrow on the left in figure 64.5, where increasing quantities of imported
textiles per exported units of agricultural goods represents improving terms of trade for the US:
•
Mexico, totally specialised in textiles, will have the reverse situation (expressed in payment per units of
agricultural goods from the US), and will not give up more than 2 units of textiles for 1 unit of agricultural
goods. Mexico’s terms of trade will improve if it can pay, i.e. export, less than 2 units of textiles in payment
for each unit of imported agricultural goods. The green column/arrow on the right show Mexico’s improving
terms of trade.
Let us finally assume that the two countries arrive at an equitable trade ratio (= terms of trade) of 1 unit of
agricultural goods to 1.25 units of textiles. (Alternatively; 1 unit of textiles for 0.8 units of agricultural goods.)4
Assuming furthermore that Mexico wishes to remain at 4 units of textiles in domestic consumption, it will be able to
export the remaining 4 units of textiles, receiving 3.2 units of imported agricultural goods. The US, having specialised
in agricultural goods, exports these 3.2 units of agricultural goods in order to import 4 units of textiles. The results of
this trade are illustrated in diagrams I and II, figure 64.6.
Figure 64.6 PPFs and CPFs for the US and Mexico
I: US’ PPF and CPF
II: Mexico’s PPF and CPF
Agricultural goods
10
Agricultural goods
US exports 3.2 units of
agricultural goods
B
6.8
A
6.4
CPF
Mexico imports
3.2 units of
agricultural goods
CPF
4
2
8* 10
Textiles
US imports 4 units
of textiles
4
PPF
D
3.2
PPF
3.2 4
Mexico produces 8 units of textiles and zero
agricultural goods. The CPF is drawn
between trading zero textiles (consumption =
8 textiles and zero agricultural goods) and
trading all textiles for agricultural goods
(consumption is 8 x 0.8 = 6.4 agricultural
goods and zero textiles).
C
4
8
Mexico exports 4
units of textiles
Quite naturally, terms of trade are not ‘negotiated’ or ‘arrived at’. Terms of trade evolve over time in accordance with each
country’s demand for imports (i.e. relative preferences) and supply/price of domestic goods.
Textiles
POP QUIZ 4.1.1:
1.
Why is the CPF for the US dotted at textile consumption levels above 8 units? (Changed!)
2.
What would US imports be if they instead exported 5 units of agricultural goods? (Changed!)
3.
What would happen to the US and Mexican terms of trade if the Mexican CPF were to ‘swivel upward’, say
going from 8T6.4A (as in the example) to 8T8A? (See figure 64.4 for help.) (Changed!)
WIN-WIN OUTSIDE THE PPFS
The example shows how differing opportunity cost ratios between countries create comparative advantages. When these
advantages are used by reallocating resources and specialising, both countries can consume outside their production
possibility frontiers while total output increases. Figure 64.6 shows that total ‘world’ (in our example consisting of the
US and Mexico) production and consumption has increased from 8 units of agricultural goods and 8 units of textiles to,
respectively, 10 and 8 units. Herein lies the argumentative power of the theory of comparative advantage; more is
produced using the same amount of resources and both parties can increase total consumption.5
COST RATIOS YIELDING A COMPARATIVE ADVANTAGE
The key point in respect to trade is to realise that comparative advantage arises only when countries’ PPFs are
divergent, i.e. when the opportunity cost ratios differ between countries. If cost ratios in producing the two goods are
identical in country A and country B, there can be no gain for either country in specialising and trading – at least not in
terms of quantity. Figure 64.7, diagrams I to III shows three possibilities between Portugal and Spain in the
production of wine and wool. Which of these diagrams shows an incentive for trade in accordance with the theory of
comparative advantage? (Answer in footnote below.6)
Figure 64.7 Possible PPFs for Portugal and Spain
5
It is important to understand the very powerful principle of comparative advantage. I once had a fierce argument with
a rather left-leading colleagues who was adamant that one should pay a maid exactly the same as I would demand for
doing the same service. This is of course utter woofle (‘woolly’ plus ‘waffle’ – the former means mental confusion and
the latter means hazy and unclear) since my opportunity costs in ironing shirts is much higher than my maid’s
opportunity costs. I am good at ironing actually, and cooking, and sewing (it’s the kind of thing men who can’t keep
wives learn over time) but the fact remains that for me to spend 20 hours a week doing house chores would mean
forgoing quite a few hours of rather productive economics. A specialised maid can to the job in less time and for lower
opportunity costs than I. The money I earn in 20 hours of writing/lecturing can pay for her opportunity costs several
times over.
6
Answer; diagrams I and III show that quantitative gains in consumption are possible since the opportunity cost ratios for
Spain and Portugal are different. Diagram II is not conductive to trade according to the theory of comparative advantage
since each country has identical opportunity cost ratios and neither can benefit (quantitatively) by trading with the other.
I
II
III
Wine
Wine
Wine
25
25
25
20
Portugal
Portugal
5 Spain
Spain
Spain
Wool
10
•
Portugal
Wool
25
20 25
Wool
20 25
Calculating opportunity costs using data
Assume that Sweden and Finland produce either steel or paper and in using the same quantity of resources (factors of
production = ‘FoPs’ in the table) can produce as follows:
Using 100%
of FoPs in...
Steel (mn
units)
Using 100%
of FoPs in...
Paper (mn
units)
Sweden
800
1000
Finland
320
800
Opportunity
cost of steel
Opportunity
cost of paper
Assume that both nations are Pareto efficient, that no barriers to trade exist, the goods are homogeneous, no economies
of scale are attainable, and that factors of production are 100% mobile.
1. Which nation has an absolute advantage?
2. Is there an incentive for trade according to comparative advantage?
3. If so, which nation will specialise in and export steel?
4. What are the possible terms of trade? Draw a cost ratio diagram for support.
5. Assume that each country specialises 100% and that the nation specialising in paper uses half of output
domestically and exports the rest. Assume valid terms of trade and draw each countries CPF based on your
terms of trade ‘exchange rate’.
(If you get stuck, have a look at point 4 in the end of chapter Summary and revision.)
•
Evaluation of comparative advantage
Does the theory of comparative advantage stand up to the test of reality? Well, yes, albeit a “yes” with some notable
qualifications (= conditions):
•
Quite evidently no country will specialise completely as in our model, which lowers the possible
specialisation gains and thus the amount available for trade. This will naturally limit the extent to which the
consumption possibility frontier lies outside the production possibility frontier.
•
The theory of comparative advantage is based on the premise of product homogeneity, which, in the light of
increased non-price competition in the trade of similar goods, is not explained by different opportunity costs
between trade partners. It is theoretically possible that two countries with identical domestic cost ratios for
goods X and Y still trade since consumers in both countries wish to have a greater range of goods.
•
The assumption of zero transport costs is unrealistic – especially for bulky goods with low value-added such
as empty plastic containers and iron ore. For such goods the proportion of transport costs to total production
costs will be very high, which might negate any comparative advantages of trade.
•
Another assumption subject to criticism is that there are no barriers to trade. This is perhaps one of the
strongest prevalent forces against the comparative advantages of countries.
•
The model used here is based on constant opportunity costs, which are highly unlikely in the real world –
however, as pointed out earlier, constant costs were assumed to make the example easier to follow and a
“convex” production possibility frontier could in fact have been used.
•
The theory also neglects to incorporate the significant benefits of scale that have been shown to exist, thus
failing to explain the very large increase in trade between similar economies, primarily OECD countries.
However, as shown earlier in Chapter 24, economies of scale support our conclusion that specialisation leads
to lower average costs which in fact strengthens the argument of international specialisation benefits.
•
Finally, the theory of comparative advantage does not deal with income distribution within countries. Trade
will create both winners and losers in terms of domestic income; sectors competing with relatively cheap
imports will see incomes fall while export sectors will show increased income. Whether the winners’ gains
outweigh the losers’ losses is a most complex question, dealing once again with the vagaries of fairness. Most
economists would prefer to view income distributions aspects and trade benefits as separate issues and look at
distributional effects in the light of domestic policy rather than trade policy.
The objections listed can in some cases carry considerable weight, yet the strength of the now over 200 year old theory
of comparative advantage lies primarily in illuminating a basic principle which has been empirically shown to hold
true; trade depends primarily on comparative rather than absolute advantage. Studies confirm that it is often the case
that countries which are less productive in all industries (i.e. have an absolute disadvantage in all areas) than another
country will still be able to export goods in which they are relatively competitive.7
POP QUIZ 4.1.2: REASONS FOR TRADE
1.
You enter a wrestling match with an opponent who is 20% faster than you and also twice as strong as you.
Explain your strategy. (No going home.) Rory, please scrap this one.
2.
Assume two neighbours; Maria is a professional house painter and Johann is an auto repair man. Using concepts
from this section, explain why it would be beneficial for Maria to paint Johann’s house while he repairs her car.
3.
Look up Jamaica and Iceland in a World Factbook and then use trade theory to explain why Jamaica is one of the
world’s largest exporters of bauxite and Iceland is a major producer of aluminium. Use the same reasoning to
explain how Icelanders can consume far more bananas than are imported! (Eh, the aluminium issue is not related
to the banana issue.)
4.
Explain why a worker at the Nissan car plant in Japan might drive a Ford.
5.
Country X and Y both produce steel and plastic. Country X has an opportunity cost ratio of 1 unit of steel to 1
7
See for example International Economics, Krugman & Obstfeld, pages 23 – 34
unit of plastic; country Y has an opportunity cost of 1 unit of plastic to 0.5 units of steel. Using the theory of
comparative advantage, explain the trade possibilities.
6.
Continuation of Question 5: Assume instead that country Y has opportunity costs of 0.5 units of plastic to 0.5
units of steel. What are the possible terms of trade for country Y?
7.
Why do economists generally regard the theory of comparative advantage as a very strong argument in favour of
trade?
8.
Can a country benefit from trade even though it has higher production costs per unit of output in all goods than
other countries?
9.
How might a country improve its comparative advantage?
10.
How might exporters view a worsening of the terms of trade? How about consumers?
Summary and revision
1.
When an economy can produce more than another using equivalent quantities of factors of
production, one says an absolute advantage exists.
2.
A country that has a lower opportunity cost in producing a good (in terms of foregone output
in other goods when factors of production are re-allocated) one speaks of a comparative
advantage.
3.
In exemplifying how an economy can benefit from trade due to a comparative advantage, we
make a number of assumptions:
a. Only two goods and two economies
b. No barriers to trade or transport costs
c. Goods are homogeneous
d. No economies of scale
e. Constant opportunity costs
f. Both nations are Pareto efficient
g. No transport costs
h. 100% specialisation for each economy
4.
Opportunity cost ratios show the cost for each economy in the production of goods. Only
when opportunity costs differ can the theory of comparative advantage be used to explain
why trade would take place.
Steel
0.8
Cost ratio for
Home
Possible terms of
trade
0.4
Cost ratio
for Foreign
Paper
1
5.
The terms of trade lie in between the cost ratios. In the figure above, the terms of trade will
lie between 1 unit of paper for 0.4 to 0.8 units of steel. Alternatively, one unit of steel for 1.25
to 2 units of paper.
6.
Trade along the lines set out be the theory of comparative advantage enable economies to
consume outside their respective PPFs. Each economy will have a consumption possibility
frontier (CPF) that ‘swivels’ outwards from the point where the PPF intercepts the axis
showing 100% specialisation in a good. The better the terms of trade, the more the CPF lies
outside the PPF.
7.
There are some notable limits to the theory of comparative advantage:
a. Products are not homogeneous
b. Barriers to trade do exist and skew comparative advantage towards the protectionist
economy
c. Transport costs can negate comparative advantage
d. Economies of scale exist – yet this would in fact increase the gains of an economy
specialising in certain sectors