Comparative Advantage
Introduction
We will focus on three of the benefits of trade (Cowen and Tabarrok, 2011, ch. 2):
1. Trade makes people better off when preferences differ.
2. Trade increases productivity through specialization and the
division of knowledge.
3. Trade increases productivity through comparative advantage.
“Simple trades of the kind found on eBay create value, but the
true power of trade is discovered only when people take the next
step, specialization. In a world without trade, no one can afford to specialize. People will specialize in the production of
a single good only when they are confident that they will be
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able trade that good for the many other goods that they need.
Thus, as trade develops, so does specialization and specialization turns out to vastly increase productivity.” (Cowen and
Tabarrok, 2011, p. 14)
Absolute Advantage A country has an absolute advantage
in production if it can produce the same good using fewer
inputs than another country.
Comparative Advantage A country has a comparative advantage in producing goods for which it has the lowest opportunity cost.
Production Possibilities Frontier A production possibilities
frontier shows all the combinations of goods that a country
can produce given its productivity and supply of inputs.
Comparative Advantage Example
Consider the following example from Cowen and Tabarrok (2011).
The production possibility data are found in Table 1 and a plot
of the data are found in Figure 2.
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Shirts Computers
Mexico
USA
12
24
2
24
Table 1: Production possibilities for the USA and Mexico. Each country has
24 units of labor to use.
Figure 1: A graph from Cowen and Tabarrok (2011) of the production possibilities for USA and Mexico. Assume that there is no trade and that each
country uses half of its labor to produce each good.
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Self-sufficient Output
Shirts
Computers
Mexico
USA
6
12
1
12
Total
18
13
Table 2: Total output of shirts and computers if each country is self-sufficient
and devotes half of their resources to producing each good.
Output with no Trade
Assume that each country is self-sufficient, which means they
only consume what they produce. Also, let’s say that half of
a country’s resources is used to produce each good. 12 hours
to shirts, 12 hours to computers. Total production is shown in
Table 2.
Using the data in Table 1 (or Table 2, which is based on
it), compute comparative advantage for each good. That means
figure out the cost of producing 1 of each good in each country.
First, the cost of making a computer:
The Cost of Making 1 Computer
Mexico 2 computers costs 12 shirts
2/2=1 computer costs 12/2=6 shirts
USA
24 computers costs 24 shirts
24/24=1 computer costs 24/24=1 shirt
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It costs less to make a computer in the USA (1 shirt) than it
does in Mexico (6 shirts). USA has a comparative advantage in producing computers.
The Cost of Making 1 Shirt
Mexico 12 shirts cost 2 computers
12/12=1 shirts cost 2/12=1/6 computers
USA
24 shirts cost 24 computers
24/24=1 shirts cost 24/24=1 computers
It costs less to make a shirt in the Mexico (1/6 computer)
than it does in the USA (1 computer). Mexico has a comparative advantage in producing computers.
The law of comparative advantage says that world output will rise if countries specialize in producing goods for which
they have comparative advantage. So, Mexico should devote
more resources to making shirts and the USA more resources to
making computers.
Specialization and Trade
Now suppose that Mexico specialized in producing shirts and
trades some of these for computers made in the USA. Mexico
devotes all resources to shirt production and agrees to sell half
of these to the USA in return for 2 computers. For sake of the
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Output with Trade
Shirts
Computers
Mexico
USA
12
10
0
14
Total
22
14
Table 3: Total output of shirts and computers if each country if each produces more of the good for which it has comparative advantage. Mexico is
completely specialized and the USA partially specialized.
example, let’s say that the USA needs 12 computers domestically so to produce 2 more to sell to Mexico, shirt production
falls by 2 to a total of 10. The outcome of this is shown in Table
3.
Note that world output of computers and shirts rises since
each country uses resources to produce the goods that they can
do so at lower cost.
Effects on Income
Not only will output rise, but incomes in both countries will rise
as well. Suppose that a shirt sells for $100 and a computer for
$300.
The value of Mexican consumption is
1 Computer ×
$100
$300
+ 6 Shirts ×
= $900.
Computer
Shirt
6
(1)
Figure 2: A graph from Cowen and Tabarrok (2011) of the production possibilities for USA and Mexico. Assume that there is trade. Mexico specialized
in shirt production (producing 12 with no computers) and USA gives up 2
shirts to produce 2 more computers to trade for Mexican shirts.
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Since there are 24 workers, the average wage is $900/24 =
$37.50. The value of U.S. consumption is 12 × $300 + 12 ×
$100 = $4,800 so the U.S. wage is $200.
Now consider the situation with trade. The value of Mexican
consumption is now 2 × $300 + 6 × $100 = $1,200 for a wage
of $50, while the U.S. wage is now (12 × $300 + 16 × $100)/24
= $5,200/24=$216.67. Wages in both countries have gone up,
just as expected.
Lesson
1. The wage in Mexico is lower than the wage in the United
States. Why? Productivity of labor is lower in Mexico.
Wages are determined by the productivity of labor. Labor
productivity depends on the amount and quality of tools
one has and the knowledge of how to use those tools–capital
and human capital.
2. Specialization and trade let workers make the most of what
they can do. Wages will rise only as high as productivity
allows, though.
3. Trade may increase productivity in the long-run if greater
specialization leads to faster improvements in knowledge
and technology. This is one of the arguments made in favor
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of trade and specialization by Adam Smith in TWN.
“In summary, workers in the United States often fear trade
because they think that they cannot compete with low-wage
workers in other countries. Meanwhile, workers in low-wage
countries fear trade because they think that they cannot compete with high productivity countries like the United States!
But differences in wages reflect differences in productivity. Highproductivity countries have high wages, low-productivity countries have low wages. Trade means that workers in both countries can raise their wages to the highest levels allowed for by
their respective productivities.” (Cowen and Tabarrok, 2011, p.
19)
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Bibliography
Cowen, Tyler and Alex Tabarrok (2011), Modern Principles of
Economics, 2nd edn, Worth, New York.
Muller, Jerry Z. (2002), The Mind and the Market: Capitalism
in Western Thought, Anchor Books, New York.
Smith,
Adam (1904),
An Inquiry into the Nature and Causes of the Wealth of Nations, Edwin
Cannan edn, Library of Economics and Liberty,
http://www.econlib.org/library/Smith/smWN.html.
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