Handout 1: Absolute and Comparative Advantage
And Gains from Trade
Absolute Advantage
Let’s imagine a little mini economy with two producers (Dante and Fifi) and two goods
(chips and salsa). Their production possibilities are described in Table 1.
Table 1
Absolute/Comparative Advantages in Production
Dante and Fifi's World of Chips and Salsa
Making Only Chips
Chips
Salsa
10
5
Dante
Fifi
Making Only Salsa
Chips
Salsa
0
0
0
0
10
15
It would appear that Dante has an absolute advantage in making chips (he can make 10
bags in a day, while Fifi can only make 5). Fifi, on the other hand, has an absolute
advantage in making salsa (she can do 15 jars in a day, while Dante can only do 10).
Assuming constant opportunity costs, their production possibilities graphs would look
like this:
Dante
Fifi
Salsa
Salsa
15
10
10
Chips
5
Chips
By allowing them to trade, they can each specialize in making what they’re best at
making1. Does this increase overall production? If they weren’t allowed to trade, each
person might spend half of their time on each good. Dante would have 5 bags of chips
and 5 jars of salsa, and Fifi would have 2.5 bags of chips and 7.5 jars of salsa. So the total
output of the economy would be 7.5 bags of chips and 12.5 jars of salsa.
1
As Dr. Allen mentioned in class, if Dante and Fifi weren’t allowed to trade with each other at all, their
production possibilities curves would also be their consumption curves.
Prepared by Nick Sanders, UC Davis Graduate Department of Economics 2005
Now what if they trade? If both specialized in production, the total output of the economy
would be 10 bags of chips and 15 jars of salsa, which is higher than our total output was
before we considered the option of trade.
Comparative Advantage
What if Fifi was better at making both salsa AND chips? Are there still gains from trade?
Would it still make sense for them to specialize? And if it would, who should specialize
in what?
Let’s imagine that Dante and Fifi now have the following production possibilities.
Table 2
Absolute/Comparative Advantages in Production
Dante and Fifi's World of Chips and Salsa
Making Only Chips
Chips
Salsa
10
12
Dante
Fifi
Making Only Salsa
Chips
Salsa
0
0
0
0
10
15
And again, in graph form . . .
Dante
Fifi
Salsa
Salsa
15
10
10
Chips
12
Chips
It would appear that Fifi is just plain more efficient at making everything. She has
absolute advantage in both goods. But that doesn’t mean there’s no reason for Dante and
Fifi to trade and/or focus their production. The decision is now based on who has the
higher opportunity cost of production for each good.
Looking at Table 3, we can see that for Dante, the opportunity cost of producing one
more bag of chips is one jar of salsa. For Fifi, the opportunity of producing one more bag
Prepared by Nick Sanders, UC Davis Graduate Department of Economics 2005
of chips is 15/12 jars of salsa, or 1.25 jars2. Since Dante has a lower opportunity cost of
producing chips, he has a comparative advantage in chip production.
Table 3
Absolute/Comparative Advantages in Production
Dante and Fifi's World of Chips and Salsa
Possible Production
Chips
Salsa
a
Dante
Fifi
b
10
12
Comparative advantage
10
15
Opp. Cost of Production
Chips
Salsa
c = b/a
d = a/b
1.00 jars of salsa
1.25 jars of salsa
1.00 bags of chips
0.80 bags of chips
Dante
Fifi
If things go nicely, it should work out that Fifi has a lower opportunity cost of producing
salsa. Looking at the table again, it would appear that for Dante, the opportunity cost of
one more jar of salsa is one bag of chips. For Fifi, the opportunity cost of one more jar of
salsa is 12/15, or 0.8 bags of chips. Just like we expected, Fifi has a lower opportunity
cost of producing salsa, so she has a comparative advantage in salsa production.
Does trade still increase overall production? Assume again that they can’t trade and they
each spend half of their time on each good. Dante would have 5 bags of chips and 5 jars
of salsa, and Fifi would have 6 bags of chips and 7.5 jars of salsa. That would mean the
total output of the economy would be 11 bags of chips and 12.5 jars of salsa.
Now what if they trade? If both specialized in production, the total output of the economy
would be 10 bags of chips and 15 jars of salsa. Wait . . . that’s fewer bags of chips that
before. How is that better?
Imagine that Fifi decides she doesn’t want to spend ALL her time making salsa. Say she
makes 2 fewer jars of salsa. That means she can make 2 x 0.8 = 1.6 bags of chips. That
brings the total output of the economy to 11.6 bags of chips and 13 jars of salsa, which
is higher than our total output was before we considered the option of trade. So allowing
for trade DOES increase our overall production, even when someone has absolute
advantage in both goods.
2
Okay, what is 5/4 of a jar of salsa? You’ve got me . . . but since we’re economists, we don’t worry
ourselves with little “reality” problems like that.
Prepared by Nick Sanders, UC Davis Graduate Department of Economics 2005