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Comparative Advantage Handout

International Economics

Nations trade, among other reasons, to take advantage of differences. Brazil, for example, grows sugarcane. Vietnam, on the other hand, has many low-skill workers. The US has many highly educated workers. International trade allows people to take advantage of these differences and improve their lives. When a nation (or individual) can produce an output using fewer inputs than another nation (or individual), we say they have an absolute advantage in production.

But even if a nation has absolute advantage in everything, it might not make sense for them to produce everything. Given that resources are scarce, and therefore trade-offs must occur, any input used in the production of one good cannot be used in the production of another good. We must consider the opportunity costs, or what must be sacrificed in order to produce a certain good. These opportunity costs lead us to consider comparative advantage.

1 The Production Possibilities Frontier

In order to properly understand and define comparative advantage, let’s explore a simple model.

Suppose there are just two goods, computers and shirts, and one input, labor. Further, assume that in Mexico, it takes 12 units of labor to make one computer and 2 units of labor to produce one shirt, and suppose Mexico has 24 units of labor. Therefore, Mexico can produce 2 computers and 0 shirts, 0 computers and 12 shirts, or any linear combination thereof. Similarly, assume there are 24 units of labor in the United States but in the US, it only takes 1 unit of labor to produce a computer and 1 unit of labor to produce a shirt. Therefore, the US can produce 24

Computers and 0 shirts, 0 computers and 24 shirts, or some linear combination thereof. This information is summarized in Table 1. We can graph the information in Table 1 to give us the Production Possibilities

Country                   Computers        Shirts

Mexico                      12                      2

United States             1                       1

Table 1: Units of Labor per Output

Frontier (PPF). Note that the slope of the PPF would be the opportunity cost! The slope is a measurement of what you have to give up to get something.

2 Opportunity Cost and Comparative Advantage

As mentioned, there is a close relationship between opportunity costs and the PPF. If you draw out the PPFs, you’ll notice the slope is the comparative advantages. Take the US, for example. The US’ slope on the PPF is -24/24 = -1. In other words, for every additional shirt the US wishes to produce, it must produce one fewer computer. One shirt has an opportunity cost of one computer and vice versa. Now consider Mexico’s PPF. The slope is -2/12 = -1/6. This interpretation is a little less straightforward, but the idea is the same: For every shirt Mexico wishes to produce, it must give up 1/6th of a computer (likewise, for every computer Mexico wishes to produce, it must give up 6 computers). The opportunity costs are summarized in Table 2.

Country       Opportunity Cost of 1 Computer               Opportunity Cost of 1 Shirt

Mexico                  6 shirts                                                        1/6 of a computer

United States       1 shirt                                                               1 computer

Table 2: Opportunity Cost

Here’s the big idea: the (opportunity) cost of a shirt in the United States is 1 computer, but for Mexico it is just 1/6th of a computer. Conversely, the United States has an (opportunity) cost of 1 shirt to make a computer whereas Mexico has a cost of 6 shirts to make a computer. Since Mexico has a lower opportunity cost for making a shirt than the United States (1=6 < 1), we say Mexico has a comparative advantage in producing shirts compared to the US. Likewise, since the US has a lower opportunity cost in computers than Mexico (1 < 6), we say the US has a comparative advantage in computers compared to Mexico.

3 Opportunity Costs and Terms of Trade

Opportunity costs also give us insight into the terms of trade that would evolve between two nations. Let’s take our example above. If Mexico wants to produce (and subsequently consume) a computer, they must sacrifice 6 shirts to do so. The US, however, need only sacrifice 1 shirt. If we assume Mexico is going to specialize in shirts and trade for computers (which they will given the lower opportunity costs), then they will be willing to trade up to 6 shirts to acquire the computer from the US (if they have to give up any more than 6, it would be cheaper for Mexico to produce the computer at home). Likewise, if the US is giving up one computer, they’re willing to do it for at least 1 shirt (if they were to get less than 1 shirt in return, then it would be cheaper to produce the shirt at home). Thus, the terms of trade (computers : shirts) would fall somewhere between 1 : 1 and 1 : 6.1

4 Now It’s Your Turn

According to the Wall Street Journal2, it takes about 30 hours to assemble a vehicle in the United States. Let’s use this figure, plus a few invented numbers, to sum up global division of auto manufacturing into two broad areas: North and South. Consider the following productivity table:

which region has an absolute advantage at making high-quality

cars?Low quality cars?

Region Labor-Hours to Make High-Quality Car Labor Hours to Make Low-Quality Car

North 30 20

South 60 30

Using the information in Table 4, estimate the opportunity cost of making high- and low-quality cars in the North and in the South. Which region has comparative advantage in high-quality cars?

Low-quality cars?

Region Opportunity Cost of High-Quality Car Opportunity Cost of Low-Quality Car

North

South

One million hours of labor are available for making cars in the North, and another one million are available in the South. In a no-trade world, let’s assume two-thirds of the auto industry labor in each region is used to make high-quality cars and the remaining third is used to make low-quality cars. How many of each kind of car would be produced in autarky?

Region Output of High-Quality Cars Output of Low-Quality Cars

North

South

Now allow for trade. If each region completely specializes in the type of car in which it holds comparative advantage, what will the global output of high-quality cars be? Of low quality cars?

Region Output of High-Quality Cars Output of Low-Quality Cars

North

South

Global Output