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Comparative Advantage

Comparative Advantage

Why do some countries focus on producing agricultural products while others focus on technology? What happens when these countries trade? Are there more benefits for a country to produce all types of products, or is it better to focus on a few? You will know how to answer all these questions once you read our explanation of Comparative Advantages. This explanation will help you find out everything you need to know about it! Interested? Then read on!

Comparative Advantage Definition

A country has a comparative advantage when its opportunity cost of producing a particular good or service is lower than of other countries. The same rule applies to individuals and companies.

Think of Country A that has managed to crack the production of computers. Its labor force contains highly skilled computer scientists. This country is capable of producing 1000 computers in a month. On the other hand, as this country has its labor force made of engineers and computer scientists, it can only produce a limited number of bottles of wine, namely 200.

On the other hand, there's another country, B. This country has managed to crack the production of wine, and its human and natural resources allow this country to scale up wine production. However, this country has a limited number of people who can develop and build computers. Its labor force mainly consists of relatively less skilled labor who usually participate in the wine production processes. While they can produce 800 bottles of wine in a month, they can only produce 150 computers.

The opportunity cost for Country A, if it decided to focus only on producing computers, is 200/1000=2/10=1/5 of a bottle of wine not made.

On the other hand, Country B has a different opportunity cost. The opportunity cost of country B focusing only on computers is 800/150=16/3, meaning they lose a lot of wine if they decide to focus only on producing computers.

Comparative advantage occurs when the opportunity cost of producing a particular good or service for one country is lower than for other countries. The same rule applies to individuals and companies.

This means that country A has a comparative advantage over Country B in producing computers. The comparative advantage of country A over country B is a result of many factors. It could also be the case that their education system has focused on producing human resources skilled at producing computers.

Country B has a comparative advantage over country A in producing wine as their opportunity cost is significantly lower. Again, there are many reasons why country B has a comparative advantage over country A. It could be that country B has better natural resources that facilitate large-scale production of wine, or it might be the case that they have a massive portion of relatively less skilled labor.

You also have another type of advantage that you should be aware of.

Absolute advantage refers to a specific country's ability to produce more of a particular good than all other countries, although they use the same level of resources.

Absolute advantage also applies to individuals and companies. It could be that one country is more productive than others in the production of a particular good, although using the same quantity and types of resources.

Country A and Country B from our example could benefit by trading with one another as both have one type of good in which they have a comparative advantage in. In this case, country A is better off making computers and exchanging them for the bottles of wine produced by country B.

Comparative Advantage Graph

Figure 1 below illustrates the comparative advantage graph.

comparative advantage graphs studysmarterFig 1. - Comparative Advantage

We have two countries, A and B, where country A can produce 200 units of wine and 1000 units of computers and country B can produce 800 units of wine and 150 units of computers.

The curve in Figure 1 above shows the Production Possibility Curve for each of the two countries. None of these countries can consume and produce above the production possibility curve.

The opportunity cost for country A, if it decided to focus only on producing computers, is 200/1000=2/10=1/5 of a bottle of wine not made. The opportunity cost of country B focusing only on computers is 800/150=16/3, meaning they lose a lot of wine if they decide to focus only on producing computers.

From the calculation above it is clear that country A has a comparative advantage over Country B in computer production, whereas country B has a comparative advantage over country A in wine production. Note that country A has an absolute advantage over Country B as it can produce more units of both wine and computers combined than country B.

The absolute advantage would suggest that country A doesn’t have to trade with country B, but that is not the case.

Comparative advantage suggests that country A will be trading with country B as the opportunity cost of trading with country B is lower than the opportunity cost country A would face if it spends time in wine production. That is to say, country A is incentivized to trade with country B as it benefits more. The same goes for country B.

Gains from Trade and Comparative Advantage

If country A and country B decided to trade with one another they both would benefit from this trade.

comparative advantage gains from trade and comparative advantage studysmarterFig 2.- Gains from trade and comparative advantage, StudySmarter Original

Figure 2 shows what happens when there is trade between these two countries. Country A can increase its consumption of wine from 200 to 250, and country B can increase its consumption of computers from 150 to 200.

This is known as gains from trade and it refers to the gains two countries receive from focusing on what they have a comparative advantage in and trading it for the good the other country has a comparative advantage in.

Another important concept that you should be aware of here is terms of trade - this refers to the price of one good in terms of the other that two individuals or countries agree to trade on. Whenever you have an individual or a country receiving a good that comes at a lower price than their opportunity cost for producing it, you have beneficial terms of trade.

Comparative Advantage and International Trade

When countries focus on specializing their production in one particular good, and they have a comparative advantage over another country, and vice-versa, both these countries could benefit from trading with one another.

The benefit of comparative advantage in international trade is that it allows countries to achieve consumption levels of certain goods that they otherwise would not be able to. The reason for that is that they lower the opportunity cost of focusing on a specific good by trading it for the good the other country is specialized in.

Think about it, if you are good at growing apples and not so good at growing oranges, why wouldn't you focus on growing apples and exchange some of the apples for oranges produced by another guy who is good at growing them? Keep in mind that the cost you pay to exchange your apples for oranges is lower than the opportunity cost of you making apples and oranges together.

Comparative Advantage Example

A comparative advantage example from today's world. Think about China and the United States. China's comparative advantage over the United States comes in the form of cheap labor, which the United States cannot match. Chinese employees create basic consumer items at a lower opportunity cost than their counterparts in the United States. The reason for that is that China has a larger portion of unskilled labor compared to the US. That's why using this labor in the production of basic customer items doesn't create much opportunity cost for China.

On the other hand, a specialized, high-skilled workforce is where the United States has a comparative advantage. American employees generate sophisticated items or investment possibilities at lower opportunity costs than their counterparts in China. Specializing and trading in this manner are beneficial to both parties: the US and China.

Comparative Advantage Formula

To determine the comparative advantage, we must know how many commodities are produced per unit of labor. The labor unit may be whatever you choose, with the most popular ones being: working days and the number of employees.

The comparative advantage formula is as follows:

Comparative Advantage formula.StudySmarter

Think about Factory A, which can produce 100 pairs of shoes and 500 belts.

You also have Factory B, which can make 90 pairs of shoes and 270 belts.

Use the comparative advantage formula to show which factory has a comparative advantage in shoe production

Comparative advantage Factory A = Shoes/Belts = 100/500 = 1/5. The opportunity cost of producing shoes equals five belts per pair of shoes.

Comparative advantage Factory B = Shoe/Belts = 90/270 = 1/3. The opportunity cost is three belts per pair of shoes.

Therefore, Factory B has a comparative advantage in making shoes.

Theory of Comparative Advantage

The theory of comparative advantage was developed by the 19th-century British economist David Ricardo1, who attributed the causes of international trade to differences countries have in their relative opportunity cost in producing the same commodity.

The comparative advantage theory suggests that the opportunity cost of producing a certain good should be considered when a country chooses which good or service to focus on making. By specializing and trading in accordance with their comparative advantages, David Ricardo demonstrated how both England and Portugal gained from this strategy.

During the time Ricardo was developing the theory of comparative advantage, England could produce clothes at a low cost while Portugal was able to produce wine at a low cost. Ricardo anticipated that each nation would finally come to terms with these realities and abandon attempts to manufacture the product that was more expensive to produce.

Indeed, as time progressed, England ceased to produce wine, and Portugal ceased to manufacture fabric.

Both nations realized that it was in their best interests to abandon their attempts to produce these things domestically and instead trade with one another in order to get them.

Comparative Advantage and Trade - Key Takeaways

  • A country has a comparative advantage when its opportunity cost of producing a particular good or service is lower than of other countries. The same rule applies to individuals and companies.
  • Absolute advantage refers to a specific country's ability to produce more of a particular good than all other countries, although they use the same level of resources.
  • Comparative advantage suggests that country A will be trading with country B if the opportunity cost of trading with country B is lower than the opportunity cost country A would face if it spends time producing the good itself.

  • Gains from trade refer to the gains two countries receive from focusing on what they have a comparative advantage in and trading it for the good the other country has a comparative advantage in.

  • Terms of trade refer to the price of one good in terms of the other that two individuals or countries agree to trade on.

  • Whenever you have an individual or a country receiving a good that comes at a lower price than their opportunity cost for producing it, you have beneficial terms of trade.


References

  1. David Ricardo 1821, Principles of Political Economy and Taxation.

Frequently Asked Questions about Comparative Advantage

A country has a comparative advantage when its opportunity cost of producing a particular good or service is lower than for other countries. The same rule applies to individuals and companies.

You calculate comparative advantages using the opportunity cost a country or an individual faces when focusing on one particular good.

Absolute advantage refers to a specific country's ability to produce more of a particular good than all other countries, although they use the same level of resources, whereas comparative advantage refers to the opportunity cost of producing a certain good.

The comparative advantage formula is as follow: 

Comparative advantage= Output A/Output B

A comparative advantage example from today's world: Think about China and the United States. China's comparative advantage over the United States comes in the form of cheap labor, which the United States cannot match. Chinese employees create basic consumer items at a lower opportunity cost than their counterparts in the United States. The reason for that is that China has a larger portion of unskilled labor when compared to the US. That's why using this labor in the production of basic customer items doesn't have much opportunity cost for China

Final Comparative Advantage Quiz

Question

What is comparative advantage?

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Answer

A country has a comparative advantage when its opportunity cost of producing a particular good or service is lower than for other countries. The same rule applies to individuals and companies.

Show question

Question

What is absolute advantage?

Show answer

Answer

Absolute advantage refers to a specific country's ability to produce more of a particular good than all other countries, using the same resources.

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Question

What is an example of a comparative advantage?


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Answer

Think about China and the United States. China's comparative advantage over the United States comes in the form of cheap labor, which the United States cannot match. Chinese employees create basic consumer items at a lower opportunity cost than their counterparts in the United States. The reason for that is that China has a larger portion of unskilled labor when compared to the US. That's why using this labor in the production of basic customer items doesn't have much opportunity cost for China

Show question

Question

Why Country A and Country B would decide to trade with one another according to comparative advantage?

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Answer

Comparative advantage suggests that country A will be trading with country B as the opportunity cost of trading with country B is lower than the opportunity cost country A would face if it spends time in producing the good itself.

Show question

Question

What is gains from trade?

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Answer

Gains from trade refer to the gains two countries receive from focusing on what they have a comparative advantage on and trading it for the good the other country has a comparative advantage on.

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Question

What is terms of trade?

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Answer

Terms of trade refers to the price of one good in terms of the other that two individuals or countries agree to trade on. 

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Question

What is beneficial terms of trade?

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Answer

Whenever you have an individual or a country receiving a good that comes at a lower price than their opportunity cost for producing it, you have beneficial terms of trade.

Show question

Question

What's the benefit of comparative advantage in international trade?

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Answer

The benefit of comparative advantage in international trade is that it allows countries to achieve consumption levels of certain goods; otherwise, they would not be able to. The reason for that is that they lower the opportunity cost of focusing on a specific good by trading the good they are specialized on for the good the other country is specialized on.

Show question

Question

Who developed the theory of comparative advantage?

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Answer

The theory of comparative advantage was developed by the 19th-century British economist David Ricardo.

Show question

Question

What does the theory of comparative advantage suggest?

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Answer

The comparative advantage theory suggests that the opportunity cost of producing a certain good should be considered when a country chooses which good or service to focus on making.

Show question

Question

What was the example Ricardo use to demonstrate his theory of comparative advantage?

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Answer

By specializing and trading in accordance with their comparative advantages, David Ricardo demonstrated how both England and Portugal gained from this strategy.

During the time Ricardo was developing the theory of comparative advantage, England could produce clothes at a low cost while Portugal was able to produce wine at a low cost.

Show question

Question

Do you have comparative advantage or absolute advantage when you can produce more pens than your coworkers using the same resources?

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Answer

Absolute advantage

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Question

What happens when a country chooses to specialize on one good and decides to trade with another country that specializes on producing another good?

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Answer

When countries focus on specializing their production in one particular good, and they have a comparative advantage over another country, and vice-versa, both these countries could benefit from trading with one another. 

Show question

Question

What's the opportunity cost of producing gums, if you in a week can produce 75 gums and 15 books?

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Answer

Opportunity cost of producing gums is 15/75= 1/5. Meaning that you would miss on 1/5 book per gum, if you only focused on producing gums.

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Question

Sam knits 18 beanies and 6 pairs of socks in one month.

Cindy knits 10 beanies and 26 pairs of socks in one month.

Calculate the opportunity cost for each person. Who has the comparative advantage in producing beanies?

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Answer

Sam's opportunity cost: 3/1

Cindy's opportunity cost: 2/13

Sam has the comparative advantage of producing beanies.

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Question

Blue Island produces 21 tons of coconut meat and 7 tons of bananas.

Green Island produces 2 tons of coconut meat and 6 tons of bananas. 

Who has the comparative advantage in producing bananas? Does one Island have an absolute advantage?

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Answer

Green Island has a comparative advantage in producing bananas. 

Blue Island has the absolute advantage.

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Question

Mr. Jones can mow 6 acres of field or plant 20 trees in one day.

Mrs. jones can mow 22 acres or plant 11 trees in one day. 

What are Mr. and Mrs. Jones' opportunity costs?

Who has the comparative advantage in mowing?

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Answer

Mr. Jones: 3/10

Mrs. Jones: 2/1

Mrs. Jones has the comparative advantage in mowing.

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Question

Should Sam bother to trade with Joe if Sam can produce more of both products than Joe can? Why or why not?

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Answer

Yes, because trading with Joe would lower the opportunity cost Sam incurs when he produces everything himself.

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Question

Why do countries trade internationally?

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Answer

To foster alliances.

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Question

If Marge can bake 5 pies and 30 cupcakes while April can bake 8 pies and 10 cupcakes for a party, who should bake which pastry?

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Answer

Marge should bake cupcakes.

April should bake pies.

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Question

Sandy has ____________ when she sews 5 dresses and 40 shirts

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Answer

An opportunity cost

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Question

By ___________ in accordance with their comparative advantages, David Ricardo demonstrated how both England and Portugal gained from this strategy.


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Answer

specializing

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Question

What must we know to determine if a nation has a comparative advantage?


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Answer

How many commodities are produced per unit of labor.

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Question

If your opportunity cost is lower than the price you'd pay to trade for the good, should you trade?

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Answer

No.

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Question

Trading can allow countries to consume beyond their production possibilities curve.

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Answer

True.

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Question

When a nation has an absolute advantage it makes no sense for it to engage in trade.

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Answer

False, if the terms of trade mean that the opportunity cost of trading is lower than the opportunity cost of producing the good oneself.

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Question

In order for a nation to have an absolute advantage, they need to have ______________ as the other nation.

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Answer

The same level of resources

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Question

Absolute advantage only applies to countries.

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Answer

False, it can apply to individuals and companies as well.

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Question

If due to international trade, England can consume twice as many pounds of cotton, what has happened?

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Answer

England is experiencing gains from trade.

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Question

When Portugal agrees to sell England 1 case of wine for every 50 pounds of fabric what is this agreement?

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Answer

Terms of trade.

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Question

Whenever you have a country receiving a good that comes at a lower price than their opportunity cost for producing it, you have...


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Answer

 Beneficial terms of trade.

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