Comparative Advantage

Comparative Advantage The Gains to International Trade (Really All Trade)

Why do we trade? The question seems to have an obvious answer – so we can get the stuff we want. This is true, but there is more to it. Do you want stuff, or a lot of stuff? My point is people typically want the most they can get from the resources they currently have. With whom should we trade? Again the answer seems obvious – trade with the folks who have the stuff you want and want what you have. Well, enough of the questions. Here we want to study the basis for trade among people or nations. We will have a simple model of two people and two goods. The example may not seem like international trade, but could be with a different story along with the basic numerical example. You will see what I mean.

Digress You know 12 inches = 1 foot. How many feet are 24 inches? The question is really one of ratio and proportion that we all experience in our schooling growing up. Here is a way to get the answer 12 is to 1 as 24 is to x. So then through a cross multiplication we get 12x = 24, or x = 2, or two feet. Now how many inches are in 237 feet? Well 12 is to 1 as x is to 237. Cross multiply to 12 times 237 = x, or x = 2844, or 2844 inches. You may need to use this stuff here.

Say we have a farmer and a rancher and each can make meat or potatoes, or some combination of the two. Also say it turns out from experience and resources that each has a certain productive ability. Specifically, we have the following table Meat Potatoes Farmer 60 min/oz 15 min/oz Rancher 20 min/oz 10 min/oz What we have here is that it takes the farmer 60 minutes to make an ounce of meat. Or it takes the farmer 15 minutes per ounce of potatoes. You see the similar numbers for the rancher. When you note the rancher uses less labor time to make an ounce of either item, you see the rancher is absolutely better at producing either item. Thus the rancher has what is called an absolute advantage in the production of both meat and potatoes because less inputs are used per unit of output.

Another way to see the absolute advantage of the rancher is to note in a given amount of time, a greater amount of either item can be made. In the following table I will show the amount of meat or potatoes each can make in one hour. I will just write the number and you will understand the number to be ounces of item per hour. Meat Potatoes Farmer 1 4 Rancher 3 6 So, again the rancher has an absolute advantage in the production of either item. Why should the rancher trade with the farmer? The answer is so the rancher can get more stuff. Will the farmer be able to deliver? Let’s develop another idea before we see.

Opportunity Cost. Remember the concept called opportunity cost relates to the idea that when you take one course of action you give up the ability to do something else. Note that when the farmer makes 1 unit of meat he can not make 4 units of potatoes. So the opportunity cost of 1 unit of meat for the farmer is 4 units of potatoes. What is the opportunity cost of 1 unit of meat for the rancher. Well, when the rancher makes 3 meat units in an hour, 6 units of potatoes can not be made. So, 1 unit of meat is like 2 potatoes. (Ratio and proportion – if 3 is to 6, then 1 is to x, where x = 6/3 = 2.)

Opportunity Cost of 1 unit of meat Farmer --> 4 units of potatoes Rancher --> 2 units of potatoes. The rancher is said to have a comparative advantage in the production of meat because per unit of meat produced the rancher gives up less potatoes. Opportunity Cost of 1 unit of potatoes Farmer --> 1/4 unit of meat (did you use the ratio and proportion here?) Rancher --> 1/2 unit of meat. The farmer is said to have a comparative advantage in the production of potatoes because per unit of potatoes produced the farmer gives up less meat.

So on the last slide we saw that the rancher, who was absolutely better in the production of both items, only has a comparative advantage in the production of one item, meat. The farmer actually has a comparative advantage in the production of potatoes! The benefits to trade are based on the notion of comparative advantage. But we need a little more in our story. Digress: say a can of pop has a price of 50 cents and a hotdog has a price of $1. Then you cost say one hotdog costs two pops. The terms of trade would be 1 hotdog for two pops, or 1 pop for ½ a hotdog. I usually write the terms of trade as an equality like 1H = 2P, or 1/2H = 1P. We can talk terms of trade and understand that goods have dollar prices behind the scenes. The dollar prices are not that important here.

A few slides back I wrote Opportunity Cost of 1 unit of meat Farmer --> 4 units of potatoes Rancher --> 2 units of potatoes. Here is another part of the story of why folks can benefit from trade. As long as the terms of trade are between the two opportunity costs (here 1 meat between 2 and 4 units of potatoes) both parties can benefit from trade. How the terms of trade get there is not so important here, but say the parties negotiate, or forces of supply and demand operate, and we get the terms of trade. For what I show on the following slides say the terms if trade are 1 meat = 3 potatoes (1m = 3p for short.)

Let’s remember the story for the farmer so far. Without any trade the farmer can make meat or potatoes. Now for the farmer, remember 1m = 4p if there is no trade between the two. But with trade 1m = 3p. So No trade  1 meat means the farmer gives up 4 potatoes (in fact, in the time the farmer makes the 1m he couldn’t make 4p. The potatoes wouldn’t be made). With trade  1 meat means the farmer only has to give up 3 potatoes (with trade the farmer would make the potatoes and trade for meat). In our story, to benefit from trade each person should specialize in the item in which they have a comparative advantage. So the rancher will make meat and the farmer potatoes. The farmer benefits because with trade he gives up less potatoes to get a unit of meat.

Let’s remember the story for the rancher so far. Without any trade the rancher can make meat or potatoes. Now for the rancher, remember 1m = 2p if there is no trade between the two. But with trade 1m = 3p. So No trade  giving up 1 meat means the rancher gets 2 potatoes (in fact, in the time the rancher could have made 1m he can make 2p. The meat wouldn’t be made). With trade  making 1 meat and then trading means the rancher can get 3 potatoes (with trade the rancher would make the meat and trade for potatoes).

Okay, I went on for several slides. Here is the quick summary. Take the production abilities of each producer Meat Potatoes Farmer 1 4 Rancher 3 6 Find the opportunity cost of 1 good, say 1 meat Framer  4p Rancher2p. Rancher has comparative advantage in meat so rancher will make meat, farmer will make potatoes. Terms of trade 1m between 2 and 4 p  say 1m = 3p. Rancher benefits because 1m will bring 3p in trade instead of only 2p without trade. Rancher gets more potatoes with trade. Framer only “pays” 3p for 1m instead of 4p. Farmer pays less for meat.

In a world without trade, the farmer and the rancher would only be able to consume what they can first produce. The same would be true of nations. (Bells are ringing and lights are flashing here because next we have the main point) As long as the terms of trade are between the opportunity costs of the two producers (Like between 2 and 4 potatoes for 1 unit of meat.), by specializing in the item in which they have acomparative advantage the producers can consume more than they actually are able to make on their own. This is good because from a given world resource base we get more stuff. Since we have a world of scarcity. Getting more stuff helps in having a better standard of living.

“Hey Parker,” I can hear you say. “Do countries totally specialize in one item and forget about making the other stuff?” I have no idear! The question is a good criticism of the story. The principle at work is what is important. For many goods we trade, both countries make some of both goods. Benefits occur though, when the greater focus is on producing the items in which the country has a comparative advantage.

Comparative Advantage