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Rationale: Comparative Advantage

Rationale: Comparative Advantage

Author: Kate Eskra

This lesson covers the Rationale: Comparative advantage -

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Source: Images of PPFs created by Kate Eskra

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Hi. Welcome to macroeconomics. This is Kate. This tutorial is called Rationale-- Comparative Advantage. As always, my key terms are in red and examples are in green.

So in this tutorial we'll talk about the difference between absolute and comparative advantage. We'll discuss how we apply these two concepts to specialisation and trade. And you'll see how these concepts are illustrated on a production possibilities frontier, or PPF. OK.

So why trade? Why would countries trade with each other? Well, part of the basis is because countries enjoy different natural resources, different technologies, and different labor forces, in terms of skills, education, and labor costs. So some countries then are going to have an advantage in labor intensive raw materials, while others have the advantage in capital intensive goods.

The United States has the potential to produce many goods and services, obviously, because we're very fortunate. We have a lot of natural resources. We have very sophisticated technologies here. And we have a trained, highly skilled, and educated workforce.

Does that mean, though, that we shouldn't trade with others who might be slightly less efficient? So this is a ridiculous question. But think about it. If you're faster at both raking leaves and mowing the lawn than your spouse, does that mean that you'll get both tasks accomplished by doing both and letting him or her just watch you? Obviously not.

It's kind of the same idea with trade, because of the concept of opportunity cost. So remember opportunity cost is the sacrifice made by choosing one value or opportunity over another. It's the value of the forgone opportunity or what we give up.

So whenever the United States decides to devote resources, like land, labor, and capital, to producing textiles, let's say, what are we giving up? What are we sacrificing? Well, we're giving up the opportunity to use those resources to produce something else, like cars, because remember, our land, labor, and capital are scarce. There is a limited amount of them. So what we give up is our opportunity cost.

So let's run through an example. Let's just say that the United States in a production period can either build 21 cars or produce seven million textiles. Whereas Mexico can, in that same production period, either produce eight cars or four million textiles. OK.

So first of all let's talk about the concept of absolute advantage. The United States enjoys an absolute advantage in both activities, because they're absolutely more productive. Absolute advantage is defined as advantage conferred between two countries, where one country clearly has a lead in the production of the given good relative to the amount of needed inputs. Basically when I think of absolute advantage, I just sum it up as, who's better at it? So that's just my quick way of remembering it.

So how should these countries divide the tasks? What we have to do is we have to figure out who has actually the lower cost for each activity. And that utilizes the theory of comparative advantage. So comparative advantage is advantage conferred with a country to one good's production relative to another. When I think of comparative advantage, I think of, who gives up less? Because it's all about opportunity cost and it being lower.

So if the United States and Mexico divide the tasks most efficiently by specializing in the task for which they have the lower opportunity cost, then both countries are going to benefit. So what we now need to look at is, who gives up less in terms of textiles whenever they produce cars? And who gives up less in terms of cars when they produce textiles?

So here I just put it in a chart form. So this is just exactly what I already presented to. The US' ability to produce either 21 cars or seven million textiles and Mexico's eight cars or four million textiles in some production period. And as we already said, the United States has an absolute advantage in both cars and textiles because they can produce more.

So who should produce each good? What we have to now look at is opportunity cost. So this chart just phrases it in terms of the opportunity cost of producing one car. So every time the United States produces one car, what is the cost of it?

Well, it's what they give up in terms of textiles. And they give up one third of a textile for each one car. Basically I'm just dividing textiles by cars. One third. And when they decide to produce a textile, how many cars do they give up? For each one textile they give up three cars.

And then I did the same thing for Mexico. And as you can see, I highlighted who has the lower cost in each activity. The United States has the lower opportunity cost in producing cars. And Mexico has the lower opportunity cost in producing textiles.

So even though the United States has the absolute advantage in both goods, the United States have comparative advantage in cars and Mexico has comparative advantage in textiles. If they specialize in trade according to this, they'll both end up with more cars and textiles. And that's what we call gains from trade.

So this sometimes is a little bit tricky for people to see. But let's just say the United States now is going to devote all their resources to producing cars. So basically using these same numbers, now they'll be able to produce 21 cars. OK.

I made the trade even here. I made it a one-to-one. So if they want, let's say, five textiles, they will have to trade away five cars, leaving them with 16. OK. So if that's the case, now you can see that the United States will have 16 cars and five textiles.

Basically I halved these, assuming that they were devoting half of their resources into cars and half into textiles. They only had 10.5 cars and 3.5 textiles when they were trying to do both things. So what are their gains from trade? Their gains from trade are five and a half cars-- they're better off-- and one and a half textiles.

Even though they are absolutely more efficient at producing both of them, they're better off when they specialize in trade with Mexico. And that's what this just says here. And why is that? It's because just like two people can get more accomplished by specializing, so can we.

So the idea here that you need to remember from this tutorial is that trade allows countries to enjoy more of both goods and to move beyond their previous resource and productivity constraints. Both goods can be produced at the lowest opportunity cost. And that's the idea of comparative advantage. OK.

Now let's look at a production possibility frontier. What a PPF shows us is the maximum combination of two goods that can be produced when an economy's resources are being utilized. If you think about it, it's kind of like the long-run aggregate supply curve, except this is a different graph completely.

Here we're not graphing price and a quantity of something. But here's all the textiles that can be produced versus cars. And you notice that I plotted exactly the numbers that we've been talking about.

The United States can either produce 21 cars or seven million textiles. And there are Mexico's numbers. So the x-intercept means, how many cars can be produced when all resources are devoted to car production or specialization in cars? And the y-intercept are, how many textiles can be produced with specialization in textiles?

So these are the numbers that we've been using. OK. You can easily see absolute advantage. On the x-intercept, who can produce more? The US. On the y-intercept, who can produce more? Yes, the US again.

Comparative advantage we can see, though, by looking at the slope. The slope represents the trade-off. It's how many of one item has to be sacrificed in order to produce one more unit of the other.

So if you think about it, the country with the flatter slope is going to have the comparative advantage in what's on the x-axis-- because for the United States, they're giving up less textiles every time they produce one more car. The country with the steeper slope is going to have the comparative advantage in y because they'll be giving up fewer of what's on this axis-- so fewer cars when they're producing one more textile. OK.

So you might need to take a little bit of time and look at that and wrap your head around it. But it does make sense if you recognize that this represents a trade-off for every time we produce one more. How many do we give up in terms of the other good?

So the idea with gains from trade is-- as we calculated earlier-- when the United States and Mexico trade according to comparative advantage-- if we just use the United States PPF here, you can see that the United States gained 5.5 cars and 1.5 textiles. That is outside of our initial possibility. So that is how we can show economic growth. When we trade with other nations, we can move beyond our PPF and that allows us to achieve economic growth.

So in this tutorial we talked about absolute advantage, comparative advantage, and how people and nations benefit when they specialize in whatever they enjoy the comparative advantage in. And we can see all of this on a PPF. Thanks so much for listening. Have a great day.

Notes on "Rationale: Comparative Advantage"

Terms to Know

Opportunity cost

The sacrifice made by choosing one value or opportunity over another; the value of the forgone opportunity. 

Comparative Advantage

Advantage conferred with a country to one good's production relative to another.

Absolute Advantage

Advantage conferred between two countries where one country clearly has a lead in the production of a given good relative to the amount of needed inputs.