Comparative Advantage and Trade: Study Guide (Microeconomics 1.4)

Why specialise and trade?

In Topic 1.3 you saw that scarcity forces every economy to choose a point on or inside its PPC. On its own, an economy can never consume more than its PPC allows. This topic shows a way round that limit. If producers specialise in what they give up least to make, and then trade, everyone can end up with more than they could make alone.

The idea works for any producer: a person, a business or a country. Throughout this guide we use two fictional countries, Corvania and Delmora. Each has the same quantity of resources (the same number of workers, machines and land), and each can make two goods:

Country	Rice (thousand sacks per month)	Shoes (thousand pairs per month)
Corvania	120	40
Delmora	60	30

Each number is the most the country can make if it puts all its resources into that one good. Both PPCs are straight lines, so opportunity costs are constant.

Absolute advantage

A producer has an absolute advantage in a good if it can make more of that good than another producer using the same quantity of resources. Put another way, it can make the same amount using fewer resources.

Corvania makes 120 thousand sacks of rice, Delmora only 60. Corvania makes 40 thousand pairs of shoes, Delmora only 30. So Corvania has an absolute advantage in both goods.

Absolute advantage is easy to spot, but it does not decide who should make what. For that you need opportunity cost.

Comparative advantage

A producer has a comparative advantage in a good if it can make that good at a lower opportunity cost than another producer. Recall from Topic 1.3:

Opportunity cost of 1 unit of X = units of Y given up ÷ units of X gained

For a straight-line PPC, use the two maximums. If Corvania moves all its resources from shoes to rice, it gives up 40 thousand pairs of shoes and gains 120 thousand sacks of rice.

Country	Opportunity cost of 1 pair of shoes	Opportunity cost of 1 sack of rice
Corvania	120 ÷ 40 = 3 sacks of rice	40 ÷ 120 = 1/3 pair of shoes
Delmora	60 ÷ 30 = 2 sacks of rice	30 ÷ 60 = 1/2 pair of shoes

• Shoes: Delmora gives up 2 sacks, Corvania 3. Delmora has the comparative advantage in shoes.
• Rice: Corvania gives up 1/3 of a pair, Delmora 1/2. Corvania has the comparative advantage in rice.

Notice two things. First, Delmora has no absolute advantage at all, but it still has a comparative advantage. Second, each country’s two opportunity costs are reciprocals (3 and 1/3; 2 and 1/2). So with two goods and two producers, one producer has the comparative advantage in one good and the other producer has it in the other good. The only exception is when the opportunity costs are equal; then neither has a comparative advantage.

Reading advantage from PPCs

You can draw both countries’ PPCs on the same axes. With shoes on the horizontal axis, the size of the slope of each line is the opportunity cost of shoes.

• Intercepts show absolute advantage: the higher intercept on an axis means more of that good from the same resources.
• Slopes show comparative advantage. With shoes on the horizontal axis, the flatter line gives up less rice per pair, so that producer has the comparative advantage in shoes. The steeper line has the comparative advantage in the good on the vertical axis.

Output data and input data

Questions give data in one of two forms. Read the column headings carefully before you divide.

Form	What the numbers mean	Who has the absolute advantage	Opportunity cost of 1 X
Output	units made in a given time or with given resources	the larger number	(output of Y) ÷ (output of X)
Input	hours (or workers, or acres) needed to make one unit	the smaller number	(input per X) ÷ (input per Y)

If the input rule is hard to remember, convert input data into output data first: divide the time available by the hours per unit. Then use the output rule. Worked example 2 does both and shows they agree.

Worked example 1: absolute and comparative advantage from output data

Question. Use the Corvania and Delmora table. (a) Who has the absolute advantage in each good? (b) Who has the comparative advantage in each good? (c) Which good should each country specialise in?

(a) Compare outputs from the same resources. Rice: 120 > 60. Shoes: 40 > 30. Corvania has the absolute advantage in both.

(b)

1. Corvania: 1 pair of shoes costs 120 ÷ 40 = 3 sacks of rice; 1 sack of rice costs 40 ÷ 120 = 1/3 pair.
2. Delmora: 1 pair of shoes costs 60 ÷ 30 = 2 sacks of rice; 1 sack of rice costs 30 ÷ 60 = 1/2 pair.
3. Shoes: 2 < 3, so Delmora has the comparative advantage.
4. Rice: 1/3 < 1/2, so Corvania has the comparative advantage.

(c) Corvania should specialise in rice and Delmora in shoes. Specialisation follows comparative advantage. If Corvania made everything because it is “better at both”, it would waste its resources on shoes, which cost it 3 sacks of rice each, when Delmora can make them for 2.

Check. The two comparative advantages are in different goods, as they must be when costs differ.

Worked example 2: input data

Question. Ana and Ben are fictional furniture makers. The table shows the hours of work each needs to make one unit.

Maker	Hours per table	Hours per chair
Ana	3	1
Ben	6	1.5

(a) Who has the absolute advantage in each good? (b) Find each maker’s opportunity cost of a table and of a chair. Who has the comparative advantage in each? (c) Check your answer to (b) by converting to output in a 12-hour day.

(a) Fewer hours per unit means more output from the same time. Tables: 3 < 6. Chairs: 1 < 1.5. Ana has the absolute advantage in both.

(b) For input data, opportunity cost of 1 X = (hours per X) ÷ (hours per Y).

1. Ana: the 3 hours she spends on a table could make 3 ÷ 1 = 3 chairs. A chair costs 1 ÷ 3 = 1/3 table.
2. Ben: the 6 hours he spends on a table could make 6 ÷ 1.5 = 4 chairs. A chair costs 1.5 ÷ 6 = 1/4 table.
3. Tables: 3 < 4, so Ana has the comparative advantage in tables.
4. Chairs: 1/4 < 1/3, so Ben has the comparative advantage in chairs.

(c) In 12 hours, Ana can make 12 ÷ 3 = 4 tables or 12 ÷ 1 = 12 chairs. Ben can make 12 ÷ 6 = 2 tables or 12 ÷ 1.5 = 8 chairs. Using the output rule: Ana’s table costs 12 ÷ 4 = 3 chairs and Ben’s costs 8 ÷ 2 = 4 chairs. The answers match.

Common slip. With input data, dividing “the other good over this good” (the output rule) gives the reciprocal: 1 ÷ 3 instead of 3. Always ask: “In the time it takes to make one table, how many chairs could I have made?”

Specialisation and gains from trade

Go back to Corvania and Delmora. Without trade, each country must consume what it produces. Suppose that before trade they choose these points on their PPCs:

	Shoes (thousand pairs)	Rice (thousand sacks)
Corvania, no trade	15	120 − 3 × 15 = 75
Delmora, no trade	10	60 − 2 × 10 = 40
Total output, no trade	25	115
Corvania specialises in rice	0	120
Delmora specialises in shoes	30	0
Total output, specialised	30	120

Specialising according to comparative advantage raises total output of both goods: 5 thousand more pairs of shoes and 5 thousand more sacks of rice, with exactly the same resources. Each good is now made by the producer who gives up least to make it. Those extra goods are the gains from specialisation. Trade is how the two countries share them.

Terms of trade

The terms of trade are the rate at which one good is exchanged for the other, such as “1 pair of shoes for 2.5 sacks of rice”.

Delmora exports shoes. Making a pair costs it 2 sacks of rice, so it will only sell a pair for more than 2 sacks. Corvania imports shoes. Making a pair itself would cost 3 sacks of rice, so it will only pay less than 3 sacks. So:

Mutually beneficial terms of trade: 1 pair of shoes for more than 2 but fewer than 3 sacks of rice.

The rule in general: the terms of trade must lie between the two producers’ opportunity costs.

• At 2.5 sacks per pair, Delmora gains 2.5 − 2 = 0.5 sack on each pair it sells, and Corvania saves 3 − 2.5 = 0.5 sack on each pair it buys. Both gain.
• At 3.5 sacks per pair, Corvania refuses: it can make shoes itself for 3 sacks.
• At 1.5 sacks per pair, Delmora refuses: it would get less than its own cost of 2 sacks.
• At exactly 2 or exactly 3, one side gains nothing, so there is no reason for it to trade.

You can state the same range the other way round. Inverting it, 1 sack of rice must trade for between 1/3 and 1/2 of a pair of shoes: again, between the two opportunity costs of rice.

Worked example 3: consuming beyond the PPC

Question. Corvania and Delmora specialise fully and trade at 1 pair of shoes for 2.5 sacks of rice. Delmora exports 18 thousand pairs of shoes to Corvania. (a) How much rice does Delmora receive? (b) What does each country consume after trade? Compare with its no-trade point. (c) Show that each country consumes a combination outside its own PPC.

(a) 18 × 2.5 = 45 thousand sacks of rice.

(b)

1. Delmora keeps 30 − 18 = 12 thousand pairs of shoes and has 45 thousand sacks of rice. Before trade it had 10 and 40. Gain: 2 thousand pairs and 5 thousand sacks.
2. Corvania keeps 120 − 45 = 75 thousand sacks of rice and has 18 thousand pairs of shoes. Before trade it had 75 and 15. Gain: 3 thousand pairs, with no loss of rice.
3. Check: totals are 12 + 18 = 30 pairs and 45 + 75 = 120 sacks, exactly what was produced.

(c) On its own PPC, with 12 thousand pairs Delmora could have at most 60 − 2 × 12 = 36 thousand sacks of rice. It now has 45, so the point (12, 45) is outside its PPC. For Corvania, with 18 thousand pairs the most rice on its PPC is 120 − 3 × 18 = 66 thousand sacks. It has 75, so (18, 75) is also outside its PPC.

Interpretation. Neither country gained any resources or technology, so neither PPC moved. What changed is what each can consume. Specialising by comparative advantage and trading at terms between the two opportunity costs gives both countries consumption possibilities beyond their own PPCs.

Common misconceptions

• “The producer with the absolute advantage should make everything.” Specialisation follows comparative advantage. Corvania is better at both goods but should leave shoes to Delmora.
• “A producer with no absolute advantage has nothing to gain from trade.” Delmora is worse at both goods but still has a comparative advantage in shoes, and it gains from trade.
• “One producer can have the comparative advantage in both goods.” Not with two goods and two producers. Lower cost in one good means higher cost in the other, because the two costs are reciprocals.
• “Trade shifts the PPC outward.” Trade changes consumption, not production possibilities. The PPC moves only when resources or technology change.
• “Any rate of exchange makes both sides better off.” Only terms strictly between the two opportunity costs do. Outside that range one side refuses; at either end one side gains nothing.
• “For input data, use the same division as for output data.” Input numbers are costs per unit, so the rule flips. Convert to output if unsure.
• “Comparative advantage is about money costs or wages.” In this model it is about opportunity cost: how much of the other good is given up.

Where this leads

Comparative advantage explains why people, firms and countries specialise and trade. Next, Topic 1.5 uses the same habit of comparing what you give up with what you get: see the Cost-Benefit Analysis study guide. Before you move on, try the practice questions, then use the revision notes and the checklist. If opportunity cost on a PPC still feels shaky, review Topic 1.3.