Comparative Advantage
Use opportunity cost to explain specialization, trade, and gains from exchange between individuals, firms, and countries.
A lesson of Economics, in Global Economics, about 10 minutes.
International Trade and Globalization
By the end of this lesson, you will be able to explain why countries trade using comparative advantage, analyze the benefits and costs of trade, describe how exchange rates work, and evaluate trade policy arguments.
Why Countries Trade: Comparative Advantage
Absolute advantage: a country can produce a good using fewer resources than another country.
Comparative advantage: a country can produce a good at a lower opportunity cost than another country. This is the basis for trade — not absolute advantage.
Example:
| Wheat (tons/worker) | Cloth (tons/worker) | |
|---|---|---|
| Country A | 6 | 4 |
| Country B | 2 | 3 |
Country A has absolute advantage in both goods. But:
- A's opportunity cost of wheat = 4/6 = 0.67 tons cloth per ton wheat
- B's opportunity cost of wheat = 3/2 = 1.5 tons cloth per ton wheat
Country A has comparative advantage in wheat (lower opportunity cost); Country B has comparative advantage in cloth. Trade benefits both — each specializes in what it does relatively best.
Key insight: even if one country is worse at producing everything, trade still benefits both countries. The concept of comparative advantage is one of the most non-obvious and important insights in economics.
Gains from Trade
When countries specialize according to comparative advantage and trade:
- Total world output increases
- Both countries can consume beyond their own production possibility frontiers
- Consumers benefit from lower prices and greater variety
Winners and losers within a country:
- Winners: producers in the export industry; consumers who buy imported goods
- Losers: producers who compete with imports (they face lower prices and may lose jobs)
- Net gain: gains to winners outweigh losses to losers — but the losers are concentrated (e.g., textile workers) and the winners are diffuse (every consumer pays less for clothing) → political pressure for protection
Trade Policy
Free trade: no government restrictions on imports or exports.
Protectionism: restricting imports to protect domestic industries.
Tools of protectionism:
- tax on imports; raises the price of foreign goods; revenue for government; helps domestic producers; hurts domestic consumers