Lesson 7.01 International Trade and Comparative Advantage

Before we start the lesson, read the definitions of vocabulary that will be introduced in the lesson.

Fullscreen version | Text-only version

Comparative Advantage and Absolute Advantage

We will learn that it is not always wise for a person or business to produce an item simply because they can do it better than someone else. Adam Smith, the Father of Economics, came up with the idea of specialization. He said that people should specialize in what they do best so that the world will have more products. This idea of absolute advantage was prevalent until another economist, David Ricardo, came up with the idea of comparative advantage.

Ricardo's idea was that a person, business or country should produce something if they have a lower opportunity cost than someone else. It is opportunity cost that dictates who should produce what items. If nations both allow free trade and produce those items they can with the lowest opportunity costs, the world will have an increased standard of living. We will look at the production possibilities curves for the countries Alpha and Beta to see how countries can specialize and trade to improve their standard of living.

The information in the Production Possibilities Curve can also be placed into a table.

PPC for Alpha and Beta

	Cars	Boats
Alpha	90	30
Beta	40	20

Now, using the given information we can learn the difference between absolute and comparative advantage. Absolute advantage means you can produce more than someone else can. In this case, Alpha has an absolute advantage in cars since they can produce 90 cars while Beta can only produce 40 cars. We can also see Alpha has an absolute advantage in boats since they can produce 30 boats while Beta can only produce 20 boats. It just seems obvious that Alpha will gain nothing from trading with Beta since they are better at producing both cars and boats. However, David Ricardo was able to put forth the idea of comparative advantage. He said that countries should produce an item if they have a lower opportunity cost. Now our goal is to find the opportunity cost associated with producing each item.

Taking the extremes of the PPCs for each country we can come up with the equations:

Alpha 90 cars = 30 boats

What this means is that if Alpha spent all of its resources on a single product it could produce 90 cars or it could use all of its resources to produce 30 boats. According to the PPC, Alpha can't have 90 cars and 30 boats. Alpha must make a choice. Using our equation, we can determine what Alpha gives up to produce boats. To calculate the opportunity cost of producing one car, we simply divide both sides of the equation by 90.

90/90 cars = 30/90 boats
or
1 car = 1/3 boat

This means that for Alpha to produce 1 car they give up the opportunity to make 1/3 of a boat.

We can start over and figure out the opportunity cost of producing one boat. We do this by dividing our original equation by 30.

90/30 cars = 30/30 boats
or
1 boat = 3 cars

This means that if Alpha chooses to make a boat they give up the opportunity to make 3 cars.

You can now use the same logic to determine the opportunity costs for Beta. Starting with the equation 40 cars = 20 boats and solving for one car and then one boat we get:

40/40 cars = 20/40 boats
or
1 car = 1/2 boat

40/20 cars = 20/20 boats
or
one boat = 2 cars

We can now compare the opportunity costs for both Alpha and Beta.

Opportunity Cost for Alpha and Beta

	Opportunity Cost to Produce 1 Car	Opportunity Cost to Produce 1 Boat
Alpha	1/3 boat	3 cars
Beta	1/2 boat	2 cars

According to David Ricardo, the key to comparative advantage is the country or person who has the lowest opportunity cost should specialize and produce that product. In this case the country with the lowest opportunity cost for producing 1 car is Alpha since their opportunity cost of producing the car is only 1/3 of a boat while Beta's is 1/2 of a boat. When we look at the opportunity costs for producing one boat, we can see that Beta's opportunity cost is only 2 cars while Alpha's is 3 cars. According to comparative advantage, Alpha should specialize in the production of cars and Beta should specialize in the production of boats. Each country should specialize then trade to obtain the other item.

When countries decide to trade, the terms of trade are very important. To set up mutually advantageous terms of trade, simply set up a range of the appropriate opportunity costs. In this case a legitimate term of trade for one boat would be:

1 boat = 2 - 3 cars

If the term of trade is between the two opportunity costs, then both countries will benefit from specialization and trade. Assume that the terms of trade is established at one boat = 2.5 cars. We can now see how both countries will gain if they specialize and trade.

In the following example, Alpha will specialize in the production of cars. Alpha will be able to produce 90 cars. With the terms of trade at 2.5 cars for one boat, then Alpha could, if they choose, trade all 90 cars for 36 boats (90/2.5). When we plot this new possibility on the PPC, we can see that the PPC for Alpha will shift out, meaning they can now have more cars and boats simply by specializing and trading.

If Beta specializes in boats, they can produce 20 of them. According to the terms of trade, if they trade all 20 boats, they can have 50 cars (2.5 * 20). Plotting their new PPC curve with specialization and trading yields the following results:

Use the information you find in the two learning activities below to complete 7.01 The Basics of Comparative Advantage.

Activity #1

1. Read The World's Greatest Athlete, a lesson that focuses on several people who have dedicated their lives to athletics. Please note: The link to the article about Bryan Clay at this site is broken. Read about him at VOA: American Bryan Clay Crowned 'World's Greatest Athlete'. As you read the lesson, pay particular attention to the scenario involving the fictional countries Swizzleland and Astroland (Process, steps 6-8). As practice, figure out which nation has a comparative advantage in the production of wheat and computers.

After you read the lesson, complete questions 1-4 of 7.01 The Basics of Comparative Advantage.

Activity #2

Read the PowerPoint slides at Should LeBron James Mow His Own Lawn? After you read the article, complete questions 5-8 of 7.01 The Basics of Comparative Advantage.

Finally, watch Benefits of Trade/Comparative Advantage (3:59) to learn more about comparative advantage. You should take the quiz at the end of the video for practice.