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Comparative Advantage

25 April, 2016 - 09:12

People participate in international trade because they make themselves better off by doing so. In this section we will find that countries that participate in international trade are able to consume more of all goods and services than they could consume while producing in isolation from the rest of the world.

Suppose the world consists of two countries, Roadway and Seaside. Their production possibilities curves are given in Figure 17.3. Roadway’s production possibilities curve in Panel (a) is the same as the one in Figure 17.1 and Figure 17.2. Seaside’s curve is given in Panel (b).

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Figure 17.3 Comparative Advantage in Roadway and Seaside

Roadway’s production possibilities curve is given in Panel (a); it is the same one we saw in Figure 17.1 and Figure 17.2. The production possibilities curve for a second hypothetical country, Seaside, is given in Panel (b). If no trade occurs between the two countries, suppose that Roadway is at Point A and that Seaside is at Point A′. Notice that the opportunity cost of an additional boat in Roadway is two trucks, while the opportunity cost of an additional boat in Seaside is 0.2 trucks. Clearly, Seaside has a comparative advantage in the production of boats.

Each country produces two goods, boats and trucks. Suppose no trade occurs between the two countries and that they are each currently operating on their production possibilities curves at points A and A′ in Figure 17.3. We will assume that the two countries have chosen to operate at these points through the workings of demand and supply. That is, resources have been guided to their current uses as producers have responded to the demands of consumers in the two countries. In turn, consumers have responded to the prices charged by sellers of boats and trucks.

The two countries differ in their respective abilities to produce trucks and boats. As we can see by looking at the intersection of the production possibilities curves with the vertical axes in Figure 17.3,Roadway is able to produce more trucks than Seaside. If Roadway concentrated all of its resources on the production of trucks, it could produce 10,000 trucks per year. Seaside could produce only 5,000.Now look at the intersection of the production possibilities curves with the horizontal axes. If Roadway concentrated all of its resources on the production of boats, it could produce 10,000 boats. Seaside could produce only 7,000 boats. Because Roadway is capable of producing more of both goods, we can infer that it has more resources or is able to use its labor and capital resources more productively than Seaside. When an economy or individual can produce more of any good per unit of labor than another country or individual, that country or person is said to have an absolute advantage.

Despite the fact that Roadway can produce more of both goods, it can still gain from trade with Seaside —and Seaside can gain from trade with Roadway. The key lies in the opportunity costs of the two goods in the two countries. The country with a lower opportunity cost for a particular good or service has a comparative advantage in producing it and will export it to the other country.

We can determine opportunity costs in the two countries by comparing the slopes of their respective production possibilities curves at the points where they are producing. At point A in Panel (a) of Figure 17.3, one additional boat costs two trucks in Roadway; that is its opportunity cost. At point A′ in Panel (b), 1 additional boat in Seaside costs only 0.2 truck. Alternatively, we can ask about the opportunity cost of an additional truck. In Roadway, an additional truck costs 0.5 boats. In Seaside, it costs five boats. Roadway thus has a comparative advantage in producing trucks; Seaside has a comparative advantage in producing boats. This situation is suggested pictorially in Figure 17.4.

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Figure 17.4 Picture of Comparative Advantage in Roadway and Seaside
 

The exhibit gives a picture of Roadway’s comparative advantage in trucks and Seaside’s comparative advantage in boats.