1.4 Comparative Advantage and Trade

Key Terms

• **Absolute Advantage—**the ability to produce more of a good or service with a given amount of resources than someone else.
• **Comparative Advantage—**the ability to produce a good at the lowest opportunity cost.
• **Terms of Trade—**the rate at which one good can be exchanged for another.

What are Absolute and Comparative Advantage?

Absolute advantage is the ability of a country, individual, or business to produce a higher quantity of a good or use fewer resources. This is usually the easiest to point out. For example, if the United States produces 100 wheat, but Canada produces 150, then Canada has an absolute advantage in wheat. Similarly, if it takes the United States 5 hours to produce 10 computers and takes Canada 10 hours to produce 10 computers, then the US has an absolute advantage in computers.

Comparative advantage, on the other hand, refers to the ability of a country, individual, or business to produce a good or service at a lower opportunity cost than its competitors. In the context of international trade, comparative advantage refers to the opportunity cost of producing a good or service in terms of the next best alternative. A country can have an absolute advantage but not a comparative advantage. This is because even if you can make more of one good than another country, that might come at higher costs.

For example, a country with a comparative advantage in wheat production may be able to produce wheat more efficiently than other countries, even if it has a lower level of technology or a less skilled workforce. This is because the opportunity cost of producing wheat in that country may be lower than the opportunity cost of producing wheat in other countries. In other words, the country may be able to produce wheat at a lower cost in terms of the opportunity cost of the next best alternative.

When countries have a comparative advantage, they can choose to specialize. This means they stop production of one good to maximize production of the other. To get the other good, they trade with a country with a comparative advantage in a different good.

Trade is the exchange of goods and services between countries, individuals, or businesses. It allows for specialization in the production of goods and services in which they have a comparative advantage and to exchange them for other goods and services that they may not be able to produce as efficiently. This leads to increased efficiency and higher levels of production and consumption. Most economists agree that free trade boosts overall welfare.

In summary, absolute advantage refers to the ability to produce more of a good (or use fewer resources when doing so), while comparative advantage refers to the ability to produce a good or service at a lower opportunity cost than competitors. Trade allows countries, individuals, and businesses to specialize in the production of goods and services in which they have a comparative advantage and to exchange them for other goods and services. This leads to increased efficiency and higher levels of production and consumption. Understanding these concepts is essential for analyzing the benefits and costs of trade and for making informed decisions about how to allocate resources.

Absolute and Comparative Advantage on the AP Exam

AP Economics exams are rife with comparative advantage questions since they test your understanding of opportunity cost.

  

There are two types of problems within these concepts:

• Output problems focus on how much can be produced given a set amount of resources. This is like the wheat example from earlier.
• Input problems focus on how much of a resource is needed to produce one unit of a particular good or service. This is like the computer example from earlier.

Output Problems

The rules for these problems are:

• To determine the absolute advantage you are simply looking for which country can produce a higher amount of the good or service.
• To determine comparative advantage you have to calculate per unit opportunity cost using the formula give up/gain (the amount of good you are giving up divided by the amount of good you are gaining). Once you have calculated per unit opportunity cost, the country with the lowest one has a comparative advantage. A good pneumonic is "OOO" or "Output Other Over" to calculate the opportunity cost.
• If the two countries can both make the same amount of the good, then we say neither country has an absolute advantage.
• Countries export what they have a comparative advantage in and import what they don't have a comparative advantage in.

Determining Absolute Advantage

Using the table above, we would determine that Japan has absolute advantage in steel (1200 > 1000) and Canada has absolute advantage in coal (500 > 300).

Determining Comparative Advantage

The per unit opportunity cost for 1 unit of steel in Canada is 1/2 unit of coal (500/1000)

The per unit opportunity cost for 1 unit of steel in Japan is 1/4 unit of coal (300/1200) 

Since 1/4 is less than 1/2, Japan has the comparative advantage in steel.

The per unit opportunity cost for 1 unit of coal in Canada is 2 units of steel (1000/500)

The per unit of opportunity cost for 1 unit of coal in Japan is 4 units of steel (1200/300)

Since 2 is less than 4, Canada has the comparative advantage in coal.

Therefore, Japan will export steel to Canada and import coal from Canada. Note that a country cannot have a comparative advantage in both goods.

Terms of Trade

Terms of trade are determined by looking at the two opportunity costs and choosing a number that falls between the opportunity costs in order for it to be beneficial to both countries.

Acceptable terms of trade for this situation would be:

• 1 unit of coal for 3 units of steel
• 1 unit of steel for 1/3 units of coal

Input Problems

The rules for these problems are:

• To determine absolute advantage, you are looking for the country that uses the least amount of resources (i.e. the lower number)
• To determine comparative advantage, you have to calculate the per unit opportunity cost using the formula gain/give up. Once you have calculated the per unit opportunity cost, the country with the lowest one has a comparative advantage. A pneumonic to remember this is "IOU" or "Input Other Under".
• If the two countries both can make one unit of the good with the same amount of resources, then we say neither country has an absolute advantage.
• Countries export what they have a comparative advantage in and import what they don't have a comparative advantage in.
  

Determining Absolute Advantage

Using the table, we would determine that Brazil has an absolute advantage in the production of cars (2 hours < 3 hours). Brazil also has an absolute advantage in the production of trucks (2 hours < 6 hours).

Determining Comparative Advantage

The per unit opportunity cost for 1 car in the United States is 1/2 a truck (3 divided by 6).

The per unit opportunity cost for 1 car in Brazil is 1 truck (2 divided by 2).

Since 1/2 is less than 1, the United States has a comparative advantage in the production of cars.

The per unit opportunity cost for 1 truck in the United States is 2 cars (6 divided by 3).

The per unit opportunity cost for 1 truck in Brazil is 1 car (2 divided by 2).

Since 1 is less than 2, Brazil has comparative advantage in the production of trucks.

Therefore, the United States will export cars to Brazil and import trucks from Brazil.

Terms of Trade

Terms of trade are determined by looking at the two opportunity costs and choosing a number that falls between the opportunity costs in order for it to be beneficial to both countries.

Acceptable terms of trade for this situation would be:

• 1 truck for 1.5 cars
• 1 car for 3/4 of a truck