The Importance of Gains from Trade
In most cases, people in an economy want to buy a wide variety of goods and services. These goods and services can either all be produced within the home country's economy or can be obtained by trading with other nations.
Because different countries and economies have different resources, it's usually the case that different countries are better at producing different things. This concept suggests that there could be mutually beneficial gains from trade, and, in fact, this is indeed the case from an economic perspective. Therefore, it's important to understand when and how an economy can benefit from trading with other nations.02of 07
In order to begin thinking about gains from trade, we need to understand two concepts about productivity and cost. The first of these is known as an absolute advantage, and it refers to a country being more productive or efficient in producing a particular good or service.
In other words, a country has an absolute advantage in producing a good or service if it can produce more of them with a given amount of inputs (labor, time, and other factors of production) than other countries can.
This concept is easily illustrated via an example: let's say the United States and China are both making rice, and a person in China can (hypothetically) produce 2 pounds of rice per hour, but a person in the United States can only produce 1 pound of rice per hour. It can then be said that China has an absolute advantage in producing rice since it can produce more of it per person per hour.03of 07
Features of Absolute Advantage
Absolute advantage is a pretty straightforward concept since it's what we usually think of when we think about being "better" at producing something. Note, however, that absolute advantage only considers productivity and doesn't take any measure of cost into account; therefore, one can't conclude that having an absolute advantage in production means that a country can produce a good at a lower cost.
In the previous example, the Chinese worker had an absolute advantage in producing rice because he could produce twice as much per hour as the worker in the United States. If the Chinese worker was three times as expensive as the U.S. worker, however, it wouldn't actually be cheaper to produce rice in China.
It's useful to note that it's entirely possible for a country to have an absolute advantage in multiple goods or services, or even in all of the goods and services if it happens to be the case that one country is more productive than all other countries at producing everything.04of 07
Because the concept of absolute advantage doesn't take cost into account, it's useful to also have a measure that considers economic costs. For this reason, we use the concept of a comparative advantage, which occurs when one country can produce a good or service at a lower opportunity cost than other countries.
Economic costs are known as opportunity cost, which is simply the total amount that one must give up in order to get something, and there are two ways to analyze these types of expenses. The first is to look at them directly -- if it costs China 50 cents to make a pound of rice, and it costs the United States 1 dollar to make a pound of rice, for example, then China has a comparative advantage in rice production because it can produce at a lower opportunity cost; this is true as long as the costs reported are in fact true opportunity costs.05of 07
Opportunity Cost in a Two-Good Economy
The other way of analyzing comparative advantage is to consider a simple world that consists of two countries that can produce two goods or services. This analysis takes money out of the picture entirely and considers opportunity costs as the tradeoffs between producing one good versus the other.
For example, let's say that a worker in China can produce either 2 pounds of rice or 3 bananas in an hour. Given these levels of productivity, the worker would have to give up 2 pounds of rice in order to produce 3 more bananas.
This is the same as saying that the opportunity cost of 3 bananas is 2 pounds of rice, or that the opportunity cost of 1 banana is 2/3 of a pound of rice. Similarly, because the worker would have to give up 3 bananas in order to produce 2 pounds of rice, the opportunity cost of 2 pounds of rice is 3 bananas, and the opportunity cost of 1 pound of rice is 3/2 bananas.
It's helpful to notice that, by definition, the opportunity cost of one good is the reciprocal of the opportunity cost of the other good. In this example, the opportunity cost of 1 banana is equal to 2/3 pound of rice, which is the reciprocal of the opportunity cost of 1 pound of rice, which is equal to 3/2 bananas.06of 07
Comparative Advantage in a Two-Good Economy
We can now examine comparative advantage by introducing opportunity costs for a second country, such as the United States. Let's say that a worker in the United States can produce either 1 pound of rice or 2 bananas per hour. Therefore, the worker has to give up 2 bananas in order to produce 1 pound of rice, and the opportunity cost of a pound of rice is 2 bananas.
Similarly, the worker must give up 1 pound of rice to produce 2 bananas or must give up 1/2 pound of rice to produce 1 banana. The opportunity cost of a banana is thus 1/2 pound of rice.
We are now ready to investigate comparative advantage. The opportunity cost of a pound of rice is 3/2 bananas in China and 2 bananas in the United States. China, therefore, has a comparative advantage in producing rice.
On the other hand, the opportunity cost of a banana is 2/3 of a pound of rice in China and 1/2 of a pound of rice in the United States, and the United States has a comparative advantage in producing bananas.07of 07
Features of Comparative Advantage
There are a couple of helpful features to note about comparative advantage. First, although a country may be able to have an absolute advantage in producing very good, it's not possible for a country to have a comparative advantage in producing every good.
In the previous example, China had an absolute advantage in both goods -- 2 pounds of rice versus 1 pound of rice per hour and 3 bananas versus 2 bananas per hour -- but only had a comparative advantage in producing rice.
Unless both countries face exactly the same opportunity costs, it will always be the case in this sort of two-good economy that one country has a comparative advantage in one good and the other country has a comparative advantage in the other.
Second, comparative advantage is not to be confused with the concept of "competitive advantage," which may or may not mean the same thing, depending on context. That said, we will learn that it is the comparative advantage that ultimately matters when deciding what countries should produce what goods and services so that they can enjoy mutual gains from trade.