Barry Haworth
Department of Economics
University of Louisville
Economics 202



Comparative Advantage




Comparative Advantage addresses a situation where two individuals or (in this case) countries are able to benefit from specialization and trade. Below, we work through an example involving two countries, Country A and Country X, where each country (first) attempts to meet domestic demand by producing only what is needed, and then (second) follows the Law of Comparative Advantage.

Country A produces compact cars and luxury cars and is able to achieve the following production possibilities (below). The table is written to reflect 10 different production/consumption choices (written as column/choice A through column/choice J).

 
A
B
C
D
E
F
G
H
I
J
Compact cars
0
2
4
6
8
10
12
14
16
18
Luxury cars
9
8
7
6
5
4
3
2
1
0


To meet domestic demand, Country A must produce at pt. E (i.e. column E). Moving from pt. E to pt. D, Country A would have to give up producing 2 compact cars in order to produce 1 more luxury car. Because this country is fully employed, the only way to get more luxury cars is by taking workers out of compact car production and putting them into luxury car production. Doing this between pts. D and E causes 2 less compacts to be built. Therefore, the opportunity cost of that additional luxury car is 2 compact cars.

Moving from pt. E to pt. F, Country A must give up producing 1 luxury car in order to produce 2 more compact cars. Therefore, the opportunity cost of each (1) additional compact car is of a luxury car.

If we consider any other pair of points, we find that the opportunity is always the same (for each good) no matter where we start. This implies constant opportunity costs, and tells us that the PPC here is a straight line.


Country X produces compacts and luxury cars as well. Their PPC relationship is:

 
Q
R
S
T
U
V
W
X
Y
Z
Compact cars
0
1
2
3
4
5
6
7
8
9
Luxury cars
18
16
14
12
10
8
6
4
2
0

To meet domestic demand in Country X, it is necessary to produce at pt. W. If we were to illustrate Country A and X's production possibilities on a graph, then we would get the following.

2 ppc graphs here


Calculating the opportunity cost here, as we did above, we get:

Opportunity cost of each (1) additional compact car = 2 luxury cars
Opportunity cost of each (1) additional luxury car = 1/2 of a compact car


Now, let's compare the opportunity costs between countries

for luxury cars:
(A) Opp cost of each 1 luxury car = 2 compact cars
(X) Opp cost of each 1 luxury car = 1/2 of a compact car

for compact cars:
(A) Opp cost of each 1 compact car = 1/2 of a luxury car
(X) Opp cost of each 1 compact car = 2 luxury cars


Country X gives up fewer compact cars when producing an additional luxury car, while Country A gives up fewer luxury cars when producing an additional compact car. Therefore, the opportunity cost of producing compacts is lowest in Country A, and the opportunity cost of producing luxury cars is lowest in Country X.

When Country A has a lower opportunity cost associated with producing something, then A is said to have a comparative advantage in producing that item. Therefore, A has a comparative advantage in producing compacts, while X has a comparative advantage in producing luxury cars.

The Law of Comparative Advantage says the following, "By specializing in the production of a good where a first country has a comparative advantage, the first country can trade with another country (who specializes in something that the first country doesn't have a comparative advantage in) and become "better off".


Suppose Countries A and X specialize where they have comparative advantage. Country A switches from pt. E to pt. J, while X switches from pt. W to pt. Q. We see this on the following table:


Country A
Domestic Demand

Specialize

Country X
Domestic Demand

Specialize
Compacts
8
18
Compacts
6
0
Luxury cars
5
0
Luxury cars
6
18


Country A now has 10 more compacts than needed domestically, whereas X has 12 more luxury cars than needed domestically. Assume that these countries are willing to trade on a 1-for-1 basis, and that A sends 9 compacts to X, in exchange for 9 luxury cars. That gives us the following result:


Country A
Before
Trade
After
Trade

Country X
Before
Trade
After
Trade
Compacts
8
9
Compacts
6
9
Luxury cars
5
9
Luxury cars
6
9


Do these countries benefit from specialization and trade? Yes, both have more of each good after trade than before trade. By specializing and trading, these countries can "consume" compact cars and luxury cars in amounts that would not be possible if these countries tried to meet domestic demand alone. That is, these countries are able to consume outside their PPC, even though they can't produce outside of it. This is illustrated in the graph below.

Country A's PPC and Country X's PPC are combined on the same graph. Consumption occurs at pt. M, a point that lies along the (green) dotted consumption possibilities line. Pt. M exists outside of each country's ability to produce, but by using the Law of Comparative Advantage, doesn't exist outside of each country's ability to consume.