Practice
Comparative advantage and gains from trade
Opportunity costs from a production table, who has the comparative advantage, and which terms of trade help both sides.
The skill
Comparative advantage belongs to whoever produces a good at the lower opportunity cost. Using the maximum outputs, one unit of a good costs the amount of the other good given up divided by the amount of this good gained. Each producer specializes in the good where its opportunity cost is lower, and trading at terms between the two opportunity costs lets both consume beyond their own PPC. A producer that can make more of both goods still has a comparative advantage in only one of them.
A worked example
With the same quantity of resources, Dunmore and Coastia can each produce two goods. The table shows the most each can produce in one day when all of those resources go into one good, and each faces a constant opportunity cost.
| Producer | Steel (tons) | Fish (pounds) |
|---|---|---|
| Dunmore | 10 | 24 |
| Coastia | 24 | 12 |
Which statement about these two producers is true?
- Coastia has an absolute advantage in fish.
- Dunmore has the comparative advantage in steel, and Coastia in fish.
- Coastia has a comparative advantage in steel, and Dunmore has a comparative advantage in fish.
- Coastia has a comparative advantage in both steel and fish, and Dunmore has a comparative advantage in neither.
Solution
- Dunmore gives up 2.4 pounds of fish for each ton of steel (24 ÷ 10), and 0.4167 tons of steel for each pound of fish.
- Coastia gives up 0.5 pounds of fish for each ton of steel (12 ÷ 24), and 2 tons of steel for each pound of fish.
- Comparative advantage goes to the lower opportunity cost: Coastia for steel and Dunmore for fish.
Answer: C, Coastia has a comparative advantage in steel, and Dunmore has a comparative advantage in fish.
Correct. Coastia gives up fewer pounds of fish for each ton of steel (0.5 against 2.4), so Coastia has the lower opportunity cost of steel. The producer with the higher opportunity cost of one good always has the lower opportunity cost of the other.