Practice
Comparative advantage and terms of trade
Opportunity costs from a production table, who has the comparative advantage, and which terms of trade help both sides.
The skill
Comparative advantage goes to the producer with the lower opportunity cost, not the one that can make more. From the maximum outputs, a producer's opportunity cost of one unit of a good is the amount of the other good given up divided by the amount of this good gained. Compare the two producers good by good. Each one has the comparative advantage in a different good, and trade helps both when the terms of trade fall between their opportunity costs. Mixing this up with absolute advantage, which only compares output, is the classic error.
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 | 40 | 20 |
| Coastia | 16 | 40 |
Which statement about these two producers is true?
- Coastia has the comparative advantage in steel, and Dunmore in fish.
- Dunmore has an absolute advantage in fish.
- Dunmore has a comparative advantage in steel, and Coastia has a comparative advantage in fish.
- Dunmore has a comparative advantage in both steel and fish.
Solution
- Dunmore gives up 0.5 pounds of fish for each ton of steel (20 ÷ 40), and 2 tons of steel for each pound of fish.
- Coastia gives up 2.5 pounds of fish for each ton of steel (40 ÷ 16), and 0.4 tons of steel for each pound of fish.
- Comparative advantage goes to the lower opportunity cost: Dunmore for steel and Coastia for fish.
Answer: C, Dunmore has a comparative advantage in steel, and Coastia has a comparative advantage in fish.
Correct. Dunmore gives up fewer pounds of fish for each ton of steel (0.5 against 2.5), so Dunmore 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.