Comparative advantage Why countries trade

Absolute advantage A country has an absolute advantage when it can produce more goods and services than other countries with the same level of inputs (lower cost/unit) Germany might be able to produce more cars than the UK with the same inputs and more financial services as well If in the very exceptional case Germany is exactly equally more efficient at both (twice in this case) then trade is not beneficial

Comparative advantage Comparative advantage exists when one country can produce a good or service at a lower opportunity cost than another For example, assume the UK can produce more cars and financial services (FS) than Spain, and so has an absolute advantage in both In this example the UK’s PPF shows it can produce 120 FS if all resources are devoted to FS, or 50 cars, whilst for Spain it is 40 and 40 The UK is comparatively better at producing FS because its opportunity cost is lower, whilst Spain has a comparative advantage in cars. See right Each country can be better off by specialising in the product for which is has a comparative advantage, and then trading Spain is willing to produce an extra car as long as it can trade this car for at least 1 unit of FS UK is willing to produce an extra unit of FS and trade this as long as it receives at least 5/12 of a car Let’s say the trade is based on 2:3, so 2 cars are traded for 3 units of FS Financial ServicesCars UK12050 Spain40 Total16090 Opportunity cost For the UK to gain 1 unit of FS it gives up 5/12 of a car For Spain to gain 1 unit of FS it gives up 1 car For the UK to gain 1 car it gives up 2.4 units of FS For Spain to gain 1 car it gives up 1 unit of FS

Comparative advantage If we assume the starting point is that both countries devote equal resources to each product, then output is as shown in the top table If Spain then devotes all its resources to cars, and the UK devotes say 80% to FS and 20% to cars then total output is as shown in the second table Output of FS rises from 80 to 96, whilst output of cars rises from 45 to 50 How can each country be better off? Before specialising, Spain consumed 20 cars and 20 units of FS It now produces 40 cars and 0 FS so let’s assume Spain trades 20 cars at an exchange rate of 2:3 This means Spain gains 30 units of FS and is better off. Same number of cars but 10 more FS The UK consumed 60 FS and 25 cars before specialisation It now produces 96 units of FS and 10 cars, and as above buys 20 cars for 30 units of FS The UK now consumes 30 cars (10 produced and 20 bought) and 66 units of FS, so 5 more cars and and 6 more units of FS Pre trade chooseFSCars UK6025 Spain20 Total8045 Specialise UK9610 Spain040 Total9650 Opportunity cost For the UK to gain 1 unit of FS it gives up 5/12 of a car For Spain to gain 1 unit of FS it gives up 1 car For the UK to gain 1 car it gives up 2.4 units of FS For Spain to gain 1 car it gives up 1 unit of FS Specialisation and trade is worthwhile if the trade takes place at an exchange rate between FS and cars of between 2.4:1 and 1:1

Comparative advantage and trading Trading makes sense because of different opportunity costs We can look at what happens with a combined PPF The point highlighted is where both countries are completely specialised

Another example WheatCorn Country A510 Country B42 Opportunity Costs: For country A to gain 1 unit of wheat, they would give up 2 units of corn. For country B to gain 1 unit of wheat, they would give up ½ unit of corn. For country A to gain 1 unit of corn, they would give up ½ unit of wheat For country B to gain 1 unit of corn, they would give up 2 units of wheat Therefore country A should produce corn and country B should produce wheat What exchange rate is possible

Other example TextilesCars China155 Japan14 Opportunity cost in China of 1 unit of textile is 1/3 car Opportunity cost in Japan of 1 unit of textile is 4 cars Opportunity cost in China of 1 car is 3 units of textile Opportunity cost in Japan of 1 car is 1/4 unit of textiles Therefore China should produce textiles and Japan cars What could the exchange rate be?