Comparative Advantage

Definitions Absolute advantage: a country can produce a good relatively more efficiently than another country (example: U.S. better at oranges than Canada) Comparative Advantage: a country can produce a good relatively more efficiently than another good in comparison with another country Applies to people as well as to countries

Numerical example: Output per day of work Shoes Phone Country 1 6 3 Country 2 1 2

Find who has a comparative advantage in what Country 1 has an absolute advantage over Country 2 in both shoes and phones for shoes 6>1, for phones 3>2 Country 1 has a comparative advantage in shoes 6/1 is greater than 3/2 Country 2 has a comparative advantage in phones 2/3 is greater than 1/6

Can define comparative advantage in terms of opportunity costs Definition: If country A has a lower opportunity cost of producing a good, then it has a comparative advantage in that good compared to country B Example. Opportunity cost of producing a phone in Country 1 is 2 shoes while it is only 1/2 shoes in Country 2 Hence, Country 2 has the comparative advantage in phones

Gains from Trade How can the Country 1 gain from trade? Two countries can gain from trade based on comparative advantage. To see this, assume that the price with trade is 1 unit of shoes for 1 phone How can the Country 1 gain from trade? reduce phone production by 3 increase shoes production by 6 trade with Country 2 for 6 phones come out ahead by 3 phones

Country 2 can also gain from trade increase phone production by 6 reduce shoes production by 3, trade with Country 1 for 6 shoes come out ahead by 3 shoes

Determining the price ratio before trade Country 1 in the Country 1, 6 shoes cost the same to produce as 3 phones Thus, phones should cost twice as much as shoes Pphone / P shoes = 2 Country 2 in Country 2, 2 phones cost the same to produce as 1 shoe Thus phone should cost half as much as shoes Pphone / P shoe = 1/2

Determining the price ratio after trade Price ratio must come together somewhere between 2 and 1/2 We cannot tell exactly what the price ratio will be; it depends on demand For ease of multiplication, we therefore assume that the price ratio is 1 that is, Pphone / P shoes = 1

Comparative Advantage and Production Possibilities Curves (10,000 workers in Country 1 and 30,000 in Country 2) Shoes (1000) Shoes (1000) Production possibility curve without trade Production possibility curve without trade 60 60 Production possibility curve with trade Production possibility curve with trade 30 30 20 15 30 60 Phone (1000) 15 30 60 Phone (1000) Country 1 Country 2

Revealed comparative advantage In practice comparative advantage is very difficult to measure. So instead we use RCA. Balassa's (1965) measure of relative export performance by country and industry, defined as a country's share of world exports of a good divided by its share of total world exports. RCAij is revealed comparative advantage of country i in product j. Xij and Xi represent country i’s exports of product j and total exports.

Revealed comparative advantage RCAij=(5/500)/(200/40000)=2 World Exports 40,000 200 500 5 B

Specialization Index Another measure of comparative advantage 𝑆𝐼 𝑖𝑗 = 𝑋 𝑖𝑗 − 𝑀 𝑖𝑗 𝑋 𝑖𝑗 + 𝑀 𝑖𝑗