Comparative Advantage

Unit 13 - Lesson 3

Learning outcomes
Draw a diagram to illustrate comparative advantage from a set of
data.
Draw a diagram to show Comparative Advantage
Calculate the opportunity cost from a set of data to identify
comparative advantage.
Explain the Theory of Comparative Advantage.
Describe the sources of Comparative Advantage including the
differences in the Factors of Endowments.
Discuss the real-world relevance and limitation of the Theory of
Comparative Advantage

Comparative Advantage

Countries can gain from specialization even if it has an Absolute Advantage in the
goods & services offered for trade.
Both countries must have different opportunity costs in order for Comparative
Advantage to hold.
Production of one good or service is relatively cheaper to produce in one country
than the other.

Theory of Comparative Advantage

The ability of a firm or individual to produce goods and/or services
at a lower opportunity cost than other firms or individuals.
Investopedia,http://www.investopedia.com/terms/c/comparativeadvantage.asp

Comparative Advantage & the PPF

Given two countries A & B that produce oranges
& olives:

Country B has an Absolute Advantage in both

Oranges and Olive.

Should Country B trade?

If so, how do they know what to produce and what
to trade for.

Produce the Good with the lower

opportunity cost & trade for the other.

https://13leesub.files.wordpress.com/2012/09/comparativeadvantage.jpg

Calculating Opportunity Cost

Remember, Other goes over.
Opportunity Cost of oranges - Country A:

Other (olives) goes over (oranges)

Olives (5) goes over oranges (10)

Remember, Other goes over.

Opportunity Cost of Olives - Country A:

Other (oranges) goes over (olives)

Oranges (10) goes over olives (5)

5 divided by 10 =

10 divided by 5 = 2

Country

Oranges

Olives

Opportunity Cost Oranges

Opportunity Cost Olives

10

5 divided by 10 = 1/2

10 divided by 5 = 2

20

15

15 divided by 20 = .75

20 divided by 15 = 1.33

So what should Countries A & B produce, and what should they trade?
Following the Theory of Comparative Advantage, the two Countries should
produce the good for which they have the lowest opportunity cost.
Country

Oranges

Olives

Opportunity Cost Oranges

Opportunity Cost Olives

10

5 divided by 10 = 1/2

10 divided by 5 = 2

20

15

15 divided by 20 = .75

20 divided by 15 = 1.33

Country A should produce oranges. They have the lowest opportunity cost of the
2 countries ( : )
Country B should produce olives. They have the lowest opportunity cost of the 2
countries (1.33 : 2)
Using the Theory of Comparative Advantage:
Country A should produce oranges and trade for olives.
Country B should produce olives and trade for oranges

Theory of Comparative Advantage

Country has a Comparative Advantage over

another country when it can produce the good
or service at a lower opportunity cost than its
trading partner.
When the opportunity cost differs between
trading partners it is possible for countries to
gain from specialization in a good or service
according to Comparative Advantage.
This allows countries to consume outside their
PPC frontier.
Allows for more efficient allocation of resources,
more global output and greater consumption.

http://study.com/cimages/videopreview/videopreviewsmall/comparative-advantage-2_102090.jpg

Using Comparative
Advantage, what should
each produce and trade
for?

Practice question:

Betty and Tom are discussing what way they

can maximize the output of Term Papers &
Cookies.
Using the Theory of Comparative Advantage
justify what each should produce and what to
trade in order to maximize output.

Person

Cookies

Term
Papers

Betty

12

Tom

http://study.com/cimages/videopreview/videopreviewsmall/comparative-advantage-2_102090.jpg

Opportunity Cost
Cookies

Opportunity Cost
Term Papers

Answer
Remember, Other goes over.

Remember, Other goes over....

1.
2.

1.
2.

3.

Betty, opportunity cost cookies:

Other (term papers) goes over
(cookies)
Term Papers (3) over Cookies (12)

3.

Betty, opportunity cost Term Papers

Other (Cookies) goes over (Term
Papers)
Cookies (12) over Term Papers (3)
12 divided by 3 = 4

3 divided by 12 = 1/4
Person

Cookies

Term Papers

Opportunity Cost Cookies

Opportunity Cost Term Papers

Betty

12

3 divided by 12 = 1/4

12 divided by 3 = 4

Tom

8 divided by 4 = 2

4 divided by 8 = 1/2

Who has the lowest opportunity cost for cookies?

Who has the lowest opportunity cost for term papers?

Conclusion
Cookies:

Betty has the lowest opportunity

cost for cookies - compared to
Tom 2.
Betty has the Comparative
Advantage in cookies.

Term Papers:

Tom has the lowest opportunity

cost for term papers - compared
to Betty 4.
Tom has the Comparative
Advantage in term papers.

Conclusion:
Betty should produce cookies and trade for term papers.
Tom should produce term papers and trade for cookies.
I am not condoning that students practice using Comparative Advantage
when it comes to academic work!

Parallel PPF Frontiers

In the case two countries have parallel
PPF Frontiers this means:
1. One country has an Absolute
Advantage in the production of both
goods & services.
2. They have the same opportunity costs.
No benefits from specialization and
trade between the two countries.
http://www.economicsonline.co.uk/Global%20macroeconomics%20graphs/Comparative-advantageconstant-opprtunity-cost.png

Comparative Advantage - Unrealistic Assumptions

1.
2.
3.
4.
5.
6.
7.
8.

Factors of Production are not very mobile.

Technology is fixed.
There is Perfect Competition
Countries utilize all resources efficiently operating on the frontier.
Import & Exports are balanced.
There is free trade
Does not account for transportation costs
May lead to excessive specialization which can be a threat to a
country - non-diversifying the countrys economy.