4.3 - Comparative advantage and trading gains

Absolute and comparative advantage

Absolute advantage means being able to produce more output with the same resources, or the same output with fewer resources. Comparative advantage means being able to produce a good at a lower opportunity cost: less of the other good is forgone. Productivity and opportunity cost are related, but they answer different questions.

The illustrative table shows the maximum output each country can produce using all of its available resources for one good. Assume resources are fully employed, freely transferable between the two industries within each country, and output changes proportionately as resources move. The figures are alternatives, not quantities that can be produced simultaneously.

North has an absolute advantage in both goods: its maximum output is higher in each column. In North, one roll of cloth costs two tonnes of wheat: 120 divided by 60. In South, one roll costs one tonne: 40 divided by 40. South therefore has a comparative advantage in cloth despite its lower absolute productivity.

For wheat, invert the ratios. One tonne costs half a roll in North and one roll in South. North has a comparative advantage in wheat. In this two-country, two-good model, different opportunity costs allow complementary specialisation. Comparing '120 with 40' alone cannot establish comparative advantage; the ratio within each country is essential. When opportunity-cost ratios are identical, this simple model provides no such gains from specialisation.

Mutually beneficial exchange ratios

An exchange ratio must beat each country's own opportunity cost if both are to gain strictly. In the table, South can produce one roll of cloth by giving up one tonne of wheat. North would give up two tonnes to produce that roll itself. If South exports cloth for more than one but less than two tonnes of wheat per roll, South gets more wheat than it sacrifices and North gives up less wheat than domestic cloth production would require.

At one roll for 1.5 tonnes, South saves half a tonne compared with producing its wheat domestically; North saves half a tonne compared with producing its cloth domestically. At a boundary ratio of one or two tonnes, one country is indifferent in this model and the other gains. The actual ratio depends on demand, bargaining and market conditions; comparative advantage identifies a beneficial range rather than a uniquely determined price.

Before trade, suppose North produces 60 tonnes and 30 rolls while South produces 30 tonnes and 10 rolls. Both combinations use all resources. Total output is 90 tonnes and 40 rolls. If North specialises in wheat and South in cloth, total production is 120 tonnes and 40 rolls. Wheat output increases by 30 tonnes, or 33.3%, while cloth is unchanged.

If North then exchanges 45 tonnes for 30 rolls, it consumes 75 tonnes and 30 rolls. South consumes 45 tonnes and 10 rolls. Both have 15 more tonnes than before and the same cloth. Trade is not creating goods during exchange: specialisation changes total output and exchange distributes it. The allocation must be checked; full specialisation does not make every possible pre-trade consumption combination improve automatically.

Production and consumption possibilities

A production possibility curve shows the combinations a country can produce with its resources and technology. Constant opportunity costs give a straight line. For North, put cloth horizontally and wheat vertically, then join (0 rolls, 120 tonnes) to (60 rolls, 0 tonnes). The slope's magnitude is two tonnes per roll. South's line joins (0, 40) to (40, 0), with slope magnitude one.

Production after specialisation remains on each country's own curve. The exchange at 1.5 tonnes per roll permits consumption beyond that curve. Starting from North's production point (0, 120), its trading line has slope −1.5: each extra roll obtained costs 1.5 tonnes. North's consumption point (30, 75) is outside its PPC because producing 30 rolls domestically leaves only 60 tonnes. Starting from South's point (40, 0), the same exchange ratio allows the consumption point (10, 45), also beyond its PPC.