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Quentin Metsys, Moneychanger and his Wife, 1514 Economics 14

Lecture 27: Comparative Advantage and the Gains from Trade

comparative advantage and trade
an example


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Comparative Advantage and Trade

Let's assume that Joe Paterno can mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should?

Let's say Joe Paterno can mow his lawn in 2 hours while a neighborhood kid can mow Joe Paterno's lawn in 4 hours. Because he can mow the lawn in less time, Joe Paterno has an absolute advantage in mowing lawns. An individual has an absolute advantage in producing a good if they can produce it using fewer resources than can someone else.

However, is mowing his lawn the best use of Paterno's time? Suppose that in the same 2 hours it takes him to mow his lawn, he could give a motivational speech at a Chamber of Commerce luncheon for $5,000. Paterno's opportunity cost (the value of his next best alternative) of mowing the lawn is $5,000.

In contrast, the neighborhood kid's next best alternative is to work at McDonalds where he earns $7.50 an hour. So, in the 4 hours it would take her to mow Joe Paterno's lawn, he could have earned $30. The neighborhood kid's opportunity cost of mowing Joe Paterno's lawn is $30.

Joe Paterno has an absolute advantage in mowing lawns because he can do the work in less time. But, the neighborhood kid has a comparative advantage in mowing lawns because he has the lower opportunity cost. A person or a country has a comparative advantage when they can produce a good at a lower opportunity cost compared to someone else.

The gains from trade are enormous. Rather than mowing his lawn, Paterno should give the speech and hire the neighborhood kid to mow the lawn. As long as Paterno pays him more than $30 and less than $10,000, both of them are better off.

Countries can benefit from specialization and trade with one another in the same way individuals can. The gains from trade do not disappear at national borders.

Without trade countries must consume at a point on their production possibilities frontiers. With trade, a country can consume at a point outside of its PPF.


An Example

In the absence of trade a country must consume the goods and services it produces. The production possibilities frontier shows combinations of goods a country can produce. Without trade countries must consume at a point on their PPF's. With trade, a country can consume at a point outside of its PPF.

foodclothing
USA53
China31

Suppose the table above shows output per worker per day in the food and clothing sectors of the American and Chinese economies. Also, suppose that there are 16 workers in each country and that both countries prefer equal amounts of food and clothing.

production possibilities frontiers for food and clothing

In the absence of trade, USA will devote 6 workers to food production and 10 to clothing, thereby producing and consuming 30 units of food and 30 units of clothing. China will have 4 workers producing food and 12 making clothing, leading to the production of 12 units of food and 12 units of clothing.

The gains from trade come from differences in opportunity costs. Recall that opportunity costs are equal to the amount given up divided by the amount gained.

foodclothing
USA53
China31
USA opportunity costs3/55/3
China opportunity costs1/33

The opportunity cost of producing food is lower in China. Therefore, China has the comparative advantage in producing food and ought to specialize in producing food. The USA has the comparative advantage in clothing production and should concentrate on producing clothing.

terms of trade
amount of a good a country must give up to obtain another good from the other country

The limits of the terms of trade are determined by the opportunity costs of the two countries. For example, the terms of trade clothing will be between 5/3 and 3. Suppose the terms of trade are 2 units of food per unit of clothing.

If the USA produces only clothing, it will produce 48 units. If China produces only food it makes 48 units of food.

Suppose the USA trades 16 units of clothing to China for 32 units of food.

The USA ends up consuming 32 units of food and 32 units of clothing, compared to 30 of each before trade. China ends up consuming 16 units of food and 16 units of clothing, compared to 12 of each before trade. Both countries are consuming at points that lie outside of their production possibilities frontiers, combinations of food and clothing that are beyond their own individual resource capabilities.


1794 U.S. 
silver dollar David A. Latzko
Business and Economics Division
Pennsylvania State University, York Campus
office: 13 Main Classroom Building
phone: (717) 771-4115
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