Comparative Advantage

L-7
Dr. Rashmi Ahuja
 Remember : Absolute advantage
• The idea here is simple and intuitive.
• If our country can produce some set of goods at lower cost than a foreign
country, and if the foreign country can produce some other set of goods
at a lower cost than we can produce them, then clearly it would be best
for us to trade our relatively cheaper goods for their relatively cheaper
goods. In this way both countries may gain from trade.
Who has absolute advantage in which good ?
Korea can produce 3 cars or 9 Motorcycles
Germany can produce 4 cars or 8 Motorcycles

Japan can produce 12 laptops or 4 phones

Brazil can produce 1 laptop or 5 phones

Cuba takes 4 hrs to make a TV & 12 hrs to make a salsa

Mexico takes 9 hr to make a TV and 5 hrs to make a Salsa
• An obvious gap in this theory is its inability to explain a situation where, for
example, one country has an absolute advantage in producing all goods.

• Would it still benefit both countries to trade if one country were more
efficient than the other in producing both goods?
 Comparative Advantage
• David Ricardo explained that both countries would still gain from trade even if one had an
absolute advantage in producing all goods.
• Suppose India has absolute advantage in both tea and sugar. (i.e. Mauritius has neither in
sugar nor tea)
• In such a scenario , why should India trade with Mauritius in the first place ?What can
Mauritius trade in ?
• Is international trade always globally beneficial ??

• Ricardo came up with an answer to this …..

Concept of Comparative Advantage
• Dinnerware market - 2 products –Plates and Cups
• Producer A who could produce these two products - All of his time if
spent on plates (10 plates) and if on cups(30 cups)
• Draw PPF for A ….
• Can you calculate the opportunity cost for A ??
• In order to produce 30 cups , he has to forego 10 plates.
• Opportunity cost of 30 cups = 10 plates
• So, opportunity cost of 1 cup = 10/30 = 1/3 plates …..

• Similarly, opportunity cost of 10 plates = 30 cups

• Opp. Cost of 1 plate = 30/10 = 3 cups.
• Consider another producer B, who if spent all time on plates could produce
30 plates and if spent all time on cups could produce 10 cups.
• Draw PPF for this producer B.
• Opp. Cost of 30 plates = 10 cups => opp cost of 1 plate = 1/3 cup
• Opp. Cost of 10 cups = 30 plates => opp. Cost of 1 cup = 3 plates.

• Compare now opp. Cost of these two producers A & B

Producers Opp. Cost of 1 Opp. Cost of 1 Plate
Cup
A 1/3 plate 3 cups

B 3 plate 1/3 cups

Opp. Cost of 1 cup is less for producer A , so it has comparative advantage in production of Cup.
Opp. Cost of 1 plate is less for producer B, so it has comparative advantage in production of plate.
• We are saying if they specialize in their area of comparative advantage then
they could go beyond their PPF’s.

Cups
30 Specialization:
Producer A Producer A : cups [ 30 cups]
Producer B : plates [ 30 plates]

20

10
Producer B

10 20 30 Plates

• Assume they trade 1 cup for 1 plate…they could end up beyond their PPF.
Another Scenario :
Cups
40

Producer A
10
Producer B

30 40 Plates
• Using the same inputs, A could produce 40 cups and B could produce 10 cups….which means
A has absolute advantage in cups. Also, A could produce 40 plates with same inputs as
compared to B producing 30 plates with same inputs so A also has absolute advantage in
plates too.

• Still they could trade because they have different comparative advantages and opportunity
costs.
• Can you calculate who has comparative advantage in which products ?
Producer A
opp. Cost of 40 cups = 40 plates or opp. Cost of 1 cup = 1 plate
Similarly, opp. Cost of 1 plate = 1 cup .

Producer B
Opp. Cost of 10 cups = 30 plates
Opp. Cost of 1 cup = 3 plates
Similarly, opp. Cost of 1 plate = 1/3 cup

Comp. adv for B in plates.

Comp. adv for A in cups.

1 cup for 2 plates -----Traded….. So beneficial for both A and B.

 Terms of Trade and Gains to Trade
• 2 countries A and B
• A - all resources on producing jeans –[20] and similarly on shirts [10]
• B - all resources on producing jeans –[30] and similarly on shirts [45]

• Output table :
B has absolute adv. in both Jeans and shirts.
Jeans Shirts A has comp. advantage in jeans
B has comp. advn in shirts
A 20 10
B 30 45
Input approach to determining comp. advantage
• Workers hours per item per country
Toy Cars Belts
A 2 1
B 4 3

• Convert this into output table as follows i.e. 1 unit of labor produces :-
Toy Cars Belts
A ½ 1
B ¼ 1/3
In country A :-
Opp. Cost of ½ car = forego 1 belt or opp cost of 1 car = 2 belt
Opp cost of 1 belt = 1/2 cars
A – comp. advn in belt
In country B:- B - comp. advn in toy cars
Opp. Cost of ¼ car = forego 1/3 belt or opp cost of 1 car = 4/3 belt
Opp cost of 1/3 belt = forego ¼ car or opp cost of 1 belt = ¾ cars
When there aren't gains from trade
Apples Banana’s
A 3 6
B 2 4

Same opp. Cost and so no comparative advantage ….No Gains from trade…
Assumptions of Ricardo Comparative Advantage
The simple theory of comparative advantage outlined above makes a number
of important assumptions:
• There are no transport costs.
• Costs are constant and there are no economies of scale.
• There are only two economies producing two goods.
• The theory assumes that traded goods are homogeneous (ie identical).
• Factors of production are assumed to be perfectly mobile.
• There are no tariffs or other trade barriers.
• There is perfect knowledge, so that all buyers and sellers know where the
cheapest goods can be found internationally.
Criticisms
• It may overstate the benefits of specialization by ignoring a number of costs.
• Assumption of perfectly competitive markets.
• Complete specialization might create structural unemployment as some
workers cannot transfer from one sector to another.
• Relative prices and exchange rates are not taken into account in the simple
theory of comparative advantage. For example if the price of X rises relative to
Y, the benefit of increasing output of X increases.
• Comparative advantage is not a static concept - it may change over time.
• Highly simple 2X2 Model.
• The continual application of economies of scale by global producers using new
technology means that many countries, including China, can produce very
cheaply, and export surpluses.
• Modern approaches to explaining trade patterns and trade flows tend to use
gravity theory.
 Understanding Check :-
Which theory did not suggest that there could be gains from specialization
and trade?
a) Mercantilism
b) Absolute advantage
c) Comparative advantage
d) Heckscher-Ohlin theory