Unit 2 - Comparative Advantage and Trade

The Introduction for this course included some basic questions asked by economists concerning how an economy functions:

• What is produced, and in what quantities?
• How are these goods produced?
• For whom are these goods produced?

As noted in the discussion of the production possibilities frontier, a necessary condition to achieve maximum output was efficiency in production. As civilizations develop, one of the most fundamental sources of improved efficiency is specialization, which results from the division of labor. The first economist to systematically analyze the role of specialization in production was Adam Smith, who commented on his observations of a pin factory. In The Wealth of Nations (1776), Smith wrote:

One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even trade by itself to put them into the paper. 1

Smith is describing the division of labor into specialties, a critical component of the Industrial Revolution. As workers specialized, they became more skilled and proficient in their specialty, increasing the productivity and output of the workers. Smith conveyed this observation by:

I have seen a small manufactory of this kind where ten men only were employed ... Those ten persons . . . could make among them upwards of forty-eight thousand pins in a day ... But if they had all wrought separately and independently . . . they certainly could not each of them have made twenty, perhaps not one pin in a day. 2

Smith is describing an essential component of the modern economy. Rather than producing everything they need, workers aspire to specialize in a profession or trade, receiving income for their efforts. The income is then used in exchange for other goods and services. The net result of specialization is higher individual output and income, and potential consumption.

The idea of specialization and the division of labor can be applied to more than individual labor; the concept can be related to an entire economy. Factors such as labor skills, resources, and technology determine the competitive relationship between two countries. An economy characterized by an educated and skilled workforce will enjoy a comparative advantage in the production of higher-technology goods, such as computers and semiconductors. In contrast, a country dominated by rich agricultural lands but a relatively low-skilled workforce will generate high volumes of grain output with minimal fertilizer inputs.

As an illustration of the advantages of specialization and trade, consider the table above. The table shows the hypothetical production possibilities of lumber and computers for two countries, the United States and Japan. For each country there are three points considered along a production possibilities frontier. The points consider the alternatives for each country in the allocation of resources entirely to the output of lumber, computers, or some combination of the two.

As the table illustrates, if both countries dedicate all resources to the production of lumber (point A), the U.S. has an absolute advantage (1 million board feet compared to 80,000 for Japan). If both countries dedicate their resources to computer production, the U.S. also enjoys an absolute advantage (100,000 to 80,000). Does the presence of an absolute advantage in the production of both goods lead us to conclude that the United States has no need for trade with Japan?

To answer the question, let us assume that both countries are self-sufficient in the production of lumber and computers (point B). The United States produces 30,000 computers and 700,000 board feet of lumber. Corresponding output levels for Japan are 40,000 computers and 40,000 board feet of lumber. Total world (U.S. + Japan) output of computers is 70,000 (30,000 + 40,000) and total world output of lumber is 740,000 (700,000 + 40,000).

Despite the absolute advantage the U.S. enjoys in the production of computers and lumber, each country will have a comparative advantage in the production of those goods in which they are relatively, not absolutely, more efficient. To show this, compare the marginal opportunity cost of switching resources from computer to lumber production for each country. As the United States moves from point A to possibility B it loses 300,000 board feet of lumber and gains 30,000 computers, yielding a ratio of -10 (-300,000/30,000). The corresponding opportunity cost for Japan as it substitutes computers for lumber is -1 (-40,000/40,000). Comparing the opportunity cost of giving up lumber for computers shows that the U.S. must give up a much greater amount of lumber than Japan. We can conclude that the United States has a comparative advantage in lumber production, Japan in computers.

If each country specializes in the production of the good in which they enjoy a comparative advantage, total world output of both goods increases. The table above summarizes this result, showing a net increase in world production of 10,000 computers and 260,000 board feet of lumber. The final result emphasizes that both countries should specialize in the production of those goods in which they have a comparative advantage, and they should engage in bilateral trade. Total world production (and consumption) of both goods increases as a result.

We can show the gains from specialization and trade graphically as well. For illustrative purposes, let us assume that the United States and Japan have the same resources available, such as total labor supply. By making this assumption we can illustrate the differences in efficiency that determine both absolute and comparative advantage. In addition, the production possibilities frontiers shown in Figure 2-1 are linear, indicating a constant (vs. increasing) opportunity cost of shifting production from lumber to computers.

Click on a part of the graph for further information.

Figure 2-1 shows the production possibilities frontiers for both the United States and Japan. Since the United States has an absolute advantage in the production of both lumber and computers, the production possibilities frontier of the U.S. lies above the production possibilities frontier of Japan. This signifies that the U.S. can produce more of both goods given the resources available.

As shown in the table above, the United States has a comparative advantage in lumber production, Japan in computers. This concept is illustrated graphically by the relative slopes of the two lines. The slope of Japan's production possibilities frontier equals AJ/CJ = 80,000/80,000 = 1. This indicates that the opportunity cost of producing an additional computer is a unit of lumber.

For the United States, the slope of the production possibilities frontier is equal to AU/CU = 1,000,000/100,000 = 10. The U.S. must sacrifice 10 board feet of lumber to gain another computer. By comparing the opportunity cost for each country, we see that the U.S. must give up much more lumber than Japan to produce an additional computer. The production possibilities frontier for the United States is steeper than Japan's, indicating that the U.S. has a comparative advantage in lumber production, Japan in computers.

We can also conclude that the price of lumber is less than that for computers, since producers in the United States are willing to give up 10 board feet of lumber for a computer. The implications for the terms of trade is that the U.S. will specialize in lumber production and Japan in producing computers. The exchange of these items between the two countries will fall somewhere between 10 to 1 (the opportunity cost in the U.S.) and 1 to 1 (the opportunity cost in Japan). Depending on the deal the two countries make, the U.S. will export between one and ten board feet of lumber in exchange for one Japanese computer.

Let us assume that trade agreements determine that a 5 to 1 ratio is used (5 lumber for 1 computer). Under these terms, the United States gains a computer by giving up only 5 board feet of lumber. Contrast this to an isolationist policy, where the U.S. must sacrifice 10 board feet of lumber to increase computer consumption by one. By trading, Japan imports five board feet of lumber for each computer it exports, for a net gain of four lumber.

Click on a part of the graph for further information.

Click on a part of the graph for further information.

The effects on the consumption possibilities frontier for each country is shown in Figure 2-2 and Figure 2-3. Note in these graphs that although each country's production possibilities remain constant, with trade their consumption possibilities expands; specialization and trade allow for increased consumption by both countries. The boundaries of Japan's consumption possibilities shows the two extremes of consuming all the computers produced (80,000) or exchanging all computers for U.S. lumber at the five to one ratio specified above (80,000 x 5 = 400,000).

The same analysis applies to the United States. The U.S. can consume domestically all of the lumber that is produced (1,000,000) or exchange the entire output of lumber for Japanese computers (200,000) at the exchange ratio of one computer for five board feet of lumber. The likely outcome for both the U.S. and Japan is consumption between the two extremes. In fact, to make our analysis more accurate we need to modify the consumption possibilities curve for the United States since it can actually trade lumber for no more than 80,000 Japanese computers, the limit of computer production when Japan specializes in computer production.

Click on a part of the graph for further information.

Figure 2-4 shows the modification that we need to make. At an exchange ratio of 5 lumber per computer, the U.S. can trade for no more than 80,000 Japanese computers which is Japan's capacity. The limit to exchange therefore will be 400,000 board feet of lumber for 80,000 computers. The vertical portion of the consumption possibilities frontier for the United States shows this. Note that the consumption possibilities frontier has a flatter slope (reflecting the 5:1 terms of trade) than the production possibilities frontier (given by the 10:1 domestic opportunity cost).

Despite this limitation, our analysis doesn't change. With specialization and trade, both countries consume greater amounts than they would without specialization and trade. The U.S. will always consume at least 600,000 board feet of lumber under our assumed terms of trade since Japan will have no additional computers to exchange. To show the consumption advantages with actual numbers, remember the production at choice B in the previous table. In this case, each country was producing both lumber and computers as follows:

Choice B on the original production possibilities frontier - no specialization and trade

Now let us follow the previous analysis of comparative advantage, where the U.S. produces only lumber, Japan computers. In addition, we choose an anchor. Japan produces a total of 80,000 computers when it specializes, let us assume that Japan will keep 40,000 and trade 40,000 in exchange for 200,000 board feet of lumber under the 5:1 terms of trade. We can summarize the new levels of consumption as follows:

Consumption with specialization and trade

Remember, the U.S. produces a total of 1 million board feet of lumber and trades 200,000 board feet for 40,000 Japanese computers. A comparison of before and post-trade outcomes shows that both countries end up consuming more of either or both goods when engaging in trade according to the principle of comparative advantage. To see this outcome graphically, refer to Figure 2-4 above.

In conclusion, we have shown that by the specialization of production in those goods in which a country has a comparative advantage and with free trade, world output levels and consumption both increase. Are we better off? In the sense that specialization raises worker productivity, incomes, and consumption, yes, we are better off. Yet the complications of the real world blur the analysis. Although society as a whole gains from the tradeoffs presented here, some individuals lose if their jobs are with industries that have a comparative disadvantage. Furthermore, although we can say total consumption increases, there is no guarantee that all citizens will share equally in the gains.

The problems of equity and fairness are important economic issues that go beyond the scope of the discussion here. Focus on the point made: countries that interact and trade with the rest of the world will enjoy greater growth and consumption than closed economies that seek to protect domestic jobs from foreign competition.

Factors Which Determine Comparative Advantage

We use comparative advantage to determine trade patterns between countries. Now we ask, what determines comparative advantage? There are a number of important considerations in discussing why a country may enjoy a comparative advantage in the production of certain goods. The reasons for a comparative advantage include:

• natural endowments such as resources,
• availability and use of technology,
• knowledge and human capital,
• specialization, and
• rapidly changing factors such as exchange rates.

Beginning with the first entry on the list, natural endowments, change occurs slowly, if at all. In this case, comparative advantage is a relatively static concept, as natural resources are fixed over long periods of time. For example, many Middle Eastern countries have large oil reserves buried beneath the sands of their arid countries. In contrast are the rich agricultural lands of countries like the United States, Argentina, and Australia. Climate, geography, and other natural endowments are very important in determining what type of products a country may enjoy a comparative advantage in.

Just because a country is lacking in abundant natural resources does not mean they will not benefit from specialization and trade. One country is resource poor, yet has a thriving export economy is Japan. Following the concept of comparative advantage, Japan imports scarce natural resources and exports goods which the highly skilled Japanese labor force produces with great efficiency and at low cost. A critical factor for the Japanese economy is a high rate of domestic savings by Japanese citizens. The abundant supply of savings is available for businesses to borrow at a low cost in order to use for investment in capital that can be used by Japanese workers to convert imported natural resources into goods with a greater value. For another example, read how the economy in China is evolving.

Technology changes at an increasingly rapid pace. But the education and skills required to effectively utilize the technology evolve much more slowly. In contrast are factors such as exchange rates. Dramatic shifts in exchange rates can rapidly modify the relative prices of goods traded between two or more countries. For some goods, the historical relationship of comparative advantage based on endowments and skills can rapidly be altered because of changes in the comparable international prices of those goods.

Copyright © 2002, Jay Kaplan
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Last updated June 1, 2002