Comparative Advantage and the Gains from Trade
With different opportunity costs, countries can gain by specialising where their sacrifice is lower than their partner's and trading on suitable terms. This can expand consumption beyond domestic production limits, even if one country has absolute advantage in both goods. A tariff can reduce these gains.
What a learner can do afterwards
- Work out each country's opportunity cost from an output table and say who should specialise in what
- Show with figures that both countries can end up with more of both goods than before trade
- Explain why being better at everything does not remove the case for trading
1 · Read
Phones and shirts use resources that could make other goods. Recall opportunity cost: the next best alternative given up. Absolute advantage means producing more with the same resources. Comparative advantage means a lower opportunity cost than the trading partner. In a two-good model, compare what each country sacrifices per unit. With different opportunity costs, specialisation and suitable trade can benefit both countries.
Suppose one worker per country works one day with constant trade-offs. Cora can make 12 wheat or 4 cloth; Dara can make 4 wheat or 8 cloth. One cloth costs Cora 12 ÷ 4 = 3 wheat and Dara 4 ÷ 8 = 0.5 wheat. Dara has the comparative advantage in cloth. Cora gives up less cloth per wheat, so has the comparative advantage in wheat. Divide the forgone output by the gained output.
Absolute advantage in both goods need not prevent gains: different opportunity costs give each partner comparative advantage in one good; identical costs give no such gains here. With each worker splitting time equally, Cora has 6 wheat, 2 cloth; Dara 2 wheat, 4 cloth. Specialisation gives Cora 12 wheat and Dara 8 cloth. Exchanging 4 wheat for 3 cloth leaves Cora 8 wheat, 3 cloth; Dara 4 wheat, 5 cloth. Both have more of both goods. Other starting mixes need not do so.
Trade can expand consumption beyond domestic production limits, but does not expand productive capacity or necessarily increase consumption of every good. With constant opportunity costs and no trade costs, both gain only if the swap rate lies strictly between their opportunity costs. A tariff taxes imports. If it blocks a mutually beneficial exchange, countries lose gains from specialisation. Protection may help domestic producers while consumers lose access to cheaper imports.
Compare opportunity costs between partners. Trade can expand consumption choices when its gains exceed its costs.
Three readings written for this dataset. Videos by Khan Academy: "Comparative advantage, specialization, and gains from trade" and "Terms of trade and the gains from trade".
More to read
Comparing output and sacrifice
Ask two different questions about producers. Who makes more using the same resources? That identifies absolute advantage. Who sacrifices less alternative output for each unit? That identifies comparative advantage. For a constant trade-off, calculate the sacrifice by dividing forgone output by gained output. A worker able to produce either 12 wheat or 4 cloth sacrifices 12 ÷ 4 = 3 wheat per cloth. Compare that result with the trading partner's cost of cloth. The producer with the smaller sacrifice has comparative advantage in that good.
Trading with a more productive partner
Making more of both products per worker does not necessarily give a country the smallest sacrifice for both. A less productive partner may give up less alternative output when making one of them. Different opportunity costs therefore allow each country to specialise in a good where its sacrifice is lower. At suitable trading terms, both can obtain consumption combinations they could not produce domestically. Their production frontiers do not move merely because they trade. In the model with two goods and constant costs, equal opportunity costs remove this source of gains.
Trading terms, tariffs and who benefits
Take a model of two goods where opportunity costs stay fixed and trading has no cost. For both countries to benefit, the exchange rate must be above the lower opportunity cost and below the higher one. Outside this range, one country may still benefit. Trade makes new consumption combinations possible, but leaves productive capacity unchanged and need not give either country more of each good. Tariffs tax imported goods. A tariff that stops a beneficial exchange removes some of its gains. Domestic firms facing import competition may gain from protection, while buyers may pay more. Outcomes depend on market conditions and the particular tariff. A gain for a country does not mean equal benefits for everyone.
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2 · Watch
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Where it sits
Where this leads
8 questions wait behind this lesson, each with its answer explained. Every answer feeds the sky: stars light as they are learned, and dim when it is time to come back.