Under What Conditions Does Comparative Advantage Lead to Gains From Trade?

Learning Objectives

• Calculate absolute and comparative advantage

Product Possibilities and Comparative Reward

Consider the example of trade in two goods, shoes and refrigerators, betwixt the United states of america and United mexican states. These goods are homogeneous, meaning that consumers and producers cannot differentiate between shoes from Mexico and shoes from the U.S.; nor can they differentiate betwixt Mexican or American refrigerators.

From Table 1, nosotros can see that it takes four U.Southward. workers to produce ane,000 pairs of shoes, merely it takes five Mexican workers to do and so. It takes i U.South. worker to produce 1,000 refrigerators, simply it takes iv Mexican workers to do so. The The states has an absolute advantage in producing both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators.

Tabular array i. Resources Needed to Produce Shoes and Refrigerators

Country	Number of Workers needed to produce 1,000 units — Shoes	Number of Workers needed to produce 1,000 units — Refrigerators
United states of america	4 workers	1 worker
Mexico	5 workers	4 workers

Absolute reward simply compares theproductivity of a worker between countries. It answers the question, "How many inputs do I demand to produce shoes in Mexico?" Comparative advantage asks this same question slightly differently. Instead of comparing how many workers it takes to produce a good, it asks, "How much am I giving up to produce this good in this state?" Another way of looking at this is that comparative advantage identifies the proficient for which the producer'due south absolute advantage is relatively larger, or where the producer's absolute productivity disadvantage is relatively smaller. The United States can produce 1,000 shoes with 4-fifths as many workers as Mexico (iv versus 5), but it can produce 1,000 refrigerators with only one-quarter as many workers (one versus iv). So, the comparative reward of the Us, where its absolute productivity advantage is relatively greatest, lies with refrigerators, and Mexico's comparative advantage, where its absolute productivity disadvantage is to the lowest degree, is in the production of shoes.

Mutually Beneficial Merchandise with Comparative Reward

When nations increase production in their area of comparative advantage and trade with each other, both countries tin benefit. The production possibilities frontier is a useful tool to visualize this do good. Recall from earlier readings that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers.

Consider a situation where the Usa and Mexico each accept xl workers. For instance, equally Table two shows, if the United States divides its labor so that 40 workers are making shoes, then, since information technology takes four workers in the The states to make one,000 shoes, a total of 10,000 shoes will be produced. (If four workers tin can make one,000 shoes, then 40 workers will make x,000 shoes). If the 40 workers in the United States are making refrigerators, and each worker tin produce one,000 refrigerators, and then a full of 40,000 refrigerators will be produced.

Table two. Product Possibilities before Trade

Country	Shoe Production — using 40 workers		Refrigerator Production — using 40 workers
United States	10,000 shoes	or	40,000 refrigerators
Mexico	8,000 shoes	or	10,000 refrigerators

As always, the slope of the production possibility frontier for each country is the opportunity cost of one refrigerator in terms of foregone shoe product–when labor is transferred from producing the latter to producing the former (see Effigy 1).

Figure 1. Production Possibility Frontiers. (a) With 40 workers, the United States tin produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and cipher shoes. (b) With 40 workers, United mexican states can produce a maximum of 8,000 shoes and zero refrigerators, or ten,000 refrigerators and zero shoes. All other points on the production possibility line are possible combinations of the two goods that can be produced given electric current resources. Point A on both graphs is where the countries outset producing and consuming before trade. Point B is where they stop up after merchandise.

Allow's say that, in the situation earlier trade, each nation prefers to produce a combination of shoes and refrigerators that is shown at point A. Table 3 shows the output of each expert for each country and the total output for the two countries.

Table 3. Production at Bespeak A before Merchandise

Country	Current Shoe Product	Current Refrigerator Production
United states	5,000	20,000
Mexico	iv,000	5,000
Total	ix,000	25,000

Continuing with this scenario, each land transfers some corporeality of labor toward its area of comparative advantage. For example, the United States transfers six workers abroad from shoes and toward producing refrigerators. Equally a result, U.Due south. production of shoes decreases by 1,500 units (6/4 × 1,000), while its production of refrigerators increases by 6,000 (that is, vi/1 × 1,000). Mexico likewise moves product toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. As a outcome, production of refrigerators in Mexico falls by 2,500 (x/4 × 1,000), but product of shoes increases past 2,000 pairs (10/5 × one,000). Discover that when both countries shift production toward each of their comparative advantages (what they are relatively better at), their combined production of both goods rises, as shown in Tabular array 4. The reduction of shoe production by ane,500 pairs in the United States is more than offset by the gain of 2,000 pairs of shoes in Mexico, while the reduction of 2,500 refrigerators in Mexico is more kickoff by the additional 6,000 refrigerators produced in the Usa.

Table 4. Shifting Production Toward Comparative Advantage Raises Full Output

Country	Shoe Production	Refrigerator Product
U.s.a.	3,500	26,000
Mexico	6,000	2,500
Total	9,500	28,500

This numerical example illustrates the remarkable insight of comparative advantage: even when ane state has an absolute advantage in all appurtenances and another country has an absolute disadvantage in all goods, both countries can still benefit from trade. Fifty-fifty though the United States has an absolute reward in producing both refrigerators and shoes, information technology makes economic sense for it to specialize in the good for which it has a comparative reward. The United states will export refrigerators and in render import shoes.

Tin a product possibility frontier be straight?

When you start met the production possibility borderland (PPF) in an earlier module, information technology was drawn with an outward-bending shape. This shape illustrated that every bit inputs were transferred from producing one good to some other—like from education to wellness services—at that place were increasing opportunity costs. In the examples in this module, the PPFs are fatigued as straight lines, which means that opportunity costs are abiding. When a marginal unit of labor is transferred away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same. In reality this is possible simply if the contribution of additional workers to output did not change as the calibration of production changed. The linear product possibilities frontier is a less realistic model, simply a straight line simplifies calculations. It also illustrates economic themes like absolute and comparative advantage just as clearly.

How Opportunity Price Sets the Boundaries of Trade

This example shows that both parties can do good from specializing in their comparative advantages and trading. By using the opportunity costs in this example, information technology is possible to identify the range of possible trades that would benefit each state.

Mexico started out, earlier specialization and merchandise, producing 4,000 pairs of shoes and 5,000 refrigerators. So, in the numerical example given, Mexico shifted production toward its comparative advantage and produced half-dozen,000 pairs of shoes just only ii,500 refrigerators. Thus, if United mexican states canexport no more 2,000 pairs of shoes (giving up 2,000 pairs of shoes) in substitution for imports of at least 2,500 refrigerators (a gain of 2,500 refrigerators), it will exist able to swallow more than of both goods than before trade. United mexican states volition be unambiguously better off. Conversely, the U.s.a. started off, before specialization and trade, producing 5,000 pairs of shoes and twenty,000 refrigerators. In the example, information technology then shifted product toward its comparative advantage, producing only 3,500 shoes but 26,000 refrigerators. If the The states can export no more than 6,000 refrigerators in exchange for imports of at to the lowest degree one,500 pairs of shoes, it will be able to consume more of both goods and volition be unambiguously better off.

The range of trades that tin benefit both nations is shown in Table 5. For instance, a merchandise where the U.South. exports four,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes would benefit both sides, in the sense that both countries would exist able to consume more of both goods than in a world without trade.

Table v. The Range of Trades That Do good Both the United States and Mexico

The U.S. economic system, after specialization, will benefit if information technology:	The Mexican economy, afterward specialization, will benefit if it:
Exports fewer than 6,000 refrigerators	Imports at least 2,500 refrigerators
Imports at to the lowest degree 1,500 pairs of shoes	Exports no more than 2,000 pairs of shoes

Trade allows each country to take advantage of lower opportunity costs in the other country. If Mexico wants to produce more refrigerators without trade, information technology must confront its domestic opportunity costs and reduce shoe production. If Mexico, instead, produces more than shoes and then trades for refrigerators made in the United States, where theopportunity cost of producing refrigerators is lower, Mexico can in effect take advantage of the lower opportunity cost of refrigerators in the Usa. Conversely, when the United States specializes in its comparative advantage of refrigerator production and trades for shoes produced in United mexican states, international trade allows the United States to take reward of the lower opportunity cost of shoe production in United mexican states.

The theory of comparative advantage explains why countries trade: they have unlike comparative advantages. It shows that the gains from international merchandise effect from pursuing comparative advantage and producing at a lower opportunity cost. The post-obit characteristic shows how to calculate absolute and comparative advantage and the fashion to use them to a country'south production.

Calculating Absolute and Comparative Reward

In Canada a worker tin can produce 20 barrels of oil or 40 tons of lumber. In Venezuela, a worker can produce 60 barrels of oil or thirty tons of lumber.

Tabular array six. Oil and Lumber Production in Canada and Venezuela
State	Oil (barrels)		Lumber (tons)
Canada	20	or	40
Venezuela	sixty	or	30

1. Who has the accented reward in the production of oil or lumber? How can you tell?
2. Which country has a comparative advantage in the production of oil?
3. Which country has a comparative advantage in producing lumber?
4. In this example, is absolute advantage the aforementioned equally comparative advantage, or not?
5. In what product should Canada specialize? In what product should Venezuela specialize?

Footstep 1. Make a table like Tabular array 6.

Step two. To calculate absolute reward, look at the larger of the numbers for each production. I worker in Canada can produce more lumber (40 tons versus 30 tons), and so Canada has the absolute advantage in lumber. 1 worker in Venezuela can produce sixty barrels of oil compared to a worker in Canada who can produce just 20.

Stride 3. To summate comparative reward, find the opportunity cost of producing one butt of oil in both countries. The country with the lowest opportunity cost has the comparative reward.

With the same labor time, Canada tin can produce either twenty barrels of oil or 40 tons of lumber. So in upshot, 20 barrels of oil is equivalent to 40 tons of lumber: 20 oil = forty lumber. Split both sides of the equation past 20 to calculate the opportunity cost of one barrel of oil in Canada. 20/20 oil = 40/20 lumber. one oil = 2 lumber. To produce i additional barrel of oil in Canada has an opportunity cost of two lumber.

Summate the same way for Venezuela: lx oil = 30 lumber. Divide both sides of the equation by sixty. I oil in Venezuela has an opportunity cost of 1/2 lumber. Considering 1/ii lumber < 2 lumber, Venezuela has the comparative advantage in producing oil.

Pace 4. Summate the opportunity cost of one lumber by reversing the numbers, with lumber on the left side of the equation. In Canada, 40 lumber is equivalent in labor time to twenty barrels of oil: 40 lumber = 20 oil. Divide each side of the equation by twoscore. The opportunity price of one lumber is 1/ii oil.

In Venezuela, the equivalent labor time will produce 30 lumber or 60 oil: 30 lumber = 60 oil. Split up each side past 30. I lumber has an opportunity cost of 2 oil. Canada has the lower opportunity cost in producing lumber.

Pace v. In this example, accented advantage is the same as comparative advantage. Canada has the absolute and comparative advantage in lumber; Venezuela has the absolute and comparative advantage in oil.

Step half-dozen. Canada should specialize in what it has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. Canada will exist exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber.

Endeavor It

Trade and Incomes

Incomes depend on labor productivity. A country with an absolute advantage in some product has higher labor productivity than some other country does in the production of that product.If a country has an absolute advantage in producing both goods, information technology has college labor productivity in both and its workers volition earn college incomes than those in the other country. Thus, the average income in a country depends on its average labor productivity. Now consider comparative advantage. If a country specializes production in the product in which it has a comparative reward, it raises its boilerplate labor productivity and raises its average income. Thus, comparative reward is more than important than absolute advantage in understanding which land should trade which product in order to maximize the standard of living in both countries.

Watch Information technology

Scout this video to review the means that comparative advantage benefits all the parties involved.

For additional practice and review using numbers, watch this video from ACDC economics.

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Source: https://courses.lumenlearning.com/wm-microeconomics/chapter/comparative-advantage-and-the-gains-from-trade/

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