Course: AP®︎/College Macroeconomics > Unit 1Lesson 3: Comparative advantage and the gains from trade
- Comparative advantage, specialization, and gains from trade
- Comparative advantage and absolute advantage
- Opportunity cost and comparative advantage using an output table
- Terms of trade and the gains from trade
- Input approach to determining comparative advantage
- When there aren't gains from trade
- Comparative advantage worked example
- Lesson summary: Comparative advantage and gains from trade
- Comparative advantage and the gains from trade
Lesson summary: Comparative advantage and gains from trade
In this lesson summary review and remind yourself of the key terms, graphs, and calculations used in analyzing comparative advantage and the gains from trade. Key concepts include how to determine comparative advantage, the terms of trade, and how comparative advantage leads to higher levels of consumption.
Absolute advantage describes a situation in which an individual, business or country can produce more of a good or service than any other producer with the same quantity of resources.
The United States, for example, has a skilled workforce, abundant natural resources, and advanced technology. Because of these three things, the US can produce many goods more efficiently than potential trading partners, giving it an absolute advantage in the production of goods from corn to computers, to maple syrup and cars. This does not, however, mean that the US does not benefit from trading for these goods with other nations.
Comparative advantage describes a situation in which an individual, business or country can produce a good or service at a lower opportunity cost than another producer.
For example, because it has an abundance of maple trees, Canada can produce maple syrup at a very low opportunity cost in relation to avocados, a fruit for which its climate is less suited.
Mexico, on the other hand, with its ample sunshine and warm climate. can grow avocados at a much lower opportunity cost in terms of maple syrup given up than Canada.
Production specialization according to comparative advantage, not absolute advantage, results in exchange opportunities that lead to consumption opportunities beyond the PPC. Trade between two agents or countries allows the countries to enjoy a higher total output and level of consumption than what would have been possible domestically.
Canada and Mexico can each specialize in the good they have a comparative advantage in and exchange with one another. This lets both countries enjoy more maple syrup and avocados than they could have enjoyed without trade. Mexico will export avocados and import maple syrup; this way Mexicans can enjoy their tasty breakfasts and Canadians will enjoy delicious guacamole!
Comparative advantage and opportunity costs determine the terms of trade for exchange under which mutually beneficial trade can occur.
In order for Canadians to benefit from trade with Mexico, they must be able to import avocados at a lower opportunity cost than it would cost them to grow domestically. Likewise, Mexico must get maple syrup more cheaply (in terms of avocados given up) than it could have produced it for domestically. The terms of trade refer to the trading price agreed upon by two agents, which when beneficial, will allow both countries to enjoy gains from trade.
|absolute advantage||the ability to produce more of a good than another entity, given the same resources. For example, in a single day, Owen can embroider pillows and Penny can embroider pillows, so Penny has absolute advantage in embroidering pillows.|
|comparative advantage||the ability to produce a good at a lower opportunity cost than another entity. For example, for every pillow Owen embroiders his opportunity cost is scarves knitted, while Penny must forego scarves for every pillow she embroiders, so Owen has comparative advantage in embroidering pillows.|
|specialization||when an individual or a country allocates most or all of its resources towards the production of a particular good or service. For example, Sal (an individual) specializes in producing educational videos, and Bangladesh (the country) specializes in producing textiles.|
|trade||the exchange of goods, services or resources between one economic agent and another|
|international trade||the exchange of goods, services, or resources between one country and another|
|gains from trade||the ability of two agents to increase their consumption possibilities by specializing in the good in which they have comparative advantage and trading for a good in which they do not have comparative advantage|
|terms of trade (also called “trading price”)||the price of one good in terms of the other that two countries agree to trade at; beneficial terms of trade allows a country to import a good at a lower opportunity cost than the cost for them to produce the good domestically, thus the country gains from trade.|
Key Graphical Models
PPCs can be used to determine opportunity costs, comparative advantage, and who should specialize in which good (as in Figure 1).
The gains from trade can be shown in a PPC by drawing a line originating at the point on the axis on which an agent is specializing its production (in the good it has a comparative advantage in) out to a point on the opposite axis beyond what it could have achieved without trade.
Assuming terms of trade are beneficial (e.g. offering each agent a lower opportunity cost than could be achieved without trade) an individual or country will be able to consume at a point beyond its PPC through specialization and trade (as in Figure 2).
- A country that has an absolute advantage in producing all goods still stands to benefit from trade with other countries, since the basis of the gains for trade is comparative advantage, not absolute advantage.
- It is not possible for an individual or country to have a comparative advantage in all goods. There will be some other individual or country that can produce some things at lower opportunity costs.
- "Self-sufficiency" is not necessarily a trait to be strived for in the global economy. Individuals or nations who try to produce everything for themselves are likely to end up poorer than those that engage in specialization and trade.
- In what circumstances might a country NOT benefit from trade with another country?
- Economist Russell Roberts once wrote, "Self-sufficiency is the road to poverty." Discuss how the principle of specialization and trade based on comparative advantage supports this claim.
- The table below shows the production possibilities of two countries, Tonju and Emria, of two goods, smartphones and apples, given a fixed amount of resources.
- a. Which country has the absolute advantage in smartphones and which has the absolute advantage in apples?
- b. Calculate Tonju’s opportunity cost of smartphones in terms of apples
- c. If the two countries were to specialize and trade with one another, which country would import smartphones?
- d. Assume the countries decide to specialize and trade and settled on a trading price of 2.5 smartphones per apple. Explain why the country that specializes in apples would experience gains from trade.
Want to join the conversation?
- In discussion question 2 poverty is defined "in comparison to other agents that do specialize and trade" correct? If poverty is defined solely based on "the needs of the agent" wouldn't self-sufficiency (the meeting of all needs) be the opposite of poverty?(7 votes)
- My take on this:
Say that you live in a country called North Pole, and that your country produces very cheap and abbundant ice, but very expensive and few bananas.
So, with your income you can buy each month a lots of ice and a couple of bananas. Formally, the country is self-sufficient because it produces both items, but the quantity of bananas the population can afford might be well below what the population would need for the well-being.
If the country could trade ice for bananas with the country called Equator (where the situation is exactly the opposite), the population of both countries could have both ice and bananas in the desired quantities (and not just in the available ones).
In other words, the trade allows to overcome the local scarcity of resources and to get beyond the PPF of each of the countries - and that is the indicator of economic growth (hence, increase of wealth).(26 votes)
- Here's question: The definition of Absolute advantage is "the ability to produce more of a good than another entity, given the SAME RESOURCES."
In the example given above, Owen can embroider 10 pillows while Penny 15. Does this not violate the definition of Absolute advantage because Penny has an advantage in labor.
In fact, if I think about it, having same resources means having same Land, Labor, Capital, and Entrepreneur. If all factors are equal, shouldn't output be equal as well?(9 votes)
- Even though both "countries" have 2 workers, the output of the workers can be different, it depends on their skill. But then idk if we could say that the human capital is different...(3 votes)
- Hi Khan Academy. I'd like to thank anyone beforehand for reading my question. It's about why nations participate in trade. Khan explained that trade is active when both nations benefit by specializing in their areas they are good at. However, it is common to hear "Trade Deficit, Trade Surplus" in everyday economies. What concepts could I possibly be confused with? Thanks.(3 votes)
- We get to that in a later lesson! A trade deficit exists when a country imports more than it exports. A trade surplus is when a country exports more than it imports. The very last unit in our macroeconomics content covers international trade in more depth.(6 votes)
- Discussion Question 2: Self-sufficiency is the road to poverty. Every country has different opportunity costs for different items which means every country has a different comparative advantage for different things. If one country has a lower opportunity cost for one thing and trades with another country which has a higher opportunity cost for that thing for something which it has a higher opportunity cost then both will benefit. If a country is self-sufficient, even though it has a higher opportunity cost for producing that thing, because it is not trading then it will be poorer than another country which trades based on comparative advantage.(4 votes)
- Question 3d has provided wrong information: "2.5 apples per smartphone". Should it be "2.5 smartphones per apple"?(2 votes)
- I don't understand the ppf's comparative advantage, could you explain more.?(2 votes)
- The header 'Speciallization' only needs one 'l'.(2 votes)
- how would u find out the comparative advantage of two different countries but instead of working with units of different goods your given the cost to make the goods. ex. the cost of producing a unit of X is $6 in Alberta and $12 in BC, while the cost of producing a unit of Y is $3 in Alberta and $4 in BC. how would u figure out comparative advantage?(1 vote)
- x y
Alberta $6 $12
BC $3 $4
Alberta's OC for x: $6 = $12 divide bother sides by 12 and you get $1/2 = $. So it's OC is $1/2.
Alberta's OC for y: $6 = $12. Divide both sides by 6. $ = 2. It's OC is $2.
BC's OC for x: $3 = $4. Divide both sides by 4. $3/4 = $. It's OC is $3/4.
BC's OC for y: It's would just be the reciprocal with is $4/3. You can always just use the reciprocal. Take a look at Alberta's OC for x an y. One is 1/2 while the other is 2.
So who has comparative advantage? Compare OCs for x. Alberta has the comparative advantage with $1/2 compared to BC's $3/4. BC has the comparative advantage for y with $4/3 while Alberta's OC is $2.(2 votes)
- The only way a country would NOT benefit from trade with another country would be if the country they're trading with has scarce resources(1 vote)
- Who would want to sell boats based on these terms of trade, and who would want to buy boats based on these terms of trade?(1 vote)