Comparative Advantage and Trade

Comparative Advantage

Comparative advantage describes the situation in which a country or person has a lower opportunity cost for each unit of output than a competitor.

Comparative advantage is the ability to produce a good or service at a lower opportunity cost than another person or group. Every person, business, or country starts out with a finite number of available resources, so there are always trade-offs involved in deciding which goods to produce. These trade-offs can be thought of as opportunity costs. An opportunity cost is the value or benefit of the next best alternative given up when making a choice. If a farmer has the chance to produce apples or cherries but can only produce one of those per season, each time they choose to produce cherries, for example, they forgo the chance to produce apples. Thus, the opportunity cost of producing cherries is the amount of apples that are not produced.

The country or person that has a lower opportunity cost for each unit of output has a comparative advantage. For example, say Costa Rica and Panama produce different kinds of fruit. Both Costa Rica and Panama produce apples and cherries. Each time Panama chooses to produce apples to compete with Costa Rica, it gives up the opportunity to produce more cherries and may face a high opportunity cost compared to Costa Rica, which may not give up as much to produce apples. Costa Rica has the comparative advantage in this case.

Comparative advantage can also be thought of when considering smaller-scale manufacturers or individuals. Alice and Becca build clocks and doorframes. It takes Alice 12 hours to build a clock and 6 hours to build a doorframe. During those 12 hours, she could have completed 2 doorframes, or Alice could build 1 doorframe when she could have been building 1/2 of a clock. It takes Becca 8 hours to build a clock and 2 hours to build a doorframe. In 8 hours, Becca could have built 4 doorframes. Meanwhile, 1 doorframe for Becca has an opportunity cost of 1/4 clocks. Becca has an absolute advantage because she can complete both doorframes and clocks the fastest; Alice has a comparative advantage in building clocks (she only gives up the opportunity to produce 2 doorframes, while Becca gives up producing 4). Becca has a comparative advantage in building doorframes (she only gives up the opportunity to build 1/4 clocks, while Alice gives up producing 1/2). It makes sense for each of them to produce the good for which they have a comparative advantage because then each person would have a lower opportunity cost in their respective good and they can increase their combined outputs through trade.

Comparative Advantage and Decision Making in Production

Opportunity Cost (to produce 1 unit)
Clock Doorframe
Alice 2 doorframes 1/2 clocks
Becca 4 doorframes 1/4 clocks

Comparative advantage accounts for each agent's opportunity costs in making production decisions. Opportunity costs are what an agent gives up when it chooses to produce one item instead of another. Alice can build 1 clock or 2 doorframes in 12 hours. Therefore, Alice's opportunity cost of producing 1 doorframe is 1/2 clock, and her opportunity cost of producing 1 clock is 2 doorframes. Becca can build 1 clock or 4 doorframes in 8 hours. Alice has a comparative advantage in the production of clocks (she only gives up 2 doorframes, while Becca gives up 4), and Becca has a comparative advantage in the production of doorframes (she only gives up 1/4 clock, while Alice gives up 1/2).

Remember, it is impossible for any one party to have a comparative advantage in producing every good or service. The opportunity cost of any one good is the inverse of the opportunity cost of the other. For example, it costs Alice 2 doorframes to build a clock and 1/2 clock to build a doorframe. In comparison, Becca's opportunity cost of producing 1 clock is 4 doorframes; her opportunity cost of producing 1 doorframe is 1/4 clocks. Therefore, for each individual, business, or country, there is always at least one good or service with a higher opportunity cost and one with a lower opportunity cost.