Comparative advantage – The theory that a country should specialise in the goods/services that it can produce at the lowest opportunity cost.

Absolute advantage – When a country is able to produce a product using fewer factors of production than that of another country.

The diagram below shows the production of cars and motorbikes for country A and country B. Both of these countries are confined to their production possibility frontiers. Therefore, in order for country A to produce 5 cars, it must give up 10 motorbikes and if they chose to produce 10 motorbikes then they must give up 5 cars. On the other hand if country B wants to produce 8 cars then they must give up 4 motorbikes and if they want to produce 4 motorbikes they must give up 8 cars. This information can also be displayed in a table format as shown below the diagram.

 Cars Motorbikes Country A 5 10 Country B 8 4

Given the theory of comparative advantage, both countries are best off producing the good in which they have the lowest opportunity cost and then trade with each other. In order to make it easier to work out which country has the lowest opportunity cost for each good, the opportunity cost per good can be worked out as shown below:

## Calculation of opportunity cost

In order for country A to produce 1 car, they must give up 2 Motorbikes (10/5). On the other hand, if country B were to produce 1 car then they would only have to give up 0.5 motorbikes (4/8). As country B has the lowest opportunity cost in producing cars, this is what they should specialise in.

The same calculations can be used to work out which country has the lowest opportunity cost in producing motorbikes. For country A to produce 1 motorbike they must give up 0.5 car (5/10). If country B want to produce 1 motorbike they must give up 2 cars. Therefore, country A should specialise in producing motorbikes as they have the lowest opportunity cost.

Country A specialise in motorbikes

Country B specialise in cars

The opportunity costs of either country producing cars and motorbikes can be seen in the table below:

 1 Car 1 Motorbike Country A 2 Motorbikes 0.5 Car Country B 0.5 Motorbike 2 Cars

Now that we know which good each country should specialise in making, an exchange rate must be worked out which makes it beneficial for both countries to trade. This can be worked out through an opportunity cost ratio diagram.

Given that country A’s opportunity cost of making 1 car is 2 motorbikes, they will not be willing to buy 1 car from country B in exchange for more than 2 motorbikes.

Given that country B’s opportunity cost of making 1 car is 0.5 motorbikes, they will not be willing to sell 1 car to country A for less than 0.5 motorbike in return.

Overall, this gives an exchange rate range of 1 car for 0.5-2 motorbike. This can be seen in the diagram below.

The closer the exchange rate is to 1 car = 0.5 motorbikes, the more it favours country A. This is because they can buy more motorbikes in exchange for fewer cars. Whereas the closer the exchange rate is to 1 car = 2 motorbikes, the more it favours country B. This is because they receive more motorbikes for each car that they sell. Although this is the case, any exchange rate within these two values will be more beneficial to both countries than if they were not to trade at all.

Country A must buy 1 car in exchange for 0.5-2 motorbikes and Country B must sell country A 0.5-2 motorbikes in exchange for 1 car. Any exchange within these two values will benefit both countries and allow them to obtain a total output beyond their PPF curve as explained below:

## The effect of trade on a country’s PPF

Before specialisation Country A could only produce 6 motorbikes and 2 cars (1 car has an opportunity cost of 2 motorbikes). However, if they were to specialise in motorbikes and produce 10 of them, they could sell the other 4 in exchange for a potential 8 cars (if the exchange rate was 1 car = 0.5 motorbikes). Therefore, in total they would have 6 motorbikes and 8 cars, compared to the 6 motorbikes and 2 cars they would’ve had if they weren’t to trade.

Country B could produce 4 cars and 2 motor bike (1 motor bike has an opportunity cost of 2 cars) without trading. However, if they were to trade they could specialise in cars, producing 8 of them and then sell 4 of them to country A in exchange for 8 motorbikes (given that the exchange rate is 1 car for 2 motorbikes). Therefore in total they would have 4 cars and 8 motorbikes compared to the 4 cars and 2 motorbikes that they would’ve had if they weren’t to trade.

## Assumptions and limitations of comparative advantage

No economies of scale

The comparative advantage theory doesn’t take into account economies of scale. For example, the country which doesn’t have the comparative advantage in a certain good/service may be able to exploit economies of scale to a much greater extent than the country with the comparative advantage. Therefore, they may end up being able to sell the good/service at a lower price than the country with the comparative advantage, due to the price saving gained through large economies of scale.

On the other hand, the country with the comparative advantage may become the world supplier for that good/service. As a result of this, their output of the good/service will be much greater than anticipated, thus allowing them to benefit from huge economies of scale. Therefore the advantage that they do have over other countries will be much greater than the comparative advantage model states.

No transport costs

Transport costs are not taken into account. For example, although one country may have the lowest opportunity cost in a good/service than other countries, their transport costs may be much higher. As a result of this, the good/service that they produce may actually be cheaper for consumers than the country that has the comparative advantage. This is one of the explanations as to why a country may continue to produce a good/service in which it has not got a comparative advantage in.

Perfect knowledge

The comparative advantage theory assumes that consumers will have perfect knowledge about where the lowest prices for a good/service are and therefore will always buy from there. However, it is often the case that consumers don’t have perfect knowledge and therefore they may end up buying the good/service for a more expensive price from the country that does not have the comparative advantage.

External costs of production are ignored

External costs such as pollution and other damage to the environment are ignored. Although one country may have the comparative advantage in producing the good/service, the external costs of them doing so may be much greater than other countries. This may be due to the fact that they make the good/service with unsustainable resources or that they give off more pollutants during the production of the good/service. As a result of this, it may be more socially beneficial for the good/service to be produced by a country that does not have the comparative advantage, but can produce it with fewer external costs.

Lower price and more choice

As shown previously regarding the effect of trade on a country’s PPF, trade causes an increase in world output. This means that consumers have much more choice of goods/services. In addition to this, comparative advantage allows countries to specialise in the good/service that they can produce at the lowest opportunity cost. As a result of this, they are able to produce the good/service at a lower cost per unit than a country that does not have the comparative advantage. Overall, this means that when the good/service is traded, consumers will be able to buy it at a lower price.

Larger markets and economies of scale for firms

By countries trading with each other countries, firms have access to much larger markets. This will increase the demand that there is for the goods/services that they produce. As a result of this, they are able to increase their output and benefit from economies of scale. Overall, this causes a decrease in their average costs which they can then pass onto consumers in the form of lower prices.

Higher economic growth rates and living standards

If a country is able to specialise in the good/service that they have a comparative advantage in, their overall output levels will increase. This will allow them to experience higher economic growth rates than before, which then translates into an increase in wages (national output = national expenditure = national income). As a result of this, citizens are likely to be better off due to an increase in material standards of living. In addition to this, an increase in a country’s output will cause an increase in the demand for labour. This is due to the fact that the demand for labour is derived from the demand for the good/service that they produce. As a result of this, unemployment levels are likely to fall.

Trade deficits may occur if a country’s goods/services are uncompetitive

Countries that do not have a comparative advantage will suffer from low export revenue and relatively high import expenditure. As a consequence of this, they are likely to experience large trade deficits, thus reducing aggregate demand and economic growth rates.

Danger of dumping by foreign firms

By trading with other countries, it opens up the risk of foreign firms dumping goods/services domestic markets. This causes a large increase in the supply of the good/service, thus causing prices to fall. If domestic firms are less competitive than their foreign competitors, they may end up making a loss at this lower price and therefore be forced out of the market. This can lead to further problems for the country such as a large increase in the unemployment rate.

Increased exposure to external shocks

With trade comes the increase in interdependence amongst countries. This causes an increase in the risk of external shocks. For example, a recession in one country can cause their demand for imports to drop largely. As a result of this, the country in which they trade with will experience a fall in export revenue from the goods/services that they sell to the country in the recession. This will then have a knock on effect in their country, causing export revenue to decrease contributing to a trade deficit and therefore a decrease in economic growth.