Economics Terms A-Z - The most important terms in economics.

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Economics Terms A-Z

Comparative Advantage

Comparative advantage means that you can produce a good or service at a relatively lower opportunity cost than that of your competitors. Comparative advantage is different from absolute advantage, which means you can produce a given item more efficiently than someone else.

These concepts are often used in reference to international trade, and are perhaps best demonstrated in that context. Consider two nations - we’ll call them Atlantis and Narnia. Below, we will demonstrate that even with absolute advantages in both goods, Atlantis is better off if it cooperates with Narnia and trades - despite being able to make more of both goods than Narnia can.

Suppose that there are only two goods, smartphones and bread. Also assume that each country has 10-hour work days. Atlantis, being a very advanced nation, can produce 15 smartphones per hour, or 150 smartphones per day (since we assume 10-hour work days). It can also make 10 loaves of bread per hour, or 100 loaves of bread per day. Meanwhile, Narnia is not as efficient; it can make 3 smartphones in an hour, or 30 per day, and it can produce 6 loaves of bread per hour, or 60 per day.

  Smartphones Bread (loaves)
Atlantis 150 100
Narnia 30 60

It is clear from the table that Atlantis has an absolute advantage in both goods. That is, Atlantis can produce more than Narnia no matter which good it produces.

Let’s consider a scenario where each country uses the 10 hours it has in a day to produce its own goods. How much can each country make on its own? We can use the table above to draw a Production Possibilities Frontier for both countries and answer this question:

Any point on this line for either country represents a product mix it can produce on its own. For example, if both countries decide to split their time equally between each good, then Atlantis can produce 50 loaves of bread and 75 smartphones; meanwhile Narnia can produce 30 loaves of bread and 15 smartphones. This gives a total of 80 loaves of bread and 90 smartphones produced in total with both countries in autarky. But, can we do better? If the countries can trade, can we improve overall economic welfare?

To answer this question, let’s examine comparative advantage by looking at opportunity costs. If Atlantis produces a loaf of bread, it gives up the chance to produce one and a half smartphones. This is because in one hour, it can produce 15 smartphones or 10 loaves of bread; so, for every loaf of bread produced, it must “give up” 1.5 smartphones. Thus, the opportunity cost for Atlantis of producing a loaf of bread is 1.5 smartphones. By similar logic, the opportunity cost of a smartphone is two thirds of a loaf of bread.

Narnia, meanwhile, can produce either 3 smartphones or 6 loaves of bread in one hour. So, Narnia’s opportunity cost of producing a smartphone is 2 loaves of bread, and its opportunity cost for producing a loaf of bread is 1/2 of a smartphone.

Let’s examine these opportunity costs in a new table.

  Opp. Cost of Smartphone Opp. Cost of Loaf of Bread
Atlantis 2/3 of a loaf of bread 1.5 smartphones
Narnia 2 loaves of bread 1/2 of a smartphone

Clearly, it is relatively more expensive for Narnia to produce a smartphone than for Atlantis; much more bread must be given up for Narnia to produce a smartphone. Likewise, Atlantis must give up more smartphones than Narnia to make a loaf of bread.

Instead of each country producing both goods, what happens if each country specializes in the good that is relatively cheaper for it to make? This should help the countries minimize difficult tradeoffs within their own economies. In this case, Narnia will spend all of its time making bread, and so it will make 60 loaves of bread. In the example where both countries split their time, 80 loaves of bread were made; so, let’s say that Atlantis brings our total bread up to par by making 20 more loaves of bread using 2 hours. It then has 8 hours left to make smartphones, and so it produces 8*15 = 120 smartphones.

The total production from both countries is now 80 loaves of bread like before, but 120 smartphones instead of just 90. By shuffling production around so each country focuses on the good it has a comparative advantage in, we’ve produced 30 extra smartphones and the world is better off (assuming the countries trade)!

This is true even though Atlantis can make both more bread and more smartphones than Narnia can. Despite its absolute advantage in both goods, it is better off when it trades with Narnia.

Good to Know

The above example of comparative advantage is one argument against trade barriers. If Atlantis and Narnia are unable to trade, or if trade is made less efficient by artificial barriers like tariffs, the countries miss out on the full benefits of comparative advantage and free trade.

Often in the real world, it is difficult to remove trade barriers like tariffs. This is because they can prop up a domestic industry, which can have political and social advantages. In Narnia’s case, trade barriers could preserve some smartphone production in the country, enriching the phone makers in Narnia. These people would be opposed to free trade in smartphones, because they would lose their entire industry to Atlantis if trade was free.