Comparative Advantage

Introduction

We will focus on three of the beneﬁts of trade (Cowen and Tabar- rok, 2011, ch. 2):

1. Trade makes people better oﬀ when preferences diﬀer.

2. Trade increases productivity through specialization and the division of knowledge.

3. Trade increases productivity through comparative advantage.

“Simple trades of the kind found on eBay create value, but the true power of trade is discovered only when people take the next step, specialization. In a world without trade, no one can af- ford to specialize. People will specialize in the production of a single good only when they are conﬁdent that they will be

1 able trade that good for the many other goods that they need. Thus, as trade develops, so does specialization and specialization turns out to vastly increase productivity.” (Cowen and Tabarrok, 2011, p. 14)

Absolute Advantage A country has an absolute advantage in production if it can produce the same good using fewer inputs than another country.

Comparative Advantage A country has a comparative advantage in producing goods for which it has the lowest op- portunity cost.

Production Possibilities Frontier A production possibilities frontier shows all the combinations of goods that a country can produce given its productivity and supply of inputs.

Comparative Advantage Example

Consider the following example from Cowen and Tabarrok (2011). The production possibility data are found in Table 1 and a plot of the data are found in Figure 2.

2 Shirts Computers Mexico 12 2 USA 24 24

Table 1: Production possibilities for the USA and Mexico. Each country has 24 units of labor to use.

Figure 1: A graph from Cowen and Tabarrok (2011) of the production possibilities for USA and Mexico. Assume that there is no trade and that each country uses half of its labor to produce each good.

3 Self-suﬃcient Output Shirts Computers Mexico 6 1 USA 12 12 Total 18 13

Table 2: Total output of shirts and computers if each country is self-suﬃcient and devotes half of their resources to producing each good.

Output with no Trade

Assume that each country is self-suﬃcient, which means they only consume what they produce. Also, let’s say that half of a country’s resources is used to produce each good. 12 hours to shirts, 12 hours to computers. Total production is shown in Table 2.

Using the data in Table 1 (or Table 2, which is based on it), compute comparative advantage for each good. That means ﬁgure out the cost of producing 1 of each good in each country. First, the cost of making a computer:

The Cost of Making 1 Computer Mexico 2 computers costs 12 shirts 2/2=1 computer costs 12/2=6 shirts USA 24 computers costs 24 shirts 24/24=1 computer costs 24/24=1 shirt

4 It costs less to make a computer in the USA (1 shirt) than it does in Mexico (6 shirts). USA has a comparative advantage in producing computers.

The Cost of Making 1 Shirt Mexico 12 shirts cost 2 computers 12/12=1 shirts cost 2/12=1/6 computers USA 24 shirts cost 24 computers 24/24=1 shirts cost 24/24=1 computers

It costs less to make a shirt in the Mexico (1/6 computer) than it does in the USA (1 computer). Mexico has a comparative advantage in producing computers.

The law of comparative advantage says that world output will rise if countries specialize in producing goods for which they have comparative advantage. So, Mexico should devote more resources to making shirts and the USA more resources to making computers.

Specialization and Trade

Now suppose that Mexico specialized in producing shirts and trades some of these for computers made in the USA. Mexico devotes all resources to shirt production and agrees to sell half of these to the USA in return for 2 computers. For sake of the

5 Output with Trade Shirts Computers Mexico 12 0 USA 10 14 Total 22 14

Table 3: Total output of shirts and computers if each country if each pro- duces more of the good for which it has comparative advantage. Mexico is completely specialized and the USA partially specialized. example, let’s say that the USA needs 12 computers domesti- cally so to produce 2 more to sell to Mexico, shirt production falls by 2 to a total of 10. The outcome of this is shown in Table 3.

Note that world output of computers and shirts rises since each country uses resources to produce the goods that they can do so at lower cost.

Eﬀects on Income

Not only will output rise, but incomes in both countries will rise as well. Suppose that a shirt sells for $100 and a computer for $300.

The value of Mexican consumption is $300 $100 1 Computer × + 6 Shirts × = $900. (1) Computer Shirt

6 Figure 2: A graph from Cowen and Tabarrok (2011) of the production possibilities for USA and Mexico. Assume that there is trade. Mexico specialized in shirt production (producing 12 with no computers) and USA gives up 2 shirts to produce 2 more computers to trade for Mexican shirts.

7 Since there are 24 workers, the average wage is $900/24 = $37.50. The value of U.S. consumption is 12 × $300 + 12 × $100 = $4,800 so the U.S. wage is $200.

Now consider the situation with trade. The value of Mexican consumption is now 2 × $300 + 6 × $100 = $1,200 for a wage of $50, while the U.S. wage is now (12 × $300 + 16 × $100)/24 = $5,200/24=$216.67. Wages in both countries have gone up, just as expected.

Lesson

1. The wage in Mexico is lower than the wage in the United States. Why? Productivity of labor is lower in Mexico. Wages are determined by the productivity of labor. Labor productivity depends on the amount and quality of tools one has and the knowledge of how to use those tools–capital and human capital.

2. Specialization and trade let workers make the most of what they can do. Wages will rise only as high as productivity allows, though.

3. Trade may increase productivity in the long-run if greater specialization leads to faster improvements in knowledge and technology. This is one of the arguments made in favor

8 of trade and specialization by Adam Smith in TWN.

“In summary, workers in the United States often fear trade because they think that they cannot compete with low-wage workers in other countries. Meanwhile, workers in low-wage countries fear trade because they think that they cannot compete with high productivity countries like the United States! But differences in wages reflect differences in productivity. High- productivity countries have high wages, low-productivity countries have low wages. Trade means that workers in both countries can raise their wages to the highest levels allowed for by their respective productivities.” (Cowen and Tabarrok, 2011, p. 19)

9 Bibliography

Cowen, Tyler and Alex Tabarrok (2011), Modern Principles of Economics, 2nd edn, Worth, New York.

Muller, Jerry Z. (2002), The Mind and the Market: Capitalism in Western Thought, Anchor Books, New York.

Smith, Adam (1904), An Inquiry into the Na- ture and Causes of the Wealth of Nations, Edwin Cannan edn, Library of Economics and Liberty, http://www.econlib.org/library/Smith/smWN.html.