Calculating Comparative Advantage
Economics (Year 12) - Free Trade and Protection
Calculating Comparative Advantage | Elucidate Video
Presenter: Christian Bien (Economics Presenter & Co-Founder)
In the above video, Christian demonstrates how to calculate comparative advantage using an example of wheat and rice for trade between Australia and Indonesia. The video is a prime example of a problem you would see at high school level economics or even first year university.
Determining Absolute Advantage
Consider a world where there are only two countries, which can use the same amount of resources to produce two goods - iron ore and cars.
In the above table, China can produce 80 units of Iron Ore or 100 units of Cars, while Australia can produce 70 units of Iron Ore or 50 Units of Cars. Absolute advantage is where a country can produce a good more efficiently than another country. Hence, China is said to have an absolute advantage in both iron ore and cars as it can produce more of both goods.
Steps to Calculating Comparative Advantage
Comparative advantage is a little more complicated. A country is said to have a comparative advantage if it produces a good or service with the lowest opportunity cost. Opportunity cost in a comparative advantage context is what is the loss of one good when producing the other. In this example, what is the cost or loss of car production when producing an additional iron ore unit or vice versa.
Step 1: Calculate the Opportunity Cost of Each Good from Each Country.
China's Opportunity Cost
Calculating China's Opportunity Cost Iron Ore China's opportunity cost of 1 unit of iron ore. China can produce 80 iron ore or 100 cars.
Calculating China's Opportunity Cost of 1 Iron Ore
China can produce 80 iron ore or 100 cars.
Therefore; 80 iron ore = 100 cars.
We need to make it 1 iron ore, so we divide both sides by 80.
80 iron ore / 80 = 1 iron ore, 100 cars / 80 = 1.25 cars
Hence, 1 iron ore = 1.25 cars.
Calculating China's Opportunity cost of 1 Car
China can produce 100 cars or 80 iron ore.
Therefore; 100 cars = 80 iron ore.
We need to make it 1 car, so we divide both sides by 100.
100 cars / 100 = 1 car 80 iron ore / 100 = 0.8 iron ore.
Hence, 1 car = 0.8 iron ore.
Australia's Opportunity Cost
Calculating Australia's Opportunity Cost Iron Ore Australia's opportunity cost of 1 unit of iron ore. Australia can produce 70 iron ore or 50 cars.
Calculating Australia's Opportunity Cost of 1 Unit of Iron Ore
Therefore; 70 iron ore = 50 cars
We need to make it 1 unit of iron ore, so we divide both sides by 70.
70 iron ore/ 70 = 1 iron ore, 50 cars / 70 = 0.71 cars
Hence, 1 iron ore = 0.71 cars.
Calculating Australia's Opportunity cost of 1 Unit of Car
Australia can produce 50 cars or 70 iron ore.
Therefore; 50 cars = 70 iron ore.
We need to make it 1 car, so we divide both sides by 50.
50 cars / 50 = 1 car 70 iron ore / 50 = 1.4 iron ore
Hence, 1 car = 1.4 iron ore.
Step 2: Plot the opportunity costs on the Two Way Table
From the previous step, we have provided the opportunity cost of producing one unit of each.
Step 3: Identify the Comparative Advantage
Comparative advantage is when a country can produce a good with the least opportunity cost.
Comparative Advantage in Iron Ore
For Iron Ore, the opportunity cost for China is 1.25 Cars and Australia's is 0.71 Cars. As Australia has the lowest opportunity cost, it should produce iron ore.
Comparative Advantage in Cars
For Cars, the opportunity cost for china is 0.8 Iron Ore and for Australia is 1.4 Iron Ore. As China has the lowest opportunity cost, it should produce cars. Hence, Australia has a comparative advantage in Iron Ore and China has a comparative advantage in Cars.
If done correctly, China should have a comparative advantage in cars, as it is impossible for a single country to have a comparative advantage in both goods.
Your Turn: Find Out Who Has the Comparative Advantage in Rice
Now it's your turn! The production possibilities of wheat and rice are shown for Mexico and Vietnam. Calculate the opportunity costs to find out which country has an absolute and comparative advantage in the production of rice. See below for the answer.
Answer: Vietnam has an absolute and comparative advantage in rice.