The Principle of Comparative Advantage
Economics (Year 12) - Free Trade and Protection
The Principle of Comparative Advantage | Open Learn by Open Universities
A short minute video that provides a quick overview on the theory of comparative advantage and how countries can benefit from trade.
Demonstrating Gains from Trade
The principle of comparative advantage states that if countries specialise and produce goods or services to which they have a comparative advantage in, and trade their surplus, they will be better off by consuming more goods and services. Let's go back to our example of Iron ore and Cars with Australia and China.
Example: Iron Ore and Cars in Australia and China
The production possibilities of the two countries are show above. In other words, what is the maximum amount of each iron ore and cars they can produce with the given resources. China can produce a maximum of 80 iron ore or 100 cars. Australia can produce a maximum of 70 iron ore or 50 cars.
Determine the Opportunity Cost of Each Product
Opportunity cost is the amount of cars we give up when we produce one unit of iron ore or vice versa. A detailed overview of how to calculate opportunity cost can be found in the previous page 'Calculating Comparative Advantage'.
Calculating China's Opportunity Cost
China's opportunity cost of 1 unit of 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
China's opportunity cost of 1 unit of 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.
Calculating Australia's Opportunity Cost
Australia's opportunity cost of 1 unit of iron ore.
Australia can produce 70 iron ore or 50 cars.
Therefore; 70 iron ore = 50 cars
We need to make it 1 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 Cars 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.
Self Sufficient Production Possibilities
Above shows the production possibilities if the two countries were self sufficient, i.e. did not trade and produced both goods.
China produces 30 iron ore and 63 cars. (Opportunity cost: 1 iron ore = 1.25 cars. If China can produce a maximum of 80 iron ore, then they are diverting the production of 50 iron ore to produce cars. 50*1.25 = 62.5 = 62 cars.) Australia produces 30 iron ore and 22 cars.
Opportunity cost: 1 iron ore = 0.71 cars. If Australia can produce a maximum of 70 iron ore, then they are diverting the production of 40 iron ore to produce cars. 40*0.71 = 28.4 = 28 cars.)
Hence, in a hypothetical world, the global economy is producing 60 iron ore and 90 cars.
Max Production for Products with a Comparative Advantage
Comparative advantage is producing products where there is the lowest opportunity. In the above example, Australia has a comparative advantage in Iron Ore and China has a comparative advantage in Cars.
Hence, Australia should only produce Iron Ore (70 units) and China should only produce Cars (100 units). As you can see the World economy production has increased by 10 units for Iron Ore and 10 units for Cars.
Determine an Exchange Rate
To determine an exchange rate for trade, a rate must be applied that provides the following: For the exporting country, an export price higher than the opportunity cost. For the importing country, an import price lower than the opportunity cost. In this example, Australia will want to export 1 Iron Ore at a price greater than 0.71 Cars, and China will want to import at a price of 1 Iron Ore to less than 1.25 Cars. Hence, we've adopted an exchange rate of 1 Iron Ore = 1 Car.
Gains from Trade
At the exchange rate of 1 Iron Ore = 1 Cars, Australia trades 35 Iron Ore with China in exchange for 35 Cars. Both countries are better off, with China and Australia consuming 5 more Iron Ore and, China receiving 3 more Cars and Australia receiving 7 more Cars. Despite China having an absolute advantage in both goods, both countries are better off in trade! Of course, this theory assumes there are no costs or barriers to trade.
The real effect of trade will be undermined by factors such as:
Protectionism - e.g. tariffs or subsidies