Unit 1 · Topic 1.3

Comparative Advantage and Gains from Trade

Absolute advantage is producing more with the same resources; comparative advantage is producing at a lower opportunity cost.

Practice 1: Principles and ModelsPractice 2: Interpretation

Part 1 · Hook

Why this matters

A surgeon types faster than anyone in her office, yet she pays an assistant to type her notes. She is not being lazy: every hour she types is an hour of surgery she does not do. Countries trade for the same reason, even when one of them is better at making everything.

Part 2 · Before you start

What this builds on

Part 3 · Prerequisite check

Quick check before you start

1. A worker can make 24 shirts or 8 hats in a day. Making one hat costs

  1. 3 shirts
  2. 8 shirts
  3. one third of a shirt
  4. 24 shirts
Show the answer

Opportunity cost per unit is what is given up divided by what is gained: 24 / 8.

  • Correct: 3 shirts:
  • 8 shirts:
  • one third of a shirt:
  • 24 shirts:

2. A straight-line PPC shows

  1. constant opportunity cost
  2. increasing opportunity cost
  3. idle resources
  4. growth
Show the answer

A straight line has the same slope, so each unit costs the same.

  • Correct: constant opportunity cost:
  • increasing opportunity cost:
  • idle resources:
  • growth:

Part 4 · See it

See it first

Two straight production possibilities lines for one worker a day: Dornia, 40 bushels of wheat or 20 yards of cloth, and Belmar, 30 bushels of wheat or 10 yards of cloth, with the opportunity costs: cloth costs Dornia 2 bushels and Belmar 3; wheat costs Dornia half a yard and Belmar a third of a yard.
One worker's production possibilities in Dornia and Belmar: cloth costs Dornia less wheat, and wheat costs Belmar less cloth. Invented data for practice. LevlPrep original diagram.

Part 5 · Step by step

How it works, step by step

  1. Two countries have different opportunity costs for the same goodseach has the comparative advantage in the good it makes at the lower cost
  2. Each country specializes in its comparative advantagetheir combined output of both goods rises
  3. They trade at terms between their two opportunity costseach gets the other good for less than it costs to make at home
  4. Both gain from tradeeach can consume a combination outside its own PPC

Part 6 · Key ideas

Key ideas

  • Absolute advantage: more output from the same resources (or fewer resources per unit). Comparative advantage: the lower opportunity cost.
  • Output data (units per worker): the cost of one good is the other good's output divided by its own. Input data (hours per unit): divide its own hours by the other good's hours.
  • A country can have the absolute advantage in both goods, but the comparative advantage in only one.
  • Terms of trade help both sides only when they lie between the two opportunity costs.

Part 7 · Misconception

A common mistake

The wrong idea: A country that is better at making everything has nothing to gain from trade.

What actually happens: Gains from trade come from comparative advantage, not absolute advantage. Even the more productive country gains by making the good with its lower opportunity cost and buying the other at a price below its own cost.

Part 8 · Check yourself

Check yourself

Exam-style questions. Anything you miss goes into your review queue.

Data

Shirts and hats: output per worker

Most shirts or hats one worker can make in a day in two invented countries (output data)
CountryShirts per worker per dayHats per worker per day
Marnovia248
Delmont126

1. Using the table, what is Marnovia's opportunity cost of making one hat, in shirts?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

A Marnovian worker who makes 8 hats gives up 24 shirts, so one hat costs 248=3\frac{24}{8} = 3 shirts.

  • Answer: 3

2. Which country has the absolute advantage in hats?

  1. Delmont, because it has the lower opportunity cost of making hats
  2. Marnovia, because one worker makes 8 hats a day to Delmont's 6
  3. Delmont, because it makes fewer shirts per worker
  4. Neither, because both countries make hats
Show the answer

Absolute advantage means more output from the same resources: 8 hats per worker beats 6.

  • Delmont, because it has the lower opportunity cost of making hats: Lower opportunity cost is comparative advantage, not absolute advantage.
  • Correct: Marnovia, because one worker makes 8 hats a day to Delmont's 6: Right: more hats from one worker.
  • Delmont, because it makes fewer shirts per worker: Making fewer shirts does not mean making more hats.
  • Neither, because both countries make hats: Absolute advantage compares how much each makes, and Marnovia makes more.

3. Which country has the comparative advantage in hats?

  1. Delmont, because a hat costs it 2 shirts and costs Marnovia 3
  2. Marnovia, because each of its workers makes more hats per day
  3. Marnovia, because it makes more of both goods
  4. Delmont, because it makes fewer shirts
Show the answer

Comparative advantage is the lower opportunity cost. A hat costs Delmont 126=2\frac{12}{6} = 2 shirts and Marnovia 3 shirts.

  • Correct: Delmont, because a hat costs it 2 shirts and costs Marnovia 3: Right: 2 shirts is less than 3.
  • Marnovia, because each of its workers makes more hats per day: More hats per worker is absolute advantage.
  • Marnovia, because it makes more of both goods: A country can have the absolute advantage in both goods but the comparative advantage in only one.
  • Delmont, because it makes fewer shirts: The comparison is of opportunity costs, not of shirt output alone.

4. If both countries specialize by comparative advantage, what does each produce?

  1. Marnovia makes both, because it is better at both
  2. Marnovia makes hats and Delmont makes shirts
  3. Each makes half of each good
  4. Marnovia makes shirts and Delmont makes hats
Show the answer

A shirt costs Marnovia 824\frac{8}{24}, a third of a hat, and Delmont half a hat, so Marnovia specializes in shirts and Delmont in hats.

  • Marnovia makes both, because it is better at both: Specializing by absolute advantage misses the gains from trade.
  • Marnovia makes hats and Delmont makes shirts: This reverses the comparative advantages.
  • Each makes half of each good: Splitting production gives up the gains from specializing.
  • Correct: Marnovia makes shirts and Delmont makes hats: Right: each makes the good with its lower opportunity cost.

5. Which terms of trade would benefit both countries?

  1. 1 hat for 1.5 shirts
  2. 1 hat for 3.5 shirts
  3. 1 hat for 2.5 shirts
  4. 1 hat for 4 shirts
Show the answer

The price of a hat must lie between the two opportunity costs, 2 shirts (Delmont) and 3 shirts (Marnovia). Delmont sells hats for more than 2 shirts; Marnovia buys them for less than 3.

  • 1 hat for 1.5 shirts: Delmont gives up 2 shirts to make a hat, so selling it for 1.5 loses shirts.
  • 1 hat for 3.5 shirts: Marnovia can make a hat for 3 shirts itself, so it will not pay 3.5.
  • Correct: 1 hat for 2.5 shirts: Right: 2.5 is between 2 and 3.
  • 1 hat for 4 shirts: Marnovia can make a hat for 3 shirts itself, so it will not pay 4.

6. A surgeon types faster than her assistant but pays the assistant to do her typing. Which idea explains this?

  1. Absolute advantage: the assistant types faster than the surgeon
  2. Scarcity: there is not enough typing to go around
  3. Comparative advantage: the assistant's opportunity cost of typing is lower
  4. Increasing opportunity cost: typing gets harder the more she does
Show the answer

The surgeon has the absolute advantage in typing, but her opportunity cost of typing (surgery not done) is much higher, so the assistant has the comparative advantage in it.

  • Absolute advantage: the assistant types faster than the surgeon: The surgeon types faster, so she has the absolute advantage in typing.
  • Scarcity: there is not enough typing to go around: The choice is about who should type, not a lack of typing.
  • Correct: Comparative advantage: the assistant's opportunity cost of typing is lower: Right: the lower opportunity cost belongs to the assistant.
  • Increasing opportunity cost: typing gets harder the more she does: Nothing suggests her typing gets harder; her time is simply worth more in surgery.

7. Can one country have the comparative advantage in both of two goods?

  1. Yes: if it has the absolute advantage in both
  2. No: a lower cost of one good means a higher cost of the other
  3. Yes: if it has more workers than the other country
  4. Yes: if its PPC lies farther from the origin
Show the answer

The opportunity cost of one good is the reciprocal of the opportunity cost of the other, so a lower cost of one means a higher cost of the other.

  • Yes: if it has the absolute advantage in both: Absolute advantage in both is possible; comparative advantage in both is not.
  • Correct: No: a lower cost of one good means a higher cost of the other: Right: the two costs are reciprocals.
  • Yes: if it has more workers than the other country: More workers can give an absolute advantage, not a comparative advantage in both.
  • Yes: if its PPC lies farther from the origin: A larger PPC shows more output, not lower opportunity costs of both.

Part 9 · Summary

Summary

Absolute advantage is producing more with the same resources; comparative advantage is producing at a lower opportunity cost. Find each country's opportunity cost of each good from output or input data, give each good to the country with the lower cost, and trade at terms between the two costs. Then both countries gain, and each can consume outside its own PPC, even if one has the absolute advantage in both goods.

Part 10 · Up next

What comes next

Part 11 · Connections

Connections

Question set for this topic