Unit 1 · Topic 1.4

Comparative Advantage and Trade

Absolute advantage is making more of a good with the same resources; comparative advantage is making it at a lower opportunity cost.

Practice 1: Principles and Models

Part 1 · Hook

Why this matters

Fenwick Workshop is faster than Garnet Workshop at making both chairs and tables. Should Fenwick make everything itself? Surprisingly, no. If each workshop makes what it gives up the least to make, and they trade, both can end up with more furniture than either could make alone. The key is not who is faster, but who has the lower opportunity cost.

Part 2 · Before you start

What this builds on

Part 3 · Prerequisite check

Quick check before you start

1. A straight-line PPC means the opportunity cost

  1. stays the same for each extra unit
  2. rises with each extra unit
  3. falls with each extra unit
  4. is zero
Show the answer

A straight line has one slope.

  • Correct: stays the same for each extra unit:
  • rises with each extra unit:
  • falls with each extra unit:
  • is zero:

2. A tailor can make 30 shirts or 10 jackets. One jacket costs

  1. 3 shirts
  2. 10 shirts
  3. 1/3 of a shirt
  4. 30 shirts
Show the answer

30 shirts given up / 10 jackets gained.

  • Correct: 3 shirts:
  • 10 shirts:
  • 1/3 of a shirt:
  • 30 shirts:

3. A point outside a producer's PPC is

  1. a combination it cannot make alone with its current resources
  2. an efficient combination
  3. a combination with idle resources
  4. its best choice
Show the answer

Outside the curve is unattainable by its own production.

  • Correct: a combination it cannot make alone with its current resources:
  • an efficient combination:
  • a combination with idle resources:
  • its best choice:

Part 4 · See it

See it first

Two straight production possibilities lines for one day: Fenwick Workshop, 12 chairs or 6 tables, and Garnet Workshop, 8 chairs or 2 tables. A table costs Fenwick 2 chairs and Garnet 4; a chair costs Fenwick 0.5 table and Garnet 0.25.
Fenwick: 12 chairs or 6 tables a day. Garnet: 8 chairs or 2 tables. A table costs Fenwick 2 chairs and Garnet 4, so Fenwick has the comparative advantage in tables and Garnet in chairs. Invented data for practice. LevlPrep original diagram.

Part 5 · Step by step

How it works, step by step

  1. Two producers have different opportunity costs for the same goodeach has a comparative advantage in the good it gives up less to make
  2. Each producer specializes in its comparative-advantage goodtogether they make more in total than when each makes some of both
  3. They trade at a price between their two opportunity costseach gets the other good for less than it would cost to make itself
  4. Both pay less than their own opportunity costboth can consume a combination outside their own PPC

Part 6 · Key ideas

Key ideas

  • Absolute advantage: producing more of a good with the same resources (or using fewer resources for the same output).
  • Comparative advantage: producing a good at a lower opportunity cost. Each producer has a comparative advantage in something, unless their costs are equal.
  • Output table: opportunity cost of X = Y given up ÷ X gained. Input table (hours per unit): opportunity cost of X = hours for X ÷ hours for Y.
  • Specialization by comparative advantage plus trade lets both producers consume beyond their own PPCs.
  • Mutually beneficial terms of trade lie between the two producers' opportunity costs.

Part 7 · Misconception

A common mistake

The wrong idea: Fenwick makes more chairs and more tables than Garnet, so Fenwick has the comparative advantage in both and gains nothing by trading.

What actually happens: That is absolute advantage. A table costs Fenwick 2 chairs but Garnet 4, while a chair costs Fenwick half a table but Garnet only a quarter. Fenwick has the comparative advantage in tables, Garnet in chairs, and both gain from trading.

Part 8 · Check yourself

Check yourself

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

1. A producer has a comparative advantage in a good when it can make that good

  1. in a larger amount than another producer
  2. with more workers than the other producer uses
  3. at a lower opportunity cost
  4. at a higher price than another producer
Show the answer

Comparative advantage is about opportunity cost: what you give up to make one more unit.

  • in a larger amount than another producer: Making more with the same resources is absolute advantage.
  • with more workers than the other producer uses: Using more workers says nothing about what each unit costs in other goods.
  • Correct: at a lower opportunity cost: Right: lower opportunity cost.
  • at a higher price than another producer: Price is not how either advantage is defined.

Data

Output tables for two workshops

The most each workshop can make in one day if it makes only that good (invented data for practice)
WorkshopChairs per dayTables per day
Fenwick126
Garnet82

2. What is Fenwick's opportunity cost of one table, in chairs?

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

Show the answer

Fenwick gives up 12 chairs to make 6 tables: 126=2\frac{12}{6} = 2 chairs per table.

  • Answer: 2 chairs

3. Which workshop has the comparative advantage in tables, and why?

  1. Garnet: a table costs it 4 chairs, Fenwick 2
  2. Fenwick: it makes 6 tables to Garnet's 2
  3. Neither: Fenwick is better at both goods
  4. Fenwick: a table costs it 2 chairs, Garnet 4
Show the answer

Compare opportunity costs of a table: 2 chairs for Fenwick, 4 for Garnet. The lower cost wins.

  • Garnet: a table costs it 4 chairs, Fenwick 2: The comparative advantage goes to the LOWER cost, which is Fenwick's.
  • Fenwick: it makes 6 tables to Garnet's 2: That compares amounts, which is absolute advantage.
  • Neither: Fenwick is better at both goods: Being better at both is absolute advantage; costs still differ, so each has a comparative advantage.
  • Correct: Fenwick: a table costs it 2 chairs, Garnet 4: Right: 2 chairs is less than 4.

Data

Hours of labor needed in two countries

Hours of labor needed to make one unit in two invented countries (invented data for practice)
CountryHours for 1 bushel of riceHours for 1 bolt of cloth
Corvania24
Lumeria39

4. Which country has the comparative advantage in rice?

  1. Corvania: it needs fewer hours for rice
  2. Corvania: 1/2 bolt per bushel, to Lumeria's 1/3
  3. Lumeria: it needs more hours for rice
  4. Lumeria: 1/3 bolt per bushel, to Corvania's 1/2
Show the answer

Opportunity cost of a bushel of rice: Corvania 2 ÷ 4 = 1/2 bolt, Lumeria 3 ÷ 9 = 1/3 bolt. Lumeria's is lower.

  • Corvania: it needs fewer hours for rice: Fewer hours is absolute advantage, not comparative.
  • Corvania: 1/2 bolt per bushel, to Lumeria's 1/3: The comparative advantage goes to the LOWER cost, Lumeria's 1/3.
  • Lumeria: it needs more hours for rice: Needing more hours is not why; its lower opportunity cost is.
  • Correct: Lumeria: 1/3 bolt per bushel, to Corvania's 1/2: Right: 1/3 is less than 1/2.

5. Fenwick can make 12 chairs or 6 tables a day, or any mix on a straight line between them. Label the axes and the curve of its production possibilities graph.

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Work on the graph (it needs JavaScript), then check.

Show the answer

Chairs go on the horizontal axis and Tables on the vertical axis, as drawn, and the straight line is Fenwick's PPC.

  • Key: see the explanation

Part 9 · Summary

Summary

Absolute advantage is making more of a good with the same resources; comparative advantage is making it at a lower opportunity cost. When producers specialize in the goods where they have a comparative advantage and trade, total output rises and both can consume combinations outside their own PPCs. Trade helps both when the terms of trade lie between the two producers' opportunity costs. From an output table, divide the other good given up by the good gained; from an input table, divide the hours for the good by the hours for the other good.

Part 10 · Up next

What comes next

Part 11 · Connections

Connections

Question set for this topic