Lesson preview · Why countries trade
Comparative advantage: why trade pays, and who loses
~8 min · Free to read
In 1817, the economist David Ricardo gave an example: Portugal could make both wine and cloth with fewer workers than England. So why should Portugal ever buy English cloth? Ricardo showed that both countries gain if Portugal makes wine and swaps it for English cloth. What matters isn’t who is better at making things, but what each country gives up.
Key Term
Absolute and comparative advantage
Shrink the problem to two people on an island. In a day, Ana can catch 20 fish or pick 10 coconuts. Ben was hurt in a shark attack, so he can catch only 4 fish or pick 8 coconuts.
Ana has an absolute advantage in both jobs: in the same time, she makes more of each.
Ana gives up 20 fish to pick 10 coconuts, so each coconut costs her 2 fish. Ben gives up 4 fish for 8 coconuts, so each coconut costs him half a fish. These costs stay the same however many they pick. What you give up to get something is its opportunity cost.
Ben has the comparative advantage in coconuts: he makes them at a lower opportunity cost than Ana. Ana has it in fish. A fish costs her half a coconut, but it costs Ben 2 coconuts.
Key Term
Specialise, then trade
Each person should specialise: put most or all of their time into the good they make at the lower opportunity cost. Then they swap.
The terms of trade are the swap rate: how many coconuts one fish buys. The rate must lie between their two costs of a fish (half a coconut and 2 coconuts), or one of them would do better alone.
At 0.8 coconuts per fish, Ana gets more for a fish than its half-coconut cost. Ben pays less than the 2 coconuts it would cost him to catch.
So trade let Ana and Ben both end up outside their own production possibility curve (PPC): the line showing every mix each can make alone. Both gained, though Ana was better at both jobs. Trade isn’t a contest where one side’s gain is the other’s loss. Countries work the same way.
Trap · Common Misconception
"A country that's better at everything doesn't need trade"
A country can have an absolute advantage in every good, but never a comparative advantage in every good. If a fish costs Ana less than it costs Ben, a coconut must cost her more. Her coconut cost is her fish cost turned upside down. So unless their costs are identical, each side has one good it gives up less to make.
Trap · Common Misconception
"Trade makes everyone better off"
A country can gain from trade while some of its people lose. When cheaper imports arrive, buyers pay less and get more choice. But firms at home that make the same goods sell less, and some of their workers lose their jobs. Each country imports something, so each can have firms like these.
In 1991, Chinese goods made up 0.6% of US spending on goods. By 2007, they made up 4.6%. A 2013 study by the economists David Autor, David Dorn and Gordon Hanson looked at the cost. It estimated that competition from these imports caused about a quarter of the fall in US factory jobs from 1990 to 2007.
Evidence: mixed. Later studies disagree about how many jobs Chinese imports cost.
Worked Example
Country A and Country B have the same number of workers. In a year, Country A can grow 60,000 tonnes of rice or make 30,000 bikes. Country B can grow 20,000 tonnes of rice or make 20,000 bikes. So Country A is better at both. (a) Find each country’s opportunity cost of one bike and of one tonne of rice. (b) Which country has the comparative advantage in each good? (c) Find a rate of rice per bike that both would accept.
Practice · 1 / 6
A country has a comparative advantage in a good when it can make that good:
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