Comparative advantage and trade

The advantages of trade are easy to see when a country cannot produce a certain type of good. For example, New Zealand cannot produce many tropical fruits. Therefore, we import those fruits from the Pacific Islands. Likewise, the Pacific Islands cannot produce beef or lamb, so New Zealand exports beef and lamb to the Pacific Islands.

In this case, trade lets each country enjoy the benefits of goods that they themselves cannot produce. However, trade can also be beneficial when both countries produce the same range of goods, and even when one country can produce all goods more efficiently the other country.

Consider two countries, both of whom can produce either cars or beef. The prices of cars and beef in each country before trade takes place are shown in the table below:

Both cars and beef are can be produced more cheaply in country A. However, it is still in the interests of both countries to engage in trade. In particular, it makes sense for country A to produce cars for country B, and for country B to produce beef for country A.

At first glance, it does not make sense for country B to produce beef for country A, because beef is cheaper in country A than in country B. However, comparative advantage lets trade take place to the benefit of both countries.

The key point here is that the price ratios are different in each country. In country A, one car is equal to 8 tonnes of beef, whereas in country B, one car is equal to 10 tonnes of beef. (These are the opportunity costs of producing one car). Therefore, country A can export a car to country B, and buy more beef than they would have been able to obtain by selling the car locally. Likewise, country B needs to sell fewer tonnes of beef to buy a car by exporting the beef to country A, than if it sold the beef locally.

Clearly, trade has the potential to change the prices of cars and beef in each country. Country A gains most benefit if they can sell their $24,000 car for $35,000 in country B, while country B will want to obtain a $35,000 car for only $24,000. At the very least, the prices at which these goods are traded will settle to some level in between the prices prevailing in each country. However, if volumes of trade are large, then the consumer prices in each country could also change (see note at the end of this article).

A key issue in this example is the rate of exchange between beef and cars. To benefit both countries, this exchange rate will need to be between 8 and 10 tonnes of beef per car. If it is less than 8, then there is no advantage for country A, as this is its own domestic price relativity. Similarly, if it is more than 10 then there is no advantage for country B. Between these two figures, both countries can gain advantage from trade.

In this example, country B has a comparative advantage in producing beef. Therefore, relative to cars, beef production is more efficient in country B than in country A. In other words, country B can produce more beef for every car than country A – and this is what provides the comparative advantage for trade purposes.

While this is a simple example of comparative advantage, the same principles apply to trade with multiple countries. Comparative advantage also applies at a much smaller scale than countries – right down to individuals in society.

A well used example is the case of a lawyer being better at the office administration than the secretary. Despite this, it does not make sense for the lawyer to do the office administration, because the opportunity cost (legal work foregone) is too high. Therefore, the secretary does the office administration, because the secretary has a comparative advantage in this role. As a result, the lawyer does more legal work, the secretary has a job, and both are better off than if the lawyer did everything.

Effect of changing prices

It was noted above that high levels of trade could change consumer prices in each country. Say that prices in country A changed to $29,250 per car, and $3,250 per tonne of beef. Both prices have gone up – does this mean that consumers are worse off?

Country A is producing cars – not only for itself, but for country B. Overall, they are selling more cars at a higher price, and the income from those sales lets them buy more beef, even though the beef is at a higher price than it could have been. At the new price ratio, one car can buy nine tonnes of beef, which means the country is better off than previously when it would only buy eight tonnes of beef.

In country B, both prices have gone down. Even though that means they are getting less money for their beef, cars are still relatively cheaper than they used to be. Now, they only need to sell nine tonnes of beef to purchase a car, whereas previously they needed to sell ten tonnes of beef.

Overall, the effect of comparative advantage is that countries (or individuals) will tend to do those things in which they have a relative advantage – even if they are not the best in absolute terms. They will then trade the output of those activities to their mutual benefit. No-one will be worse – otherwise, they wouldn’t trade. But comparative advantage offers the opportunity for both countries to improve their overall position.