Comparative Advantage

Why Do Countries Trade?

Comparative advantage can be illustrated through a PPC diagram.
- While some countries might have absolute advantages in producing both of two goods, some countries might have a comparative advantage as they have to sacrifice less of one good to produce more of the other.

Here we can see that England can produce either 8 units of wine or 4 units of cloth.
- England can produce more cloth or more wine than Portugal can, meaning it has absolute advantage.
However, for every extra unit of wine England wants to produce, they sacrifice 4/8 units of cloth, or 1/2 units of cloth.
- This is their opportunity cost.
For every extra unit of cloth England wants to produce, they sacrifice 8/4 units of wine, or 2 units of wine.
Portugal on the other hand only has the opportunity cost of 2/2, or 1 for producing wine or cloth.
As the opportunity cost of 1 unit of wine for Portugal is less than the opportunity cost of 2 units of wine for England, the most efficient would be if Portugal produced cloth and England produced wine.

Comparative advantage can also be shown using possible production curves.
- Here the curves are assumed to be straight as there is no additional efficiency loss from switching from producing one good to another.

Only 2 goods and 2 countries producing
- Simplified and unrealistic
Assumption of homogenous goods
- In reality there might be a difference in quality
Assumption of free trade
Assumption that factors of production stay in the country
Assumption of full employment
Assumption of perfect information
Assumption that technology is fixed
No calculation of the cost of transportation between countries

Sources