Comparative Advantage & Trade

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Comparative Advantage

Free trade can allow countries to specialise in the goods they are most efficient at producing. Trade means that they can buy some goods from other countries, rather than producing them themselves.

Opportunity cost of production

If a country produces sugar, it has an opportunity cost of production.
The labour and capital used to make sugar cannot be used to make wheat at the same time.
- E.g. if Brazil can produce a lot of sugar cane per acre but not much wheat, and the US can produce a lot of wheat but not sugar cane, then the US has a lower opportunity cost of producing wheat than Brazil.
This can be shown using production possibility frontiers (PPFs).

Comparative advantage

The US has a comparative advantage in producing wheat.
Brazil has a comparative advantage in producing sugar cane.
If both countries could specialise in producing the goods they had a comparative advantage in, then:
- The total world output of goods will rise.
- Brazil and the US can trade wheat for sugar cane, and they both benefit.
Think of comparative advantage as what a country is least bad at - they all have to produce something!

Absolute advantage

A country has an absolute advantage in producing a good over another country if it uses fewer resources to produce that good.
- E.g. if Saudi Arabia can produce corn and oil more efficiently than the US, but can only produce 100 barrels of oil or 25 bushels of corn, the opportunity cost for Saudi of producing one barrel of oil is the loss of 0.25 bushels of corn.
If the US lost a bushel of corn by producing one barrel of oil, then the US has a comparative, but not absolute advantage in corn.

Costs of international trade

Negative externalities such as pollution from freight.
Risk of structural/regional unemployment because employers relocate.
While international trade may benefit skilled workers, it can be bad for low-skilled workers.
Low-skilled workers in developed countries compete against extremely low wage workers worldwide, which is unsustainable.

Benefits of International Trade

Free trade is defined as “the free movement of goods and services cross-border between countries with no attempt from government to unfairly restrict imports from, or exports to, other countries.”

Improved allocative efficiency

Free trade improves allocative efficiency.
Free trade improves the efficiency of resource allocation because countries produce in sectors they are better suited to, rather than all goods and services.
The more efficient use of resources leads to higher productivity and increasing total domestic output of goods and services.

Higher global output

Comparative advantage theory states that, if countries specialise in goods and services, have a lower opportunity cost of producing than other countries, and engage in free trade, they have the possibility of achieving an allocation of resources outside their initial PPF.

Greater competition and choice

Free trade causes increased competition, which will lead to cheaper prices and higher consumer surplus.
The reduction in prices increases real incomes, increases purchasing power and allows more goods and services to be bought. So this increases standard of living.
Free trade brings down cost-push inflationary pressure.
Free trade increases choice. Free trade allows countries to consume bananas even if they don’t have the climate for it.

Economies of scale

Firms and countries can specialise in the production of a small range of good and services, and trade them with other countries.
Because firms can focus on producing a few goods and services, there is scope for more economies of scale, lower LRAC, lower prices, higher consumer surplus and increased demand for goods.