Definitions
Absolute advantage occurs when one country can produce a particular good at a lower cost compared to another country.
Comparative advantage occurs when one country can produce a particular good at a lower opportunity cost than another country.
How to find which country has the comparative advantage
In summary:
- Numerical method – to calculate the opportunity cost of producing good X, calculate the maximum output of good Y divided by the maximum output of good X for a particular country.
- Graphical method – whichever country has the steeper PPF has the comparative advantage in producing the good on the vertical axis.
Approach 1: numerical example
Here is a table showing the maximum possible production of two goods in two countries:
| Maximum possible production [if all factors of production are allocated to that task in trillions of US$] | UK | Spain |
| Oranges | 1 | 1 |
| Apples | 4 | 2 |
To calculate the opportunity cost of producing good X, calculate (maximum output of good Y) divided by (maximum output of good X) for a particular country.
In this example, to calculate the opportunity cost of producing oranges, find Maximum output of applesMaximum output of oranges for each country.
| Maximum possible production [if all factors of production are allocated to that task in trillions of US$] | UK | Spain | Comparative advantage |
| Oranges | 1 | 1 | |
| Apples | 4 | 2 | |
| Opportunity cost of producing oranges | 4/1 = 4 apples | 2/1 = 2 apples | To produce 1 (more) orange, Spain has to give up fewer apples. So Spain has the medicines in oranges. |
| Opportunity cost of producing apples | ¼ = 0.25 oranges | 1/2 = 0.5 oranges | To produce 1 extra apple, the UK has to give up fewer oranges. So the UK has the comparative advantage in apples. |
Approach 2: using the graph
Consider the same data as above but in graphical form. See the graph below:
- The (magnitude of the) slope of the PPF represents the opportunity cost of producing oranges. To produce 1 orange, the UK has to give up 4 apples. Meanwhile, Spain has to give up only 2 apples.
- The UK PPF is steeper than the PPF for Spain. So the UK has a greater opportunity cost of producing oranges. So Spain’s comparative advantage is in producing oranges (while the UK’s comparative advantage is in producing apples).
Here is a general rule:
- Whichever country has the flatter PPF has the comparative advantage in producing the good on the horizontal axis.
- [Or the country with the steeper PPF has the comparative advantage in producing the good on the vertical axis].
In this case, Spain has the flatter PPF. So it has a lower opportunity cost of producing oranges. So Spain’s comparative advantage is in producing oranges.
The gains from trade in the context of comparative advantage
Consider the numerical example for comparative advantage given previously.
The conclusion of the previous exercise was that Spain had a comparative advantage in producing oranges, while the UK had a comparative advantage in producing apples.
The theory of comparative advantage states that to maximise social welfare, countries should specialise in the goods in which they have comparative advantages.
So Spain should produce only oranges. The UK should produce only apples. This means that combining Spanish and UK production, there are a total of 4 apples produced and 1 orange produced.
Next, suppose the UK agrees to give Spain 1.5 apples in exchange for 0.5 oranges.
- Then Spain has 1.5 apples and 0.5 oranges.
- Meanwhile the UK has 2.5 apples and 0.5 oranges.
- These allocations put both countries outside each of their domestic PPFs.
- In other words, specialising in one good, then exporting that good to trade in exchange for importing another good to consume, is more efficient than directly producing the good you want to consume.
The limitations of the theory of comparative advantage
The limitations of the theory of comparative advantage include:
- Comparative advantage implies that countries should specialise in goods according to their comparative advantage. However specialisation exposes the economy to the risk that demand for the specialised good will suddenly drop. This would cause a significant fall in workers’ wages and the real GDP.
- Assumes only two countries and two goods. In the real world there are many different goods being traded and by many different countries..
- No tariffs/protectionism. If there are protectionist measures in place, there may not be gains from trade.
- Assumes no transport costs. Particularly for island or geographically isolated economies, transport costs may be significant.
- Assumes perfect factor (e.g. labour) mobility between sectors. In practice there is likely to be diminishing marginal returns to moving labour into a new sector. Workers cannot easily move to a new sector to exploit comparative advantage – this is likely to lead to structural unemployment.
- Assumes the countries are willing to trade but in practice poor international relations may stop this.
What are the UK’s comparative advantages?
What are examples of comparative advantage for the UK?
Based on the measure of “revealed comparative advantage”, the UK has a comparative advantage in the following sectors:
- Financial and insurance activities.
- Arts, entertainment, recreation and other service activities.
- Publishing and broadcasting.
- Education.
- Telecommunications.
Note this is based on very old data (no easy-to-find more recent release exists at the time of writing). See this source from BIS (2012).
How to find which country has the absolute advantage
A country has the absolute advantage when it can produce a good at a lower cost than another country.
In other words, a country that can produce more units of a good with the same inputs has the absolute advantage.
In the numerical example above, the UK had the absolute advantage in producing apples (4 > 2).
Specialisation and trade
The theory of comparative advantage suggests that countries should specialise in goods and services where they have comparative advantages, then trade with other countries.
More broadly, what are the advantages and disadvantages of specialisation and trade?
Advantages:
- Comparative advantage and gains from trade (see above).
- Economies of scale from specialisation. Producing only one good may allow firms to lower their long-run average costs, which can be passed on to consumers in the form of lower prices.
- Welfare gains from trade compared to autarky or protectionism (see the section on showing the welfare gain from trade).
- Intuitively free trade may increase competition. By forcing domestic firms to compete with foreign firms, costs and prices may fall. This leads to higher consumer surplus.
- Free trade allows firms to access new markets where firms can sell exports. This leads to higher demand for their products, increasing profits.
Disadvantages:
- Dependency on producing only one good makes the economy vulnerable to external falls in demand for that individual product. An economy’s lack of diversification increases the risk of a severe downturn.
- This may result in structural unemployment.
- Free trade creates winners and losers and may increase inequality.
- For instance, increased competition from firms abroad could reduce demand for manufactured goods in developed economies like the US and UK.
- This could contribute to deindustrialisation.
- Specialisation could reduce choice as fewer countries produce their unique varieties of the good.
- Specialisation could reduce competition. If only one country produces a particular good, that country could use its market power to raise prices. This would make consumers worse off.
Showing the welfare gain from free trade using a trade diagram
Here I show the welfare gain from free trade. This analysis uses a trade diagram with the world supply curve.
[Note you can also show the welfare gain from trade using a tariff reduction diagram.]
Start from autarky (no trade)
In this case:
- The market equilibrium is where domestic supply meets domestic demand at quantity qA and price pA.
- Social welfare is the sum of consumer surplus (CS) and producer surplus (PS).
With free trade
- Now suppose the economy opens up to trade with the rest of the world. This means the country can import goods from the rest of the world (world supply).
- The price is now the world price pw.
- At price pw, consumer demand is q1. Domestic supply is q. The difference, q1-q, is imported from the rest of the world.
- Consumer surplus increases to the red area. Meanwhile producer surplus decreases to the blue area (compared to autarky).
Overall welfare gain from opening up to trade.
- The increase in social welfare (consumer surplus + producer surplus) from opening up to trade with the rest of the world is the green shaded area below.
- This comes from comparing the sum of CS and PS in the two diagrams prior.
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