Theory of Comparative Advantage

Comparative Advantage. A country has a comparative advantage if it can produce a good at a lower opportunity cost than another country. A lower opportunity cost means it has to forego less of other goods in order to produce it.

In this example two countries, UK and India produce textiles and books

OUTPUT

Textiles

Books

UK

1

4

India

2

3

Total

3

7

 

 

 

 

 

 

 

  • For the UK to produce 1 unit of textiles, it has an opportunity cost of 4 books.
  • For India to produce 1 unit of textiles it has an opportunity cost of 1.5 books
  • Therefore India has a comparative advantage in producing textiles because it has a lower opportunity cost

Opportunity cost of producing books

If the UK produces a book, the opportunity cost is 1/4 (0.25)

If India produces a book, the opportunity cost is 2/3 (0.66)

  • Therefore the UK has a comparative advantage in producing books

(because it has a lower opportunity cost of (0.25 compared to India’s 0.66)

The theory of comparative advantage

  • If each country now specializes in one producing good then assuming constant returns to scale, output will double.

Output after specialisation

Textiles

Books

UK

0

8

India

4

0

TOTAL

4

8

  • Therefore output of both goods has increased illustrating the gains from comparative advantage.
  • The total output is now 4(T) and 8(B), which is higher than the previous totals.

In the real world, other issues may come into play. If India specialises in textiles, there may be economies of scale, which enable even bigger output.

The two countries can now trade. UK exports books, India exports textiles. There will be some costs of trade. But containerisation has helped reduce cost of trade.

This example shows, how in theory free trade can increase overall economic welfare.

There are many examples of comparative advantage in the real world e.g. Saudi Arabia and Oil, New Zealand and butter, USA and Soya beans, Japan and cars e.t.c

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