3.1 A2 HL
Comparative Advantage and Trade
What determines greater efficiency
or lower costs?
Costs of production varies between countries
because of “factor endowments” – types of factors of
production a country is “gifted” with.
Task:
Think of a country’s 2 or 3 major exports
• Research the relevant factor endowments
A Parable for comparative advantage

Imagine . . .
only two goods: potatoes and meat
only two people: Mr. Jones and a Mrs. Choi

Should they each produce for their own
needs or should they trade?
Who is most efficient at each product?
Would you think there’s a good reason to trade?
Jones
Choi
Hours Needed to Make 1 lb. of:
Meat
Potatoes
20 hours/lb
10 hours/lb
10 hours/lb
8 hours/lb.
Amount Produced in 40 Hours
Meat
Potatoes
2 lbs.
4 lbs.
4 lbs.
5 lbs.
The producer that requires a smaller quantity of
inputs (in this case, hours of labour) to produce a
good is said to have an absolute advantage in
producing that good. Does that mean Mrs. Choi
has no reason to trade?
Consider Mr. Jone’s Production – and
consumption – Possibilities Frontier
Meat
(pounds)
2
1
0
A
2
4
Potatoes (pounds)
Mrs. Choi’s Production – and consumption –
Possibilities Frontier
Meat
(pounds)
4
B
2
0
2.5
5 Potatoes (pounds)
Compare the Opportunity Cost for each person
producing Meat and Potatoes
1 lb. of Meat
1lb. Of Potatoes
Mr. Jones
2 lb. potatoes
0.5 lb. meat
Mrs. Choi
1.25 lb. potatoes
0.8 lb. meat
The producer who has the smaller opportunity cost
of producing a good is said to have a comparative
advantage in producing that good.
Who has the comparative advantage for
a) meat
b) potatoes?
The Gains from Trade:
Suppose the “terms of trade” is 0.66 Lbs. of meat = 1 Lbs. of Potatoes
[see the table for how much each person has gained]
Can you show the new “consumption frontier” for each person?
That’s why it’s good to trade even for Mrs. Choi!
The Outcome With Trade:
What They
What They
Trade
Produce
What They
Consume
1.3 lbs meat (A*)
2 lbs potatoes
Jones
0 lbs meat
4 lbs potatoes
Gets 1.3 lbs meat
for 2 lb potatoes
Choi
4 lbs meat
0 lbs potatoes
Gives 1.3 lbs meat 2.7 lbs meat (B*)
2 lbs potatoes
for 2 lb potatoes
Limitations of the theory
To what extent are these assumptions valid?
• there is perfect knowledge of cheapest
products
• No cost is involved for transportation
• Only 2 countries that trade
• costs do not change, there are no EoS
• The goods traded are identical
• FoP remain in the country
• Trade is perfectly free
The Limitations of the Theory
1.
2.
3.
4.
Transport costs and tariffs will change the relative prices of
goods and may therefore 'blur' the impact of comparative
advantage.
Exchange rates do not always relate exactly to what
comparative advantage theory suggests as they have many
other determinants - this may also negate the theory.
Imperfect competition may lead to prices being different to
opportunity cost ratios. Imperfect competition may also lead to
the exploitation of economies of scale which may adjust to
what comparative advantage theory suggests should happen.
Comparative advantage theory is a static theory and does not
take account of some of the more dynamic elements
determining world trade. In particular, the factor of production
capital is not a natural resource, and so may come outside the
scope of the theory.