Sunday, June 12, 2011

Comparative Advantage

An important concept in economics is comparative advantage. It helps to illustrate the importance of trade between countries. Though one country may produce a number of goods more efficiently and at a lower cost than another, it is beneficial to trade if the other country has a comparative advantage.

Imagine that countries A and B both produce tractors and wheat. However, the number of hours needed to produce them is different in both countries. For one tractor, Country A needs 12 hours and Country B needs 4. For one tonne of wheat, Country A needs 4 hours and Country B needs 2. Here is a chart to summarize:

Country A tractor- 12 hours wheat- 4 hours
Country B tractor- 4 hours wheat- 2 hours

By comparing these numbers, it is clear that Country B can produce both tractors and wheat in less time than Country A. In other words, Country B is more efficient in the production of these goods and can produce both at a lower cost. It may thus seem that it is unnecessary for Country B to trade these goods with Country A.

However, trade is beneficial because the ratios spent on the production of the two goods are different in the two countries. If we compare opportunity cost, we notice that it is beneficial for both to specialize in the good which they produce most efficiently.

What does Country A give up if it produces a tractor? For every tractor that Country A produces, it gives up the opportunity to produce 3 tonnes of wheat.

What does Country B give up if it produces a tractor? For every tractor that Country B produces, it gives up the opportunity to produce 2 tonnes of wheat.

Likewise, we can also analyze what each country gives up in tractor production to produce one tonne of wheat. What does Country A give up if it produces one tonne of wheat? It gives up the opportunity to produce 1/3 of a tractor.

What does Country B give up if it produces one tonne of wheat? It gives up the opportunity to produce 1/2 a tractor.

It is clear that when the two countries produce tractors, Country A gives up more in wheat production. However, when the two countries produce wheat, Country B gives up more in tractor production. It is clear that trade can benefit both countries. Country A should specialize in wheat production and Country B should specialize in tractor production.

Though Country A can produce both tractors and wheat at a lower cost than Country B, it is beneficial for the two countries to trade with one another. Country A has a tractor-wheat ratio of 3:1 but Country B has a tractor-wheat ratio of 2:1. Viewed in a different light, Country A has a wheat-tractor ration of 1/3 and Country B has a wheat-tractor ratio of 1/2.

Country A can focus on the good which it produces most efficiently, wheat, and trade it for tractors from Country B. Country B can focus on the good which it produces most efficiently, tractors, and trade them for wheat from Country A. As a result, both countries benefit.

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