Comparative Advantage, Absolute Advantage, and Terms of Trade
Updated 12/20/2016 Jacob Reed
A fundamental goal of economics is the efficient use of resources. Using the concept of comparative advantage to guide the use of resources can help with that end. The Advanced Placement Economics Exam usually has a few questions about comparative advantage in the multiple choice section and it appears on both the microeconomics and macroeconomics exams so it is an important for students to review. Below you will find a run-down of absolute advantage, comparative advantage and terms of trade are and how to apply them along with a 6 problem review game containing 48 questions.
Absolute Advantage: is the ability of one entity to produce more of a good or service with fixed resources (or the same amount with less resources) than another entity. For example, if Katrina can type 6 pages in an hour and Davis can type 8 pages in an hour, Davis has an absolute advantage in typing because he can produce more than Katrina. But if Katrina can mow a lawn in 15 minutes but it takes Davis 20 minutes to mow that same lawn, then Katrina has an absolute advantage in mowing lawns because she can mow a lawn using fewer resources (minutes of labor). Absolute advantage is a term you need to understand and remember (it is usually on the exam), but it isn’t very helpful in determining how resources should be used. To determine how resources should be used comparative advantage is needed.
Comparative Advantage: is the ability of one entity to produce a good or service at a lower opportunity cost than another entity. When it comes to calculating opportunity cost there are 2 methods; depending on if you are looking at outputs (with fixed inputs) or inputs (with fixed outputs).
While David has the absolute advantage for both goods (able to produce more of both outputs), that fact isn’t relevant when determining comparative advantage. Determining comparative advantage requires calculating the opportunity costs. When calculating opportunity costs with Outputs, use the “Other Over” formula (output and other both start with “O”). The “Other Over” formula is:
OC of 1 A = B/A of B
So the opportunity cost of Cakes is Pies (the other one) divided by Cakes. Using the numbers from the PPC’s above, the opportunity costs are found below:
Opportunity cost of 1 pie = 2/4 cakes = 1/2 cakes
Opportunity cost of 1 cake = 4/2 pies = 2 pies
Opportunity cost of 1 pie = 4/6 cakes = 2/3 cakes
Opportunity cost of 1 cake = 6/4 pies = 1 1/2 pies
Based on the calculations above, William can produce a pie with an opportunity cost of 1/2 a cake but David has an opportunity cost of 2/3 a cake every time he makes a pie. William therefore, has the comparative advantage for pies. For cakes, William has an opportunity cost of 2 pies and David has an opportunity cost of 1 1/2 a pies. Since David gives up fewer pies every time he makes a cake, he has the comparative advantage for cakes. As a result, David should specialize in the production of cakes while William should specialize in the production of pies.
Note: the numbers found in the PPC’s above could also be displayed in a chart like the one below. The method for displaying the numbers doesn’t change anything. The key to deciding if you should use the Other Over formula is determining if the numbers are outputs. Since cakes and pies are what come out of the production, these are outputs.
Inputs: Take a look at the chart below with a new example. In this example, the numbers have been switched to inputs. Instead of how many cakes and pies they could each make in an afternoon (pies and cakes are outputs), the numbers are minutes it takes each of them to produce 1 cake or 1 pie. Since minutes of labor are an input into the production of each product, a different formula is required.
Based on these numbers, one can see David still has the absolute advantage for each good because he can produce pies and cakes with fewer inputs (fewer is better with inputs). To calculate opportunity costs for comparative advantage when Inputs are given, use the “It Over” formula (input and it both start with “I”). The “It Over” formula is:
OC of 1 A = A/B of B
So the opportunity cost of Cakes is Cakes (it) divided by pies. Using the numbers from the PPC’s above the opportunity costs are found below:
Opportunity cost of 1 pie = 60/120 cakes = 1/2 cakes
Opportunity cost of 1 cake = 120/60 pies = 2 pies
Opportunity cost of 1 pie = 30/45 cakes = 2/3 cakes
Opportunity cost of 1 cake = 45/30 pies = 1 1/2 pies
Based in the opportunity costs above William can produce pies at a lower opportunity cost (1/2 cakes <2/3 cakes) so he has a comparative advantage for pies. David, on the other hand, can produce cakes at a lower opportunity cost (1 1/2 pies<2 pies) so David has the comparative advantage for cakes.
Terms of Trade: If William and David specialize in the goods for which they have a comparative advantage, then trade, they would be able to exceed their own production possibilities (consume outside their own PPC curves). Terms of trade is the rate at which one good could be traded for another. Terms of trade for a good (that benefit both entities) will fall between each entities opportunity costs. In the example above William could produce 1 pie with an opportunity cost of 1/2 a cake and David can produce 1 pie with an opportunity cost of 2/3 of a cake. If William and David specialize then trade, they will agree to trade 1 pie for between 1/2 and 2/3 of a cake. Likewise, they will trade a cake for between 1 1/2 pies and 2 pies.
If the terms of trade fall outside the relative opportunity costs, one entity will benefit while the other will not. If 1 cake traded for 3 pies, for example, that would benefit David because he would have to give up 2 cakes if he wanted to make 3 pies himself (3 times his opportunity cost of 2/3 cakes), so only giving up 1 cake is good for him. These terms would however hurt William because he can make 1 cake himself and only lose 2 pies (his opportunity cost for making 1 cake) so losing 3 pies to get a cake would not help him. As a result, William and David would not likely trade if 1 cake was worth 3 pies.