Comparative advantage
Opportunity cost
To determine whether trade between Portugal and England would be beneficial, we must first think about how much it costs for each of them to produce each good in terms of the other good. In other words, what is the relative price of a bottle of wine in terms of meters of cloth, and vice-versa? Economists call this an opportunity cost: what are they giving up to produce one good instead of the other?
To calculate the opportunity costs, it is necessary to bring back the production table:
| Production if the entire labor force produces only one good | |
|---|---|
| Portugal | 1,000 bottles of wine or 2,000 meters of cloth |
| England | 1,250 bottles of wine or 3,750 meters of cloth |
How many bottles is Portugal giving up when it decides to produce one meter of cloth instead? Divide the number of bottles Portugal can produce with 100% of its labor by the meters of cloth it can produce with 100% of its labor. In this case, it gives up half a bottle of wine per meter of cloth. We can calculate the other opportunity costs, represented in the following table:
Opportunity costs
| Opportunity cost of cloth: bottles of wine per meter of cloth |
Opportunity cost of wine: meters of cloth per bottle of wine |
|
|---|---|---|
| Portugal | \(\dfrac{1,000}{2,000} = \dfrac{1}{2}\) | \(\dfrac{2,000}{1,000} = 2\) |
| England | \(\dfrac{1,250}{3,750} = \dfrac{1}{3}\) | \(\dfrac{3,750}{1,250} = 3\) |
When the maximum amount of cloth or wine a country can produce changes, so does its opportunity cost. Adjust the numbers in this table to observe how the tradeoffs shift. This table and all of the following tables report data with two decimal points of precision:
Adjustable opportunity costs
Comparative advantage
Portugal is giving up the production of one-half of a bottle of wine to produce one meter of cloth. England is giving up the production of one-third of a bottle of wine to produce one meter of cloth. For England, the opportunity cost of making cloth in terms of wine foregone is lower. However, with wine production, it is the other way around. Portugal gives up 2 meters of cloth to make one bottle of wine while England must give up 3 meters.
Even though England has an absolute advantage in both goods, Portugal has a comparative advantage in wine because its opportunity cost for producing wine is lower than England’s—it can produce more wine for each meter of cloth given up. England has a comparative advantage in cloth for the same reason.
Exercise
Consider the case of a world economy consisting only in Italy and Spain. They both produce olive oil and oranges, but their productivity differs. Italy can produce 100 liters of olive oil or 500 oranges if it devotes all its time to one good, while Spain can produce 80 liters or 600 oranges. Who has the comparative advantage in producing oranges?
- Think about how to calculate comparative advantage in producing oranges. Who gives up the least oranges when producing one liter of olive oil?
- Spain has a comparative advantage in oranges and Italy has a comparative advantage in olive oil. To produce one liter of olive oil, Spain gives up 7.5 oranges while Italy only gives up 5.
- Two countries can not both have the comparative advantage in producing a good - remember that comparative advantage is being better relative to the other country.
- Think about how to calculate comparative advantage in producing oranges. Who gives up the least oranges when producing one liter of olive oil?