Free Trade and Protection

Calculating Comparative Advantage

 

 
Absolute Advantage

A country is said to have an absolute advantage if it can produce a good or service more efficiently than another country.

Consider the world where there are only two countries, producing two goods - iron ore and cars. In the above table, China can produce 80 units of Iron Ore or 100 units of Cars, while Australia can produce 70 units of Iron Ore or 50 Units of Cars. China is said to have an absolute advantage in both iron ore and cars as it can produce more of both goods.

 

Comparative Advantage

Comparative advantage is a little more complicated. A country is said to have a comparative advantage if it produces a good or service with the lowest opportunity cost.

 

Calculating Comparative Advantage

To calculate comparative advantage, you have to calculate the opportunity cost of each good or service. 

 

Step 1: Calculate the Opportunity Cost of Each Good from Each Country.

We need to calculate the opportunity cost of 1 unit of iron ore from each country.

 

China's opportunity cost of 1 unit of iron ore.

China can produce 80 iron ore or 100 cars.

Therefore; 80 iron ore = 100 cars

We need to make it 1 iron ore, so we divide both sides by 80.

80 iron ore / 80 = 1 iron ore

100 cars / 80 = 1.25 cars

 

Hence, 1 iron ore = 1.25 cars

 

Australia's opportunity cost of 1 unit of iron ore.

Australia can produce 70 iron ore or 50 cars.

Therefore, 70 iron ore = 50 cars

We need to make it 1 iron ore, so we divide both sides by 70.

70 iron ore / 70 = 1 iron ore

50 cars / 70 = 0.71 cars

 

Hence, 1 iron ore = 0.71 cars

 

We now need to calculate the opportunity cost of 1 unit of cars from each country. This is just the same process as before, but with 1 unit of car instead.

 

China's opportunity cost of 1 unit of cars

China can produce 100 cars or 80 iron ore.

Therefore, 100 cars = 80 iron ore. 

We need to make it 1 car, so we divide both sides by 100.

100 cars / 100 = 1 car

80 iron ore /100 = 0.8 iron ore.

 

Hence, 1 car - 0.8 iron ore

 

Australia's opportunity cost of 1 unit of cars.

Australia can produce 50 cars or 70 iron ore.

Therefore, 50 cars = 70 iron ore.

We need to make it 1 car, so we divide both sides by 50.

50 cars /50 = 1 car

70 iron ore / 50 =1.4 iron ore

 

Hence, 1 car = 1.4 iron ore

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Step 2: Plot the opportunity costs on the Two Way Table

Step 3: Identify the Comparative Advantage

Comparative advantage is when a country can produce a good with the least opportunity cost. In this example, the opportunity for iron ore is 1.25 cars in China and 0.71 cars in Australia. As Australia has the lowest opportunity cost for iron ore, it, therefore, has a comparative advantage in the production of iron ore. 

 

If done correctly, China should have a comparative advantage in cars, as it is impossible for a single country to have a comparative advantage in both goods.

 

For cars, the opportunity cost for 1 unit of a car is 0.8 iron ore in China and 1.4 iron ore in Australia. Therefore, China has a comparative advantage in the production of cars.

 

Calculating Comparative Advantage for Inputs

If a two-way table showed the inputs, such as labour hours or cost to manufacture rather than production possibilities, than the comparative advantage is the one that has the highest comparative advantage. Consider the same example, but instead shows labour hours.

In this example, continue to calculate the opportunity cost as if it were production possibilities.

Except for this time, we're looking for the highest number, as we're measuring inputs rather than outputs. The lowest opportunity cost is one with the highest inputs

 

The opportunity cost of 1 labour hour of iron ore is 1.25 labour hours of car production in China and 0.71 labour hours of car porduction in Australia. As China has a larger figure, China has a comparative advantage in iron ore.

 

The opportuntiy cost of 1 labour hour of car production is 0.8 hours of iron ore production in China or 1.4 hours of iron ore porduction in Australia. As Australia has the higher figure, it has a comparative advantage in cars.

Now It's Your Turn

The production possibilities of wheat and rice are shown for Mexico and Vietnam. Calculate the opportunity costs to find out which country has an absolute and comparative advantage in the production of rice.

Answer: Vietnam has an absolute and comparative advantage in rice. 

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