Free Trade and Protection
Principles of Comparative Advantage Explained
The principle of comparative advantage states that if countries specialise and produce goods or services to which they have a comparative advantage in, and trade their surplus, they will be better off by consuming more goods and services.
Let's go back to our example of Iron ore and Cars with Australia and China.
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If both countries are self-sufficient, they will produce both goods. We'll assume they produce and consume in the following pattern.
China will produce 20 iron ore and 75 cars.
Australia will produce 40 iron ore and 21 cars.
World production will total 60 iron ore and 96 cars.
As Australia has a lower opportunity cost in iron ore, hence a comparative advantage, it should specialise in the production of iron ore. As China has a lower opportunity cost in cars, hence a comparative advantage, it should specialise in the production of cars.
After specialisation, we see China produces 0 iron ore and 100 cars, while Australia produces 70 iron ore and 0 cars. World production of iron ore is 70 while production for cars is 100. Both countries can now exchange their surpluses.
An exchange rate needs to be decided. The exchange rate must satisfy the opportunity costs of both countries.
As Australia specialises in iron ore, they will want to export iron ore for more than 0.71 cars while China, will want to import iron ore for less than 1.25 cars.
An exchange rate for 1 unit of iron ore must be between 0.71 to 1.25 cars.
Vice Versa, China will want to export a car for more than 0.8 iron ore while Australia will import a car for less than 1.4 iron ore.
In this example, we will use the exchange rate of 1 iron ore = 1 car as it satisfies all requirements.
Using the 1 iron ore = 1 car exchange rate, China trades 25 of its surplus cars for 25 units of iron ore. As a result, Australia receives 25 cars in exchange for 25 of its iron ore.
Despite China having an absolute advantage in both goods, based on comparative advantage both countries benefit from trade with China receiving an additional 5 units of iron ore, while Australia receives 5 additional units of iron ore and 4 additional units of cars.
Of course, this theory assumes there are no costs or barriers to trade. The real effect of trade will be undermined by factors such as:
Protectionism - e.g. tariffs