Comparative Advantage Definitions Absolute advantage a country can

Comparative Advantage

Definitions � Absolute advantage: a country can produce a good relatively more efficiently than another country (example: U. S. better at oranges than Canada) � Comparative Advantage: a country can produce a good relatively more efficiently than another good in comparison with another country � Applies to people as well as to countries

Numerical example: Output per day of work Shoes Phone Country 1 6 3 Country 2 1 2

Find who has a comparative advantage in what � Country 1 has an absolute advantage over Country 2 in both shoes and phones ◦ for shoes 6>1, for phones 3>2 � Country shoes 1 has a comparative advantage in ◦ 6/1 is greater than 3/2 � Country phones 2 has a comparative advantage in ◦ 2/3 is greater than 1/6

Can define comparative advantage in terms of opportunity costs � Definition: If country A has a lower opportunity cost of producing a good, then it has a comparative advantage in that good compared to country B � Example. Opportunity cost of producing a phone in Country 1 is 2 shoes while it is only 1/2 shoes in Country 2 ◦ Hence, Country 2 has the comparative advantage in phones

Gains from Trade � Two countries can gain from trade based on comparative advantage. ◦ To see this, assume that the price with trade is 1 unit of shoes for 1 phone � How ◦ ◦ can the Country 1 gain from trade? reduce phone production by 3 increase shoes production by 6 trade with Country 2 for 6 phones come out ahead by 3 phones

Country 2 can also gain from trade ◦ ◦ increase phone production by 6 reduce shoes production by 3, trade with Country 1 for 6 shoes come out ahead by 3 shoes

Determining the price ratio before trade � Country 1 ◦ in the Country 1, 6 shoes cost the same to produce as 3 phones ◦ Thus, phones should cost twice as much as shoes ◦ Pphone / P shoes = 2 � Country 2 ◦ in Country 2, 2 phones cost the same to produce as 1 shoe ◦ Thus phone should cost half as much as shoes ◦ Pphone / P shoe = 1/2

Determining the price ratio after trade � Price ratio must come together somewhere between 2 and 1/2 � We cannot tell exactly what the price ratio will be; ◦ it depends on demand � For ease of multiplication, we therefore assume that the price ratio is 1 ◦ that is, Pphone / P shoes = 1

Comparative Advantage and Production Possibilities Curves (10, 000 workers in Country 1 and 30, 000 in Country 2) Shoes (1000) Production possibility curve without trade 60 Production possibility curve with trade 30 20 15 30 Country 1 60 Phone (1000) 15 30 Country 2 60 Phone (1000)

Revealed comparative advantage In practice comparative advantage is very difficult to measure. So instead we use RCA. � Balassa's (1965) measure of relative export performance by country and industry, defined as a country's share of world exports of a good divided by its share of total world exports. � RCAij is revealed comparative advantage of country i in product j. � Xij and Xi represent country i’s exports of product j and total exports. �

Revealed comparative advantage RCAij=(5/500)/(200/40000)=2 World 5 500 B Exports 40, 000 200

Specialization Index � Another measure of comparative advantage