Comparative advantage exists when a country or entity can produce a particular good or service at a lower opportunity cost than another country or entity.
The principle of comparative advantage is a fundamental concept in international trade theory. It posits that global output and welfare can be maximised when countries specialise in producing the goods and services for which they have a comparative advantage. They then trade these specialised goods with other countries.
Opportunity cost refers to the value of the next best alternative forgone when a choice is made. In the context of comparative advantage, it is the amount of one good that must be given up to produce an additional unit of another good.
By specialising, countries can produce more efficiently, leading to lower average costs and potentially lower prices for consumers. This specialisation and subsequent trade allow countries to consume a greater variety and quantity of goods and services than they could if they each tried to produce everything domestically.
Consider an example with two countries, Thailand and Mexico, producing corn and sugar:
Before specialisation, the production possibilities for each country might be:
To determine comparative advantage, we calculate the opportunity cost for each good in each country:
- In Thailand, producing 1 tonne of corn requires giving up 0.5 tonnes of sugar.
- In Mexico, producing 1 tonne of corn requires giving up 2 tonnes of sugar.
Therefore, Thailand has a comparative advantage in corn production as its opportunity cost for corn (0.5 tonnes of sugar) is lower than Mexico’s (2 tonnes of sugar). Conversely, Mexico would have a comparative advantage in sugar production.
For mutually beneficial trade to occur, the terms of trade (the ratio at which goods are exchanged) must lie between the opportunity cost ratios of the two countries. For instance, an exchange rate of 1 tonne of sugar for 1.5 tonnes of corn would benefit both nations. Thailand would gain more sugar than it would have to give up domestically for corn, and Mexico would gain more corn than it would have to give up domestically for sugar.
After specialisation according to comparative advantage and subsequent trade, both countries can achieve consumption levels beyond their individual production possibilities frontiers:
This outcome demonstrates how comparative advantage facilitates increased efficiency and greater overall economic welfare through international trade.