Opportunity Cost and Comparative Advantage

The concept of opportunity cost and Comparative Advantage

  • The opportunity cost of producing something measures the cost of not being able to produce something else.
  • A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries.
  • A country with a comparative advantage in producing a good uses its resources most efficiently when it produces that good compared to producing other goods.

A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in another country

England:
Opportunity cost of producing

  • 1 unit of wine is 4 units of cheese
  • 1 unit of cheese is 1/4 units of wine.

Portugal:
Opportunity cost of producing

  • 1 unit of wine is 1/2 units of cheese
  • 1 unit of cheese is 2 units of wine.

The opportunity cost of producing wine in terms of cheese is lower in Portugal than in England (1/2<4), therefore Portugal has a COMPARATIVE ADVANTAGE in the production of wine.

Likewise, the opportunity cost of producing cheese in terms of wine is lower in England than in Portugal (1/4<2) so England has a COMPARATIVE ADVANTAGE in the production of cheese.

Let England and Portugal expand production in the direction of their comparative advantage.

OUTCOME

England reduces production of wine by 1 unit freeing 8 hours of labour which go on to produce an additional 4 units of cheese.

Portugal reduces the production of cheese by 1 unit freeing 4 hours of labour which go on to produce an additional 2 units of wine.

                                   Additional CHEESE                Additional WINE
ENGLAND                      +4                                        -1
PORTUGAL                     -1                                       +2
World                               +3                                       +1

Without using any additional resources the world output rises just following the simple rule of Comparative Advantage.

Question: If each country specialises in the good in which it has a comparative advantage and exports it in exchange for the other good would both countries be better off? Why?

Answer: Yes if the relative world price is right!!!

Example:
Assume that the Relative World Price: One unit of wine sells for one unit of cheese.

Portugal
With Trade: Gets 1 unit of cheese from England for 1 unit of wine.
Autarky: For 1 unit of wine Portugal could only get ½ unit of cheese.
Result: Better off!!!

England
With Trade: Gets 1 unit of wine from Portugal for 1 unit of cheese.
Autarky: For 1 unit of cheese England could only get 1/4 unit of wine.
Result: Better off!!!

Remarks
1. The principle of comparative advantage predicts the pattern of trade and the gains from trade on the basis of relative prices in autarky (opportunity cost).
2. If a country trades at relative prices that differ from its relative autarky prices, then the country will be better off as a result of trading.

Assume that consumers trade at a new relative price that differs from the autarky price → New Equilibrium
A country will export the good which relative price under autarky is smaller than under trade.