Comparative Advantage

Figs and Peaches

Two fruits which until today I have rarely regarded important to my life, and more so important to understanding economics. But today I was humbled by the simplicity of fruit and trade. No I didn’t walk to a supermarket and compare the prices of what is ultimately the same fig or peach at varying price levels. I sat down in a classroom and considered the opportunity cost in the production of peaches or figs, within the scenario of being on an island which exclusively produces figs or peaches (i.e. a nation capable of trade).

The premise of what seemed like an amiable task, turned out to reveal the essence of trade and the benefit gained from engaging in trade. The simple definition of trade is the exchange of goods between two parties, but the real question to ask is what motivates us to trade?

Now as I am meandering my way into the topic of trade, and its benefits I must bring forward what has become an economic cliché of mentioning Adam Smith’s thoughts on the matter. Obviously, he was not the first to consider aspects of trade but it was his critique of Mercantilism alongside his development of what was to become the explanation for the need to trade. This extract summarises the basis of what was going to become the critique of mercantilism and the purpose of trade:

If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage. The general industry of the country, being always in proportion to the capital which employs it, will not thereby be diminished, no more than that of the above-mentioned artificers; but only left to find out the way in which it can be employed with the greatest advantage.”

Adam Smith, The Wealth of Nations Book IV, Chapter II

Here, Smith notes the existence of a trade-off that benefits both parties involved. As the terms of trade are established in order to allow two nations who have specialised in the production of a given good to gain an advantage. The critique of mercantilism is clearer in David Hume’s use of the bullion example, which was in essence a supply of money issue. But Smith highlights the mercantilist’s inability to recognise absolute and comparative advantage. The final remark suggests that Smith was thinking in terms of what we would now consider a Production Possibility Frontier (PPF) in which trade will allow us to operate at a point outside of our original output.

Significantly, Smith had developed what was to become classical economics based on a Laissez-Fair approach, which encouraged free trade (removal of tariffs, and protectionism). However, it was not until the early 19th century when David Ricardo had begun to build up the theory of comparative advantage which facilitated the need for free trade and the benefits of trade even when a country has an absolute advantage in the products being traded.

Comparative Advantage:
“A country can produce a good at a lower opportunity cost than its direct competitor”

Absolute Advantage:
“A country is able to produce more of a good or service with the same amount of resources”

Now back to the figs and peaches, firstly it is important to establish why a country would be able to produce a product “better” than its competitor. This is where the factor of endowment comes into place; in accordance with this example it can take the form of an investment into human capital in order to educate the workforce so they know the correct growing conditions for peaches or figs.

Let’s assume that the islands are producing the following goods in the amounts stated, where they will specialise in the production of one good as they cannot maximise the production of both at the same time.

Picture1

Opportunity Cost:

If country A produces 300 peaches it gives up 600 figs, and if it produces 600 figs it gives up 300 peaches. Providing the ratios:

1 Fig – ½ Peach
1 Peach – 2 Figs

If country B produces 100 peaches it gives up 300 figs, and if it produces 300 figs it gives up 100 peaches. Providing the ratios:

1 Fig – ⅓ Peach
1 Peach – 3 Figs

So should there be trade?

Well, first who should export figs or peaches and who should import figs or peaches.

Country A has a lower opportunity cost in the production of peaches in comparison to country B, therefore, Country A should produces peaches as the only lose 2 figs per peach. So A has a comparative advantage in the production of peaches.

Country B has a lower opportunity cost in the production of figs in comparison to Country A, therefore Country B should produce figs as they only lose a 1/3 of a peach per fig. So B has a comparative advantage in the production of figs.

Terms of Trade:

Country A should trade 1 peach for between 2 figs & 3 figs. Below 2 figs they can produce it more effectively themselves, but above 3 country B can produce peaches themselves.

Country B should trade 1 fig for between ⅓ peach & ½ peach. Below ⅓ peach they can produce it more effectively themselves, but above ½ country A can produce figs themselves.

So the (approximate) terms will be:

1P: 2.5F for Country A
&
1F: 0.4P for Country B

This identifies the direct benefit of trade as the ability to go beyond the country’s original PPF, as now Country A can have approximately 150 more figs than before, and Country B can have approximately 20 more peaches. Even though Country A has an absolute advantage in the production of both peaches and figs, the differing comparative advantage means there is still a benefit to trade.

Is this the best model?

Well, not really. It is clear there are some major flaws in this ultimately very simply model of how trade occurs. Firstly, it can be noticed that once a third country is involved a different formulation is necessary, and the existence of a large range of goods makes it difficult to have a clear trade-off. Secondly, the model is based on the immobility of capital, of which we are living in a world where capital is increasingly mobile. Finally, the model would suggest that agrarian nations would remain agrarian thereby not developing but specialising in natural resource production, this would create a larger technological gap and also led to an increasing inequality gap between nations. One alternative is the competitive advantage model, but it fails to provide an outlook on the trade-off and opportunity cost, and has a greater dependence upon the assumption that labour and natural resources are abundant and don’t necessarily effect the economy.

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