ECON111 Lecture Notes - Lecture 2: Barter, Opportunity Cost, Comparative Advantage
Specialisation and Trade
Comparative Advantage and Specialisation
Consider two countries which produce the same two products.
A country has an absolute advantage in a product if they can produce a greater quantity of the
product. In this example, Tom has an absolute advantage in the production of both coconuts and
fish.
A country has a comparative advantage in a product if they can produce at a lower opportunity cost
than the other country. Differences in opportunity cost arise from differences in productive
resources. This opportunity cost is calculated through the gradient. In this example, Tom has a
comparative advantage in the production of fish, while Hank has a comparative advantage in the
production of coconuts.
Note that while it is possible to have an absolute advantage in the production of both products, a
country can only have a comparative advantage in the production of one product. This is
independent of the actual numbers produced – because the ratio is inverted. If each country has
equal opportunity costs, then it is possible to have no comparative advantage.
Terms of Trade
Each country should specialise in the product that they have a comparative advantage and trade
with the other country. In this context, trade is barter and commodities are exchanged. In this
example, Tom should specialise in fish, and Hank should specialise in coconuts.
To trade, we must first decide the terms of trade, which is in terms of opportunity cost. Country B
will pay country A more than the opportunity cost of producing of that good, but less than it would
cost country B to produce that good. So, both countries profit. The actual price depends on the
bargaining power and political power of both countries.
In this example, it costs Tom 0.75 coconuts to produce one fish, and Hank 2 coconuts to produce 1
fish. Therefore, the price of the fish should be between 0.75 and 2 coconuts. Let 1 fish = 1.5 coconut
But as soo as youe hose the pie of oe good, youe ipliitly chosen the price of the other,
as they are inverses of each other. So 1 coconut = 0.66 fish.
Expanding the PPF
Now value what you have produced according to the terms of trade and draw the new PPF.
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You ill otie that the podutio of the othe good has ieased eause of trade. The new
expanded line is called the trade line. Therefore, if you specialise in your comparative advantage and
you trade, you can expand your production possibilities.
But there is a limit to the e tade lie, as outies hae a liit to how much they can produce.
For example, Hank cannot produce more than 20 coconuts.
With this e liit da i, e hae the osuptio possiilities fotie CPF.
Dynamic Comparative Advantage
At any given point in time, the resources and technologies available determine the comparative
advantages that nations have. But just repeatedly producing a particular good makes that nation
more productive in that good. This is a phenomenon called learning by doing, which is the basis of
dynamic comparative advantage.
Limitations
Theoretically in trade, both countries can increase their consumption, but in the short term, certain
industries will suffer.
Two conditions for gains of trade to work:
• The transaction and transportation costs must be very low (e.g. small distance to work).
Transaction costs (such as tariffs, licensing, taxes etc.) can be increased by government to
restrict trade.
• The selles podut is of opaale uality to the uyes o podut
Otherwise, the gain might not be as large.
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Document Summary
Consider two countries which produce the same two products. A country has an absolute advantage in a product if they can produce a greater quantity of the product. In this example, tom has an absolute advantage in the production of both coconuts and fish. A country has a comparative advantage in a product if they can produce at a lower opportunity cost than the other country. Differences in opportunity cost arise from differences in productive resources. This opportunity cost is calculated through the gradient. In this example, tom has a comparative advantage in the production of fish, while hank has a comparative advantage in the production of coconuts. Note that while it is possible to have an absolute advantage in the production of both products, a country can only have a comparative advantage in the production of one product. This is independent of the actual numbers produced because the ratio is inverted.
