Comparative Advantage and the Incentive to Trade
What is the fundamental force that drives international trade (or any trade for that matter)? Comparative advantage. Comparative advantage is also cause of productive specialization. Let’s see why using an example.
Assume that France only produces wine and cheese. They currently consume all of the wine and cheese that they produce. Given their current resources, the French can produce 36 million gallons of wine or 9 million pounds of cheese per year or a combination of the two goods. For simplicity, assume that France’s PPF is linear.
France’s PPF will look as follows:
This PPF can also be written in equation form:
Wine = 36 – 4*Cheese
Recall that the opportunity cost of cheese is the slope of the PPF (constant in this example). From the equation above, we can see that the slope of the PPF is –4. Therefore, the opportunity cost of producing one more pound of cheese is 4 gallons of wine. We can easily calculate the opportunity cost of wine by taking the reciprocal of the opportunity cost of cheese. So, the opportunity cost of wine is ¼ pound of cheese.
Because we are talking about international trade, we need to throw a trading partner into the mix. Let’s pick Germany. The German people also produce wine and cheese. They can produce 16 million gallons of wine or 8 million pounds of cheese or a combination of the two. Again, we will assume a linear PPF that looks like this (next page):
This PPF can be written as an equation as well:
Wine = 16 – 2*Cheese
Therefore, the opportunity cost of one pound of cheese is two gallons of wine and the opportunity cost of one gallon of wine is ½ pound of cheese.
In summary,
Country / Opp. Cost Cheese / Opp. Cost WineFrance / 4 gal wine / ¼ lbs cheese
Germany / 2 gal wine / ½ lbs cheese
In terms of opportunity cost, cheese is cheaper to produce in Germany and wine is cheaper to produce in France. This means that Germany has a comparative advantage in the production cheese and France has a comparative advantage in the production of wine.
As a side note, think about the two PPF’s drawn together:
Notice that the PPF for France lies completely above the PPF for Germany. What does this mean? It simply means that France has more resources to make more wine and more cheese than Germany. In other words, France has an absolute advantage in the production of both goods. Does this mean that France and Germany will not trade? Absolutely not. To determine the ability of two countries to trade, we have to consider their relative efficiencies or comparative advantage.
Imagine that France is able to buy cheese for what it costs Germany to produce it. France would pay two gallons of wine for one pound of cheese which is cheaper than France can produce cheese themselves. So, France can benefit from trade.
Likewise, if Germany can buy wine from France for what it costs France to produce it (¼ lbs cheese), then Germany can benefit from trade. Therefore, both countries can be made better off with trade.
As an example, let’s consider the situation where France produces only wine (36 million gallons) and Germany produces only cheese (8 million pounds). We have not discussed price determination yet, so let’s just consider a price that both countries would be willing to accept. Assume that price to be 3 gallons of wine for 1 pound of cheese. Also assume that, under this price scheme, France sends 18 million gallons of wine to Germany in exchange for 6 million pounds of cheese.
Now, France consumes 18 million gallons of wine and 6 millions pounds of cheese. If you refer back to France’s PPF, you can verify that this combination is outside the normal PPF.
Similarly, Germany now consumes 18 million gallons of wine and 2 million pounds of cheese. That combination is well outside Germany’s PPF.
So, everybody is better off.