Calculating comparative advantage worksheet

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Calculating comparative advantage worksheet

For cars, the opportunity cost for 1 unit of a car is 0.8 iron ore in China and 1.4 iron ore in Australia. Free Trade and Protection Absolute Advantage A country is said to have an absolute advantage if it can produce a good or service more efficiently than another country. Divide each side by 30. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources. If the United States can export no more than 6,000 refrigerators in exchange for imports of at least 1,500 pairs of shoes, it will be able to consume more of both goods and will be unambiguously better off. 1 oil = 2 lumber. When a marginal unit of labor is transferred away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same. Learning Objectives Calculate absolute and comparative advantage Consider the example of trade in two goods, shoes and refrigerators, between the United States and Mexico. Then, in the numerical example given, Mexico shifted production toward its comparative advantage and produced 6,000 pairs of shoes but only 2,500 refrigerators. A country with an absolute advantage in some product has higher labor productivity than another country does in the production of that product. If a country has an absolute advantage in producing both goods, it has higher labor productivity in both and its workers will earn higher incomes than those in the other country. Australia can produce 50 cars or 70 iron ore. In this example, absolute advantage is the same as comparative advantage. So in effect, 20 barrels of oil is equivalent to 40 tons of lumber: 20 oil = 40 lumber. In this example, is absolute advantage the same as comparative advantage, or not? When you first met the production possibility frontier (PPF) in an earlier module, it was drawn with an outward-bending shape. If Mexico, instead, produces more shoes and then trades for refrigerators made in the United States, where the opportunity cost of producing refrigerators is lower, Mexico can in effect take advantage of the lower opportunity cost of refrigerators in the United States. The opportunity cost of one lumber is 1/2 oil. Let's say that, in the situation before trade, each nation prefers to produce a combination of shoes and refrigerators that is shown at point A. One worker in Canada can produce more lumber (40 tons versus 30 tons), so Canada has the absolute advantage in lumber. As China has a larger figure, China has a comparative advantage in iron ore. Hence, 1 car - 0.8 iron ore Australia's opportunity cost of 1 unit of cars. It answers the question, "How many inputs do I need to produce shoes in Mexico?" Comparative advantage asks this same question slightly differently. It shows that the gains from international trade result from pursuing comparative advantage and producing at a lower opportunity cost. Mexico will be unambiguously better off. From Table 1, we can see that it takes four U.S. workers to produce 1,000 pairs of shoes, but it takes five Mexican workers to do so. (If four workers can make 1,000 shoes, then 40 workers will make 10,000 shoes). The range of trades that can benefit both nations is shown in Table 5. In the above table, China can produce 80 units of Iron Ore or 100 units of Cars, while Australia can produce 70 units of Iron Ore or 50 Units of Cars. For example, a trade where the U.S. exports 4,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes would benefit both sides, in the sense that both countries would be able to consume more of both goods than in a world without trade. The production possibilities of wheat and rice are shown for Mexico and Vietnam. Notice that when both countries shift production toward each of their comparative advantages (what they are relatively better at), their combined production of both goods rises, as shown in Table 4. Thus, comparative advantage is more important than absolute advantage in understanding which country should trade which product in order to maximize the standard of living in both countries. In this example, the opportunity for iron ore is 1.25 cars in China and 0.71 cars in Australia. These goods are homogeneous, meaning that consumers and producers cannot differentiate between shoes from Mexico and shoes from the U.S.; nor can they differentiate between Mexican or American refrigerators. If you're behind a web filter, please make sure that the domains *. and *. are unblocked. The following feature shows how to calculate absolute and comparative advantage and the way to apply them to a country's production. For additional practice and review using numbers, watch this video from ACDC economics. In Venezuela, a worker can produce 60 barrels of oil or 30 tons of lumber. To calculate comparative advantage, you have to calculate the opportunity cost of each good or service. Step 1: Calculate the Opportunity Cost of Each Good from Each Country. Canada will be exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber. Divide both sides of the equation by 60. Step 1. In this example, continue to calculate the opportunity cost as if it were production possibilities. If a country specializes production in the product in which it has a comparative advantage, it raises its average labor productivity and raises its average income. To calculate absolute advantage, look at the larger of the numbers for each product. Improve this pageLearn More The United States has an absolute advantage in producing both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators. (a) With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. Mutually Beneficial Trade with Comparative Advantage When nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. Step 2. Therefore, 70 iron ore = 50 cars We need to make it 1 iron ore, so we divide both sides by 70. The United States can produce 1,000 shoes with four-fifths as many workers as Mexico (four versus five), but it can produce 1,000 refrigerators with only one-quarter as many workers (one versus four). Calculate the opportunity cost of one lumber by reversing the numbers, with lumber on the left side of the equation. Table 2. We need to calculate the opportunity cost of 1 unit of iron ore from each country. Even though the United States has an absolute advantage in producing both refrigerators and shoes, it makes economic sense for it to specialize in the good for which it has a comparative advantage. To produce one additional barrel of oil in Canada has an opportunity cost of 2 lumber. Thus, the average income in a country depends on its average labor productivity. If Mexico wants to produce more refrigerators without trade, it must face its domestic opportunity costs and reduce shoe production. China is said to have an absolute advantage in both iron ore and cars as it can produce more of both goods. Which country has a comparative advantage in the production of oil? The opportuntiy cost of 1 labour hour of car production is 0.8 hours of iron ore production in China or 1.4 hours of iron ore porduction in Australia. In reality this is possible only if the contribution of additional workers to output did not change as the scale of production changed. In Canada a worker can produce 20 barrels of oil or 40 tons of lumber. With the same labor time, Canada can produce either 20 barrels of oil or 40 tons of lumber. In the example, it then shifted production toward its comparative advantage, producing only 3,500 shoes but 26,000 refrigerators. Divide each side of the equation by 40. Table 3 shows the output of each good for each country and the total output for the two countries. To calculate comparative advantage, find the opportunity cost of producing one barrel of oil in both countries. Answer: Vietnam has an absolute and comparative advantage in rice. If you're seeing this message, it means we're having trouble loading external resources on our website. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. The country with the lowest opportunity cost has the comparative advantage. Therefore, 100 cars = 80 iron ore. We need to make it 1 car, so we divide both sides by 100. In the examples in this module, the PPFs are drawn as straight lines, which means that opportunity costs are constant. A country is said to have a comparative advantage if it produces a good or service with the lowest opportunity cost. Table 1. 100 cars / 100 = 1 car 80 iron ore /100 = 0.8 iron ore. Canada has the lower opportunity cost in producing lumber. In Venezuela, the equivalent labor time will produce 30 lumber or 60 oil: 30 lumber = 60 oil. Production at Point A before Trade Country Current Shoe Production Current Refrigerator Production United States 5,000 20,000 Mexico 4,000 5,000 Total 9,000 25,000 Continuing with this scenario, each country transfers some amount of labor toward its area of comparative advantage. It also illustrates economic themes like absolute and comparative advantage just as clearly. For example, as Table 2 shows, if the United States divides its labor so that 40 workers are making shoes, then, since it takes four workers in the United States to make 1,000 shoes, a total of 10,000 shoes will be produced. Except for this time, we're looking for the highest number, as we're measuring inputs rather than outputs. Production Possibilities before Trade Country Shoe Production -- using 40 workers Refrigerator Production -- using 40 workers United States 10,000 shoes or 40,000 refrigerators Mexico 8,000 shoes or 10,000 refrigerators As always, the slope of the production possibility frontier for each country is the opportunity cost of one refrigerator in terms of foregone shoe production?when labor is transferred from producing the latter to producing the former (see Figure 1). Table 6. Calculate the opportunity costs to find out which country has an absolute and comparative advantage in the production of rice. How can you tell? Point B is where they end up after trade. Now consider comparative advantage. 70 iron ore / 70 = 1 iron ore 50 cars / 70 = 0.71 cars Hence, 1 iron ore = 0.71 cars We now need to calculate the opportunity cost of 1 unit of cars from each country. One worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who can produce only 20. China can produce 80 iron ore or 100 cars. Mexico also moves production toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. In what product should Canada specialize? We'd love your input. How Opportunity Cost Sets the Boundaries of Trade This example shows that both parties can benefit from specializing in their comparative advantages and trading. Therefore; 80 iron ore = 100 cars We need to make it 1 iron ore, so we divide both sides by 80. Table 4. This is just the same process as before, but with 1 unit of car instead. The lowest opportunity cost is one with the highest inputs The opportunity cost of 1 labour hour of iron ore is 1.25 labour hours of car production in China and 0.71 labour hours of car porduction in Australia. Resources Needed to Produce Shoes and Refrigerators Country Number of Workers needed to produce 1,000 units -- Shoes Number of Workers needed to produce 1,000 units -- Refrigerators United States 4 workers 1 worker Mexico 5 workers 4 workers Absolute advantage simply compares the productivity of a worker between countries. Oil and Lumber Production in Canada and Venezuela Country Oil (barrels) Lumber (tons) Canada 20 or 40 Venezuela 60 or 30 Who has the absolute advantage in the production of oil or lumber? Step 5. Therefore, 50 cars = 70 iron ore. In Canada, 40 lumber is equivalent in labor time to 20 barrels of oil: 40 lumber = 20 oil. Australia can produce 70 iron ore or 50 cars. China's opportunity cost of 1 unit of iron ore. Consider the world where there are only two countries, producing two goods - iron ore and cars. 50 cars /50 = 1 car 70 iron ore / 50 =1.4 iron ore Hence, 1 car = 1.4 iron oreStep 2: Plot the opportunity costs on the Two Way TableStep 3: Identify the Comparative Advantage Comparative advantage is when a country can produce a good with the least opportunity cost. We need to make it 1 car, so we divide both sides by 50. The United States will export refrigerators and in return import shoes. Mexico started out, before specialization and trade, producing 4,000 pairs of shoes and 5,000 refrigerators. Table 5. Production Possibility Frontiers. Which country has a comparative advantage in producing lumber? One oil in Venezuela has an opportunity cost of 1/2 lumber. 80 iron ore / 80 = 1 iron ore 100 cars / 80 = 1.25 cars Hence, 1 iron ore = 1.25 cars Australia's opportunity cost of 1 unit of iron ore. Watch this video to review the ways that comparative advantage benefits all the parties involved. Step 3. If the 40 workers in the United States are making refrigerators, and each worker can produce 1,000 refrigerators, then a total of 40,000 refrigerators will be produced. Divide both sides of the equation by 20 to calculate the opportunity cost of one barrel of oil in Canada. Instead of comparing how many workers it takes to produce a good, it asks, "How much am I giving up to produce this good in this country?" Another way of looking at this is that comparative advantage identifies the good for which the producer's absolute advantage is relatively larger, or where the producer's absolute productivity disadvantage is relatively smaller. Therefore, China has a comparative advantage in the production of cars. Trade and Incomes Incomes depend on labor productivity. Make a table like Table 6. By using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country. As a result, production of refrigerators in Mexico falls by 2,500 (10/4 ? 1,000), but production of shoes increases by 2,000 pairs (10/5 ? 1,000). Shifting Production Toward Comparative Advantage Raises Total Output Country Shoe Production Refrigerator Production United States 3,500 26,000 Mexico 6,000 2,500 Total 9,500 28,500 This numerical example illustrates the remarkable insight of comparative advantage: even when one country has an absolute advantage in all goods and another country has an absolute disadvantage in all goods, both countries can still benefit from trade. Step 6. For example, the United States transfers six workers away from shoes and toward producing refrigerators. This shape illustrated that as inputs were transferred from producing one good to another--like from education to health services--there were increasing opportunity costs. Thus, if Mexico can export no more than 2,000 pairs of shoes (giving up 2,000 pairs of shoes) in exchange for imports of at least 2,500 refrigerators (a gain of 2,500 refrigerators), it will be able to consume more of both goods than before trade. As Australia has the lowest opportunity cost for iron ore, it, therefore, has a comparative advantage in the production of iron ore. If done correctly, China should have a comparative advantage in cars, as it is impossible for a single country to have a comparative advantage in both goods. The theory of comparative advantage explains why countries trade: they have different comparative advantages. The linear production possibilities frontier is a less realistic model, but a straight line simplifies calculations. Calculate the same way for Venezuela: 60 oil = 30 lumber. China's opportunity cost of 1 unit of cars China can produce 100 cars or 80 iron ore. As a result, U.S. production of shoes decreases by 1,500 units (6/4 ? 1,000), while its production of refrigerators increases by 6,000 (that is, 6/1 ? 1,000). Conversely, the United States started off, before specialization and trade, producing 5,000 pairs of shoes and 20,000 refrigerators. Conversely, when the United States specializes in its comparative advantage of refrigerator production and trades for shoes produced in Mexico, international trade allows the United States to take advantage of the lower opportunity cost of shoe production in Mexico. As Australia has the higher figure, it has a comparative advantage in cars. It takes one U.S. worker to produce 1,000 refrigerators, but it takes four Mexican workers to do so. 20/20 oil = 40/20 lumber. The production possibilities frontier is a useful tool to visualize this benefit. Recall from earlier readings that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers. So, the comparative advantage of the United States, where its absolute productivity advantage is relatively greatest, lies with refrigerators, and Mexico's comparative advantage, where its absolute productivity disadvantage is least, is in the production of shoes. Consider a situation where the United States and Mexico each have 40 workers. Canada has the absolute and comparative advantage in lumber; Venezuela has the absolute and comparative advantage in oil. Figure 1. Table 3. The Range of Trades That Benefit Both the United States and Mexico The U.S. economy, after specialization, will benefit if it: The Mexican economy, after specialization, will benefit if it: Exports fewer than 6,000 refrigerators Imports at least 2,500 refrigerators Imports at least 1,500 pairs of shoes Exports no more than 2,000 pairs of shoes Trade allows each country to take advantage of lower opportunity costs in the other country. Point A on both graphs is where the countries start producing and consuming before trade. Because 1/2 lumber < 2 lumber, Venezuela has the comparative advantage in producing oil. Consider the same example, but instead shows labour hours. Step 4. Contribute! Did you have an idea for improving this content? One lumber has an opportunity cost of two oil. Canada should specialize in what it has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. Comparative Advantage Comparative advantage is a little more complicated. The reduction of shoe production by 1,500 pairs in the United States is more than offset by the gain of 2,000 pairs of shoes in Mexico, while the reduction of 2,500 refrigerators in Mexico is more than offset by the additional 6,000 refrigerators produced in the United States. Calculating Comparative Advantage for Inputs If a two-way table showed the inputs, such as labour hours or cost to manufacture rather than production possibilities, than the comparative advantage is the one that has the highest comparative advantage. In what product should Venezuela specialize?

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