Comparative and Absolute Advantage
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This Demonstration explains the difference between absolute and comparative advantage in a simple linear model of trade specialization with two players, and , each capable of producing and trading two goods, and . The connection of a trade model with the concept of production possibility frontier is highlighted. This is a fundamental model, which is necessary to understand a lot of topics from international trade to interest rate swaps.
Contributed by: Timur Gareev (April 2018)
Open content licensed under CC BY-NC-SA
There are two players, and . Each player is capable of producing two goods, and . To compare the efficiency of the players, and can be seen as productivity per resource unit. In international economics, players are countries.
Each player has a linear production possibility curve (blue for and orange for ) that shows all possible combinations of resource distribution between the two goods. Corner points mean that a player invests all resources to produce only one good (in simple terms, it means specialization). Without trade, each player never specializes because they have to consume both goods. The slope of an individual production possibility curve is the relative price of good in terms of good (by construction of the left plot). A negative slope means that we have to sacrifice "slope" units of to get one unit of . In general, the slope at each point is and is known as the opportunity costs.
If player can produce more goods than player (her corner value is larger), is said to have absolute advantage in . To put it differently, . She simply can produce more if both specialize in the same good. Absolute advantage does not characterize efficiency unless productivity is compared instead of production volume.
If a player can produce one good relatively cheaper than the other player (her slope absolute value of, say, is simply smaller), she is said to have comparative advantage in this good. Comparative advantage is central for trade, and trade is effective if comparative advantage is in place.
Production possibility frontier (right plot) unifies the capacity of both players if trade is possible. The best (Pareto optimal) case is if both players specialize in those goods that they have a comparative advantage in.
It is recommended to set the sliders so that player has absolute advantage in both and and to carefully consider the case. However, except in the "no trade case", has a comparative advantage in one of the goods.
The table in the upper-left corner helps to interpret all results in all settings. Notice also that we designed the numbers so that always has an absolute advantage in for the sake of simplicity. We consider a couple of specific cases (exceptions) that can be set with buttons.