1.4 Comparative Advantage and Trade

Absolute vs. Comparative Advantage

Absolute advantage means producing more output using fewer resources than another producer. Comparative advantage means producing a good at a lower opportunity cost than another producer. Trade should be based on comparative advantage, not absolute advantage — even a producer without any absolute advantage can still have a comparative advantage in something.

Opportunity Cost from a PPC

Using a production possibilities curve (PPC), opportunity cost equals the amount of one good given up to produce one more unit of another. Calculate it as the slope: (units of good given up) ÷ (units of good gained). The producer with the lower opportunity cost for a good has the comparative advantage in that good.

Gains from Trade & Terms of Trade

When each party specializes according to comparative advantage and trades, total output increases and both can consume beyond their own PPC — this is the gains from trade. The terms of trade (the agreed exchange rate between goods) must lie between each producer's opportunity costs for both parties to benefit.

Key terms

Absolute advantage

Producing more output using fewer resources than another producer.

Comparative advantage

Producing a good at a lower opportunity cost than another producer.

Opportunity cost (on a PPC)

The amount of one good given up to produce one more unit of another; equals the slope of the PPC.

Gains from trade

The increase in total output/consumption when producers specialize based on comparative advantage and trade.

Terms of trade

The agreed rate of exchange between two goods; must lie between the two producers' opportunity costs for both to benefit.

Try an AP-style question

Who has the comparative advantage in hats?

1. Ben
2. Neither
3. Both equally
4. Ana