Chapter 14 · International trade: Part I
Comparative advantage using PPCs
Compare two countries’ opportunity costs using production possibilities curves. Explain comparative advantage, specialisation and gains from trade.
The economic idea
Absolute advantage exists when a country can produce more of a good with the same resources, or the same output with fewer resources, than another country. It is a productivity comparison and does not by itself determine specialization.
Comparative advantage exists when a country can produce a good at a lower opportunity cost than another country. Because opportunity costs are relative, a country can have comparative advantage in one good even when it has absolute disadvantage in both goods.
A production possibilities curve shows the maximum combinations of two goods that can be produced with current resources, technology and productive efficiency. On a linear PPC, its absolute slope gives the constant opportunity cost of the horizontal-axis good in units of the vertical-axis good.
Specialization means reallocating resources toward the good in which a country has comparative advantage. Trade then allows production and consumption decisions to differ, so a country may consume a combination beyond its own PPC without producing beyond it.
The terms of trade are the rate at which exports exchange for imports. With constant opportunity costs and no trade costs, a mutually beneficial rate lies between the countries’ opportunity-cost ratios. The exact distribution of the gain depends on that rate and bargaining conditions.
Comparing Country A PPC with Country B PPC
“Good X” is measured horizontally and “Good Y” vertically. Each intercept is a maximum output if all resources are devoted to one good.
“Country A PPC” and “Country B PPC” are separate national production constraints, not demand and supply curves.
The absolute value of each PPC slope measures units of the vertical-axis good forgone for one additional unit of the horizontal-axis good.
Begin with absolute advantage
“Country B PPC” has absolute advantage in “Good X” because its PPC reaches farther along that axis.
“Country A PPC” has absolute advantage in “Good Y” because its PPC reaches farther along that axis.
Move from intercepts to opportunity cost
“Country B PPC” has the flatter PPC and the lower opportunity cost of “Good X”, so it has comparative advantage in “Good X”. “Country A PPC” has the lower reciprocal opportunity cost and therefore comparative advantage in “Good Y”.
Explain what the opportunity-cost ratio means
For one more unit of “Good X”, each country gives up some “Good Y”. Compare those sacrifices in the same units before deciding who should specialise. For “Good Y”, reverse the ratio; a country cannot have the lower opportunity cost of both goods in this two-good model.
The intercept comparison assumes a comparable resource input. A country may have a larger maximum output because its economy is larger, so national production totals alone do not establish greater productivity.
From comparative advantage to trade
If “Country B PPC” specializes relatively more in “Good X” and “Country A PPC” in “Good Y”, a terms of trade between their opportunity costs can make imports cheaper than domestic production for both. The graph identifies the cost ordering but does not plot a trading line or a post-trade consumption point.
How the current PPCs generate a trade proposition
Read each country’s maximum “Good X” and “Good Y” from its intercepts.
Use each PPC slope to compare the opportunity cost of “Good X”; take the reciprocal to compare the opportunity cost of “Good Y”.
Choose a terms of trade strictly between the two domestic opportunity costs, then explain how each country can obtain imports at a lower opportunity cost than producing them domestically.
Common mistakes to avoid
- The country with the larger maximum output does not automatically have comparative advantage; compare opportunity costs.
- A flatter PPC means a lower opportunity cost of “Good X”, while a steeper PPC means a lower opportunity cost of “Good Y”.
- Specialization need not be complete when opportunity costs increase, industries are diverse or adjustment costs are significant.
- Trade can permit consumption beyond a national PPC; it does not permit production beyond that PPC without growth or improved efficiency.
- The diagram establishes a potential aggregate gain, not that every household, firm or region gains.
How to draw this diagram
- Title the diagram “Comparative advantage using PPCs”. Label the horizontal axis “Good X” and the vertical axis “Good Y”.
- Draw Country A PPC first and label it clearly.
- Draw Country B PPC next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The linear PPCs assume constant opportunity costs, fixed resources and technology, full employment and productive efficiency.
- Transport, insurance, border, information and compliance costs can remove an apparent cost advantage.
- Resources are not instantly or costlessly mobile between industries; workers, firms and regions can face persistent adjustment losses.
- Externalities, strategic dependence, market power, exchange rates and dynamic learning can change the welfare conclusion.
- A national gain from trade does not establish an equitable distribution of gains within either country.