AP® Macroeconomics review sheet from Aim for Five (aimforfive.com/macro/units/1/1-3)
Unit 1 · Topic 1.3
1.3 Comparative Advantage and Gains from Trade
Comparative advantage explains why trade makes both sides better off, even when one side is better at making everything. When each producer specializes in the good it makes at the lower opportunity cost, and they trade at a price between their costs, both can consume more than they could alone.
Key terms
- absolute advantage
- comparative advantage
- specialization
- terms of trade
- gains from trade
Absolute vs. comparative advantage
You have an absolute advantage in a good if you can make more of it than another producer using the same resources (or make the same amount using fewer resources).
You have a comparative advantage in a good if you can make it at a lower opportunity cost than the other producer. Comparative advantage is the one that decides who should make what.
One producer can have an absolute advantage in both goods, but it can't have a comparative advantage in both. (If the two producers' opportunity costs are identical, neither has a comparative advantage, and there's no gain from trade.) If your opportunity cost of X is lower, your opportunity cost of Y must be higher, because one is the reciprocal of the other.
Output problems vs. input problems
Exam tables come in two forms, and you treat them differently.
An output problem tells you how much each producer can make with a set amount of resources (for example, tons of fish per worker). Bigger numbers mean more productive. For the opportunity cost of one unit of a good, put the other good's number on top: "other over."
An input problem tells you how many resources it takes to make one unit (for example, hours per shirt). Smaller numbers mean more productive. For the opportunity cost of one unit of a good, put that good's own number on top: "own over."
Whichever kind you have, check your answer with common sense: the producer who is relatively better at a good should end up with the lower cost for it.
Specialization and the terms of trade
The terms of trade are the price at which the two sides swap goods, measured in units of one good per unit of the other. For trade to help both sides, the terms of trade must fall between the two producers' opportunity costs.
Here's why. Suppose a computer costs Atlantis 2 fish to make itself and costs Borealis 4 fish. If they trade 1 computer for 3 fish, Atlantis gets 3 fish for a computer that cost it only 2, and Borealis gets a computer for 3 fish instead of 4. Both gain. At 1.5 fish per computer, Atlantis would lose. At 5 fish per computer, Borealis would refuse.
When each side specializes in its comparative advantage and trades at good terms, each can end up at a combination of goods outside its own PPC. That's the gain from trade: consumption beyond what you could produce alone.
Why it works for people and countries
The same logic explains why people specialize in jobs instead of making everything themselves. A surgeon may type faster than her assistant, but every hour she spends typing costs her an hour of surgery, which is far more valuable. Letting the assistant type is cheaper in opportunity cost, even though the surgeon is faster.
Countries trade for the same reason. A country with a comparative advantage in software and another with one in coffee can each focus on what they give up least to make, then trade. Each can end up consuming more than it could produce alone, and the terms of trade decide how the gains are split.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Output problem: who should make what, and at what price
With all its resources, Atlantis can produce 120 tons of fish or 60 computers. Borealis can produce 60 tons of fish or 15 computers. Both have straight-line PPCs. (a) Who has the absolute advantage in each good? (b) Who has the comparative advantage in each good? (c) Give a range of terms of trade for computers that benefits both. (d) Before trade, Atlantis makes 60 fish and 30 computers, and Borealis makes 40 fish and 5 computers. Show that trading 10 computers for 30 fish lets both consume outside their PPCs.
Show the solutionHide the solution
- Step 1: (a) Atlantis can make more of both goods (120 > 60 fish and 60 > 15 computers), so it has the absolute advantage in both.
- Step 2: (b) This is an output problem, so use "other over." Atlantis: 1 computer costs 120 ÷ 60 = 2 fish, and 1 fish costs 60 ÷ 120 = 0.5 computer. Borealis: 1 computer costs 60 ÷ 15 = 4 fish, and 1 fish costs 15 ÷ 60 = 0.25 computer.
- Step 3: Atlantis has the lower cost for computers (2 fish < 4 fish), so it has the comparative advantage in computers. Borealis has the lower cost for fish (0.25 < 0.5 computer), so it has the comparative advantage in fish.
- Step 4: (c) The price of a computer must fall between the two costs: more than 2 fish and less than 4 fish.
- Step 5: (d) Atlantis specializes in computers (makes 60) and Borealis in fish (makes 60). They trade 10 computers for 30 fish, a price of 3 fish per computer, which is inside the range.
- Step 6: Atlantis ends with 50 computers and 30 fish. On its own, keeping 30 fish would leave resources for only (120 − 30) ÷ 2 = 45 computers. It now has 50, so it's outside its PPC.
- Step 7: Borealis ends with 30 fish and 10 computers. On its own, keeping 30 fish would leave resources for only (60 − 30) ÷ 4 = 7.5 computers. It now has 10, so it's outside its PPC too.
Answer: (a) Atlantis in both. (b) Atlantis: computers (2 fish each); Borealis: fish (0.25 computer each). (c) Between 2 and 4 fish per computer. (d) Atlantis consumes 30 fish and 50 computers (vs. 45 possible alone); Borealis consumes 30 fish and 10 computers (vs. 7.5 possible alone), so both gain.
- Example 2Calculator allowed
Input problem (classic trap)
Lee needs 2 hours to make a shirt and 4 hours to make a hat. Kim needs 3 hours to make a shirt and 9 hours to make a hat. Who has the comparative advantage in hats?
Show the solutionHide the solution
- Step 1: These numbers are hours per unit, so this is an input problem. Smaller is better, and you use "own over."
- Step 2: Lee: 1 hat takes 4 hours, and in 4 hours Lee could make 4 ÷ 2 = 2 shirts. So 1 hat costs Lee 2 shirts.
- Step 3: Kim: 1 hat takes 9 hours, and in 9 hours Kim could make 9 ÷ 3 = 3 shirts. So 1 hat costs Kim 3 shirts.
- Step 4: Lee's cost for hats is lower (2 < 3 shirts), so Lee has the comparative advantage in hats. Kim's cost for a shirt is 3 ÷ 9 = 1/3 hat, lower than Lee's 2 ÷ 4 = 1/2 hat, so Kim has the comparative advantage in shirts.
- Step 5: The trap: if you used "other over" here, you'd get Lee's hat cost as 2 ÷ 4 = 0.5 shirt and pick the wrong person. Lee also has the absolute advantage in both goods (fewer hours for each), which doesn't change the answer.
Answer: Lee has the comparative advantage in hats (1 hat costs 2 shirts, vs. 3 for Kim); Kim has it in shirts.
Common mistakes
- Deciding who should specialize using absolute advantage. Specialization follows comparative advantage, the lower opportunity cost.
- Using "other over" on an input problem. With hours or workers needed per unit, use "own over," or convert to outputs first.
- Picking terms of trade outside the two opportunity costs. The price must be strictly between them, or one side loses.
- Claiming one country has a comparative advantage in both goods. If its cost of one good is lower, its cost of the other must be higher.
On the exam
- Multiple-choice questions give a small table and ask who has an absolute or comparative advantage, or which terms of trade both sides would accept. Write out both opportunity costs for both producers before answering.
- Watch the units in the table header. "Units per worker" is an output problem; "hours per unit" is an input problem.
Connected topics
Videos
Check yourself
4 questions on 1.3 Comparative Advantage and Gains from Trade. Pick an answer to see if you got it, and why.
| Country | Corn (bushels per worker per day) | Cloth (yards per worker per day) |
|---|---|---|
| Atlantis | 40 | 20 |
| Borealis | 30 | 10 |
Hypothetical output data; each worker has the same resources
Which of the following statements about absolute advantage is correct?
Which of the following is the opportunity cost for Borealis of producing 1 bushel of corn?
According to the principle of comparative advantage, which country should specialize in which good?
Which of the following terms of trade would benefit both countries?
0 of 4 answered