Comparative Advantage Law

• Absolute advantage


  A country can produce a product using fewer factors of production than another nation
• Comparative advantage


  A country should specialize in producing goods or services at the lowest opportunity cost relative to another nation
• The key difference between absolute and comparative advantage is the notion of opportunity cost
• Assumptions made

  • Only two countries in the world
  • Producing only two goods and services
  • Goods and services are identical
  • Exactly the same quantity and quality of factors of production available for both countries
• Calculating opportunity cost

  1. Divide both sides by tons of cotton and computers

  2. To produce one ton of cotton, India gives up 0.5 computers, Ghana gives up 0.125 computers

  3. To produce one computer, India gives up 2 tons of cotton, Ghana gives up 8 tons of cotton
• Whoever has the lowest opportunity cost in producing a good should specialize in that good and trade with the other country
• Drawing PPC diagrams

  1. Plot the PPC for India and Ghana based on the given production figures

  2. The axis with the biggest gap between the two PPCs indicates the country's comparative advantage in that good
• Opportunity cost ratio


  The amount of one good that must be given up to produce one unit of another good
• For trade to be mutually beneficial, the exchange rate must lie between the opportunity cost ratios of the two countries
• Factors determining comparative advantage


  • Quantity and quality of factor endowments in a given nation
• Specializing in goods/services with comparative advantage and trading can allow countries to consume beyond their own PPCs