COMPARATIVE ADVANTAGE AND ECONOMIES OF PRODUCTION

COMPARATIVE ADVANTAGE AND ECONOMIES OF PRODUCTION

BY: EDE KENECHUKWU KENNETH edekenechukwuk@gmail.com

International trade takes place because of differences in opportunity cost or comparative advantage. Trading economies will benefit by producing and exporting those commodities in which they have comparative advantage. Therefore, no country should lose by trading freely with another.

A country enjoys a comparative advantage when the opportunity cost of production (in terms of other goods) is lower than in other countries. Even if on country has a greater productivity than another in all commodities (i.e. enjoys an absolute advantage in all commodities) it will still benefit that country to specialize.

For simplification, consider two economies G and H, each capable of producing two goods Y and Z. Let us assume the G is technically more efficient than H in both commodities (G has an absolute advantage over H). This means that G uses fewer resources to produce one unit of either Y or Z than H.

Superficially, it would seem that G should not trade with H, since H uses more resources in production. But, this is not correct because the gains from trade are based on differences in opportunity costs, which are independent of many comparative advantages to explore from a nation.

For example, suppose the opportunity cost of producing one unit of Z in country G is sX, while in H it is tX, where s and t are constant. Without loss of generality, assume that s is greater than t. then the opportunity costs of the two commodities in the two countries may be represented below:

Country	Opportunity Cost of Y	Opportunity Cost of Z
G	1     y S	sX
H	1     y t	tX

                                                                                            Since S > t,    1/S < 1/tG has a comparative advantage in producing Y and a comparative disadvantage in producing Z. In the situation before we introduce trade, both countries would have to produce both commodities. Now consider the effect of allowing them to specialize and trade. If H increases its production of Y by one unit (by reducing output of X by tX and G produces one extra sX) then overall output of Y remains constant while output of X is raised by sX – tX = (s – t)X. Since s is greater than t, there is more X available, which can be distributed between the two countries. The rate of exchange will determine the proportion of additional output going to each country (i.e. who gains most from trade). Therefore, no country has to lose by trading with another, and both can gain.

This situation is depicted in the fig. above. There are two countries, each have a domestic production possibility curve, shown as PP_G and PP_H respectively. The slope of this curve is constant, reflecting the assumed constancy of opportunity costs. Country G specializes in X and H in Y. with an international exchange rate between the two opportunity costs then both countries gain by specialization and trade, as they may achieve combinations of both goods which lay beyond their domestic production boundaries. In the diagram, E_G and E_H indicate the trading possibilities open to both countries for a particular exchange rate. Thus country G could exchange an amount ED of X for HO of Y to reach Z_G. Consequently country H has obtained an amount OC (equal to ED) of X for GF (equal to HO) of Y to reach point ZB.

In practice, the assumption of a constant opportunity cost is not real. The Law of diminishing returns would suggest that in the short-run opportunity costs rise production of one commodity increases. This implies that economies will only partly specialize in producing goods until opportunity costs are equalized. In the lung-run however, there may be economies of scale derived from specialization, which would increase the gains from trade.