Absolute and Comparative Advantage, Terms of Trade

Absolute and comparative advantage

A country has an absolute advantage in a good when it can produce more of that good than another country from the same quantity of resources. A country has a comparative advantage when it can produce the good at a lower opportunity cost than the other country, that is, giving up less of the other good. The theory of comparative advantage (Ricardo) states that both countries can gain from trade if each specialises in the good in which it has a comparative advantage and they exchange at a rate of exchange lying between the two domestic opportunity-cost ratios. Absolute advantage in both goods is not a barrier to mutually beneficial trade; it is only the difference in opportunity costs that matters.

Assumptions and limitations

The simple model assumes constant opportunity costs (straight-line PPCs), two countries and two goods, no transport costs, perfect factor mobility within each country and immobility between countries, free trade with no barriers, and full employment. In reality opportunity costs rise as output expands (so specialisation is partial), transport costs and tariffs erode the gains, and factors cannot move easily between industries, so structural unemployment may result. Comparative advantage also changes over time as technology, education and capital stocks change.

Terms of trade

The terms of trade measure the rate at which a country's exports exchange for its imports:

A rise in the index is an improvement (each unit of exports buys more imports); a fall is a deterioration. The terms of trade change when export or import prices change, for example through exchange-rate movements, commodity price shocks or changes in productivity. An improvement is not automatically good for the current account: if demand for exports is price elastic, higher export prices reduce export revenue.