Comparative Advantage Essay Nations trade simply because it is advantageous to do so.

Trade is defined as the exchange of goods and services between countries. Specialisation and trade allows countries to operate outside their production possibility frontier, increasing their consumption possibilities through imports and their production possibilities through exports. Through the models of comparative and absolute advantage we are able to demonstrate the benefits of specialisation and trade on the world economy. A country has an absolute advantage over its trading partners if it can produce the same good using fewer resources. A country is said to have a comparative advantage over its trading partners if it can produce the same good at a lower opportunity cost. Opportunity cost is the real of economic cost of a decision. The following comparative advantage model assumes there are only two countries in the global economy: Spain and France. There are only two goods being trade: Olives and cheese. There are no barriers to trade and all producers have full knowledge about the market. OLIVES 40 100 OR OR OR CHEESE 160 200

SPAIN FRANCE

In this instance, Spain can produce 40 units of olives OR 160 units of cheese, and France can produce 100 units of olives, OR 200 units of cheese. It is evident that France has an absolute advantage in both goods. To work out how much of each good each country can produce, we must look at each country in isolation. This is done by assuming each nation devotes half their resources to the production of each good. OLIVES 20 50 70 AND AND AND AND CHEESE 80 100 180

SPAIN FRANCE WORLD

In isolation, France has an absolute advantage in both goods but would gain benefits if they specialised in the good in which they were most efficient at producing. To work out efficiency we must calculate the opportunity cost for each country producing each good. OLIVES 4 2 CHEESE 0.25 0.5

SPAIN FRANCE

By working out the opportunity cost, it is evident that Spain should specialise in the production of cheese and France should specialise in olives.

For trade to be viable, given both countries specialise 100% in the good which they have a comparative advantage in, world production of olives and cheese must be greater after specialisation than it was in isolation. OLIVES 0 100 100 AND AND AND AND CHEESE 160 0 160

SPAIN FRANCE WORLD

Using 100% specialisation, trade is NOT viable because even though the world production of olives is higher than in isolation, world production of cheese is not. For trade to work, partial specialisation must occur. With partial specialisation, the country with the absolute advantage in both goods devotes 80% of its resources to the good which they are most efficient at producing, and 20% in the other good. The country with an absolute disadvantage in both goods will specialise 100% in the good which they have a comparative advantage in. In this case, France will put 80% of their resources into the production of olives, and 20% into the production of cheese, and Spain will specialise 100% in the production of cheese. OLIVES 80 0 80 AND AND AND AND CHEESE 40 160 200

SPAIN FRANCE WORLD

Trade is now viable, because world output in both olives and cheese has increased. Once weve established whether trade is viable or not, we now must work out the Terms of Trade, that is, how much of each good will each country import and export. The ToT must lay between the opportunity cost ratios. France will want to keep more olives than it had in isolation, and export the rest, whereas Spain will want to keep more cheese than it had in isolation, and export the rest. OLIVES 25 55 80 AND AND AND AND CHEESE 85 115 (75+40) 200

SPAIN FRANCE WORLD

To make sure these figures work, we must check the new opportunity cost ratios. OLIVES 3.4 2.09 CHEESE 0.29 0.48

SPAIN FRANCE

Now that these figures work, we can establish the Terms of Trade how much of each good will each country import and export. We can now work out that France exports 25 units of olives and imports 75 units of cheese, and Spain exports 75 unites of cheese, and imports 25 units of olives.