One of the first ideas International Business students encounter is the Theory of Comparative Advantage, introduced by Robert Torrens in 1815, and later codified by economist David Ricardo in 1817 in his book “The Principles of Political Economy and Taxation“.
To explain Comparative Advantage, one must first understand Absolute Advantage, which essentially says that a person, Country, or other entity produces some good at a lower total cost than some other entity. By contrast, Comparative Advantage says that an entity can produce a good more efficiently relative to another entity in terms of opportunity and marginal costs.
What does this mess of terms really mean?
Let’s assume I’m from Country X, and I produce coffee really well; so well in fact that none of my neighbors can produce as much coffee as my Country can at the same low cost. This is Absolute Advantage.
But what if I have a lot more coffee than I can use, but at the same time a shortage of wheat? I can stay awake all night long, and never miss an appointment, but I don’t have enough bread to eat because I’ve used all of my fields to grow coffee.
There may be a lot of reasons why Country X has so much coffee and is so efficient at producing it, and equally why there’s a wheat shortage. Coffee grows well on hills and mountains, while wheat does much better in warm fields for example. If Country X can’t produce all the wheat it needs, then it must trade with some other entity that has wheat available. Or, perhaps the sale of coffee has such high profit margins that the ruler of Country X selected to produce more coffee at the expense of wheat, or said another way, the ruler’s choice to produce more coffee has forced an opportunity cost against the productive capacity of Country X’s ability to produce wheat.
But what if that ruler really wasn’t quite as mad as they initially appear?
Enter trade.
Now imagine Country Y has a wheat surplus in much the same manner that Country X has a surplus of coffee. Country Y’s citizens make wonderful breads, but can’t seem to work more than a few hours because they have a shortage of coffee. Country Y also has a geographical problem in so much as their Country is really flat and hot, and coffee doesn’t grow well there. They could use the production possibilities curve to determine how many wheat fields they would have to sacrifice to produce the coffee they need, but it might be too substantial and cause the citizens to starve.
Meanwhile Country X’s citizens are starving because they not only don’t have enough wheat to make bread from, and their local witch doctor has discovered that coffee is a diuretic stimulant that aggravates hunger and starvation. Country X could sacrifice some of their coffee fields for wheat fields, but would it be too much?
So what happens if these two countries elect to trade coffee for wheat and visa versa?
Country X is in dire need of wheat, so the ruler is happy to trade coffee for wheat. Country Y would like some coffee so that its citizens can stay awake long enough to cultivate the entire wheat harvest.
Here’s where it starts to get a little complicated.
The first question is how much coffee needs to be exchanged for wheat to satisfy Country X’s food needs, and alternatively how much coffee does Country Y need to keep its citizens awake?
One could also argue that Country X has a greater need, because its citizens are already hungry, so does this mean that Country Y’s ruler could take advantage of Country Y’s problems? Perhaps, but the point here is that the amount of goods required by each Country will largely determine the price of the trade. That is to say, Country X needs a certain number of bushels of wheat to satisfy its citizens, while Country Y needs a certain amount of coffee to satisfy its citizens.
We’ve already established that Country X’s need is greater than Country Y. In other words, Country X is desperate to have more wheat, but Country Y would simply like to have more coffee.
So the negotiations and price discovery begin. I won’t get deeply into the political complexities this negotiation could produce, but I will mention a few to put some strategic thinking behind this.
What would happen to Country X if these negotiations took place on their soil? Perhaps Country Y would see that Country X’s people are starving and place a price premium on their wheat.
What would happen if the negotiations took place in Country Y? Would Country X be able to show the people of Country Y just how wonderful coffee really is? And more graphically, what if Country X was unable to convince Country Y to trade or sell or trade some of their wheat? Would Country X declare war on Country Y to save their people from starving? Certainly there are enough historical examples of precisely this sort of thing in even the most recent context of history: The Ukraine’s current need for Russian oil, Japan’s attack on Pearl Harbor, the list goes on.
Returning to the point at hand however, Comparative Advantage assumes the idea of ceteris paribus (all else equal), and this is important because the ultimate solution, and price point in terms of how many bushels of wheat will be traded for pounds of coffee, can’t be found without first dealing with the basics. So let’s look at an optimum scenario mathematically under ceteris paribus conditions.
Country X Produces Coffee and Wheat at these costs and volumes:
| Product | Cost | Volume | Total Cost | Target | Required |
| Coffee | $1 | 2000 | $2,000 | 1200 | 1000 |
| Wheat | $20 | 100 | $2,000 | 900 | 600 |
| Net Total Cost | $4,000 |
Country X has a specific need for 600 more bushels of wheat, but would like to have 900 bushels. They also need at least 1000 pounds of coffee, but would like to have 1200.
Country Y Produces Coffee and Wheat at these costs and volumes:
| Product | Cost | Volume | Total Cost | Target | Required |
| Coffee | $10 | 100 | $1,000 | 600 | 300 |
| Wheat | $1 | 1500 | $1,500 | 1000 | 800 |
| Net Total Cost | $2,500 |
Country X has an implied need for 600 more pounds of coffee; implied need because Country Y’s citizens may not know how wonderful coffee is yet. Country Y can get by with only 300 pounds of coffee. They also need at least 800 bushels of wheat, but would like to have 1000.
Country X can supply all 600 pounds of coffee that Country Y would like to have.
If Country Y sells all of their spare inventory they can supply 700 bushels of wheat out of the 600 Country X needs.
Assuming both countries agree to these conditions and full production occurs in each country, let’s rework the tables in the context of this trade.
Country X Trade Production Schedule
| Product | Cost | Volume | Total Cost | Target | Required |
| Coffee | $1 | 1400 | $1,400 | 1200 | 1000 |
| Wheat | $20 | 100 | $2,000 | 900 | 600 |
| Wheat Imports | $1 | 700 | ($700) | ||
| Net Total Cost | $2,700 |
Country Y Trade Production Schedule
| Product | Cost | Volume | Total Cost | Target | Required |
| Coffee | $10 | 100 | $1,000 | 600 | 300 |
| Wheat | $1 | 1500 | $1,500 | 1000 | 800 |
| Coffee Imports | $10 | 600 | ($6,000) | ||
| Net Total Cost | ($3,500) |
Notice I’ve added a line to each table indicating the volume of imports for each country at their own respective costs of producing that good. This is very important because it shows the specific line item cost savings incurred by importing goods in trade for other goods. Viewed this way, both Country X and Country Y had a net cost savings. Also notice that Country Y actually made a substantial $3500 profit from the trade.
Let’s take a closer look at country X. If we examine the percentage of efficiency produced by the trade for Country X, the total cost of production went from $4000 to $3400, or a net cost savings of $600, equivalent to 15%.
1-(3400/4000)=.15
By contrast, Country Y was able to buy coffee that’s very expensive for them to produce themselves on the cheap. By trading most of their excess wheat supply, Country Y actually saved $6000 in coffee production. In efficiency terms, this is a net efficiency increase of 340%.
(2500+6000)/ (-3500+6000) = 8500/2500 = 3.4
So what if the conditions aren’t all equal? We’ve already discovered that Country X has a very specific need for food, but Country Y considers coffee to be important, but not inherently necessary.
Let’s assume for a moment that Country Y only wants 300 pounds of coffee from Country X, and is only willing to provide 300 bushels of wheat to Country X in return.
Country X Production Schedule
| Product | Cost | Volume | Total Cost | Target | Required |
| Coffee | $1 | 1400 | $1,400 | 1200 | 1000 |
| Wheat | $20 | 100 | $2,000 | 900 | 600 |
| Wheat Imports | $1 | 300 | ($300) | ||
| Net Total Cost | $3,100 |
Country Y Production Schedule
| Product | Cost | Volume | Total Cost | Target | Required |
| Coffee | $10 | 100 | $1,000 | 600 | 300 |
| Wheat | $1 | 1500 | $1,500 | 1000 | 800 |
| Coffee Imports | $10 | 300 | ($3,000) | ||
| Net Total Cost | ($500) |
Now we have a problem. Country X doesn’t have all the wheat it needs, and is still short 200 bushels of wheat. Country Y is perfectly satisfied with the 300 pounds of coffee it got from Country X. Country X still had a net efficiency increase, but still doesn’t having enough wheat supply to feed its citizens.
So what should Country X do?
This is where the political economy becomes increasingly important to understand. Here’s a few options Country X might consider to cover their 200 bushel wheat deficit.
- Country X could trade coffee production capacity for wheat to equalize the combined demand for coffee in both countries, although they might still come up short of wheat, or they might sacrifice too much supply. (The later of which isn’t necessarily bad if one wishes to raise prices and can still maintain a buyer at higher prices while producing enough wheat for themselves.)
- Country X could trade coffee with a third country.
- Country X could convince Country Y to sell some of their excess coffee to a third country at a premium.
- Country X could buy wheat from a third country with their $900 cost savings.
- What other options can you think of, short of starting a war, or stealing food?
Let’s take this a step further shall we?
Over time, Country Y has grown to enjoy their coffee from Country X. Productive capacity at producing wheat in Country Y has increased by 30% because its citizens are awake enough to be able to work a full day. Instead of producing 1500 bushels, they’re now producing 1950 bushels in the same period of time.
Because Country X is now well fed, their coffee production has increased 25% from 2000 pounds to 2500 pounds in the same period.
1. Recalculate and find the net productive efficiency of each country assuming that Country X now requires 1000 bushels of wheat, and Country Y requires 700 pounds of coffee.
2. Assume that there has been zero population growth for both countries, but an increase in productive capacity as listed above. What actions could each country take to use up their excess supply and simultaneously reduce their costs of production?
3. Both Country X & Y have been building wooden carts to ship their products back and forth to each other, but they’re running out of lumber. Country Z has a surplus of lumber of 1000 units at a production cost of $5 per cord. Country Z would like to have 800 bushels of wheat, and 500 pounds of coffee. Can it be done? Find the optimum solution in this scenario, assuming Country X is producing 2500 pounds of coffee and Country Y is producing 1950 bushels of wheat. Justify your result.
4. If the three countries couldn’t find a trade solution to Country Z’s problems, what else could Country Z do?
Tags: Absolute Advantage:, Comparative Advantage:, Price Discovery:, Production Possibilities Curve:, Productive Capacity:
