Name: Class: Date:

G8 Economics
AARON GIRONA

Absolute Advantages, Comparative Advantages, Terms of Trade

Key Concepts:
• Trade problems will always be between 2 countries or people making two items
• Output analysis compares finished products
• Input analysis compares time of production or resources needed for production
• For trade to occur, both partners must benefit from the trade range
• A trade range is any range where importing is better than paying the domestic opportunity
cost for that item
• Absolute advantage: which country can produce more with the same amount of resources
• Comparative Advantage: where is “relatively cheaper” to produce a determine good or
service in relation with the opportunity cost of that good or service.
• The opportunity cost of one good is: How many units of the other good you give up
producing your good or service?
• AA: Absolute Advantage. Using the same number of resources, the country that can
produce more has absolute advantage.
• CA: Comparative Advantage. Using the same number of resources, the country that can
produce at a lower opportunity cost (cheaper) has comparative advantage.
 EXAMPLE 1: Output Problem

Country Delta can produce 1200 hats or 300 bicycles

Country Epsilon can produce 600 hats or 300 bicycles

1. Delta has the absolute advantage in hat production, but they are tied in bicycle production.
2. Now, we must find the comparative advantages.
3. Build the grid:

Delta Epsilon
1200 Hats or 300 Bicycles 600 Hats or 300 Bicycles

Assume each country makes 1 hat. What is their opportunity cost? Reduce the 1200 and 600 to one
each by dividing the numbers by themselves. Now divide the other number by 1200 for Delta and
600 for Epsilon in order to create opportunity cost:
Delta Epsilon
1200 Hats or 300 Bicycles 600 Hats or 300 Bicycles
1 Hat = ¼ Bicycle 1 Hat = ½ Bicycle

Note that Delta gives up the opportunity cost of ¼ of a bicycle every time they make a hat.
Epsilon gives up the opportunity cost of ½ of a bicycle every time they make a hat.
Delta has a lower opportunity cost, therefore has the comparative advantage and will make hats

Now reduce the other side of the equation, the bicycles:

Delta Epsilon
1200 Hats or 300 Bicycles 600 Hats or 300 Bicycles
1 Hat = ¼ Bicycle 1 Hat = ½ Bicycle
4 Hats = 1 Bicycle 2 Hats = 1 Bicycle

Note that Epsilon give up 2 hats when making bicycles and Delta gives up 4 hats.
Epsilon has the lower opportunity cost and comparative advantage and will make bicycles

Now find the potential trade range. Each country will offer a trade BETTER than their own
opportunity cost:
Delta (trade offer) Epsilon
1200 Hats or 300 Bicycles 600 Hats or 300 Bicycles
1 Hat = ¼ Bicycle 1 Hat for > ¼ Bicycle 1 Hat = ½ Bicycle
4 Hats = 1 Bicycle 1 Bicycle for > 2 Hats 2 Hats = 1 Bicycle
Remember that trade will always occur in whole goods. A trick is to look at the whole number
offer: 1 bicycle for more than 2 hats (from Epsilon). The next whole number after 2: Three.
1 bicycle for 3 hats will make Epsilon happy. Will that also make Delta happy, giving up 3 hats to
get 1 bicycle? Mathematically, 1 to 3 is the same as 1/3rd to 1. Would giving up 1 hat to get back
1/3rd of a bicycle be a good trade for Delta? Yes, since 1/3rd is better than 1/4th.

Acceptable trade is 1 bicycle for 3 hats: both countries gain.

 EXAMPLE 2: Input Problem

Example information:

Ted needs 20 minutes to build a radio but needs 5 minutes to gather a bushel of wheat.
Nancy needs 30 minutes to build a radio but needs 15 minutes to gather wheat.
Ted has the absolute advantage in both, since he needs less effort for either item.

The quickest method is to recreate the grid, converting to an output of 1 each item:

Here is the start:

Ted Nancy
20 min. radio or 5 min. wheat 30 min. radio or 15 min. wheat
1 radio = 4 wheat 1 radio = 2 wheat

Apply the 20 minutes Ted would need to make a radio. If he used those 20 minutes, he could have
4 units of wheat. Therefore, the opportunity cost is 4. For Nancy, since she only gives up time for
making 2 units of wheat, she has the lower opportunity cost.

Now, switch the ratios and you find the opportunity costs of spending time making a unit of wheat.

In the next page you can find some more exercises to practice.
 Absolute (AA) and Comparative (CA) Advantages: Problems
Absolute: Make the most (if using similar resources). Comparative Outputs: Lowest opportunity costs
Comparative Inputs: Least resources or effort needed to make one unit
#1. Hats Bicycles
Delta 1200 300
Epsilon 600 300
AA Hats = AA Bicycles = CA Hats = CA Bicycles =
Trade can occur: _____________ hats for ________________ bicycles

#2. Fish Wheat

Alpha 10 labor hours 20 labor hours
Beta 20 labor hours 80 labor hours
AA Fish = AA Wheat = CA Fish = CA Wheat =
Trade can occur: _____________ fish for ________________ wheat

#3. Cloth Food

Gamma 10 2
Kappa 10 1
AA Cloth = AA Food = CA Cloth = CA Food =
Trade can occur: _____________ cloth for _______________ food

#4. Cars Tractors

Lambda 30 10
Mu 20 40
AA Cars = AA Tractors = CA Cars = CA Tractors =
Trade can occur: ____________ cars for ______________ tractors
#5.
Watches
40 Omega

10 Phi

10 20 Radios

AA Watches = AA Radios = CA Watches = CA Radios =

Trade can occur: __________ watches for _____________ radios

#6 Minutes needed to produce 1 radio Minutes needed to produce 1 bushel of wheat

Ted 20 minutes 5 minutes
Nancy 30 minutes 15 minutes
AA Radios AA Wheat CA Radios CA Wheat
Trade can occur: __________ radios for ___________wheat