Comparative advantage means that all countries can benefit from free trade even if they are characterized by low levels of productivity Underlying this result is the concept of opportunity cost which means that countries have a comparative advantage in in

The theory of comparative advantage says that all countries can benefit from trade. However, there are some things comparative advantage does not imply:

(a) Comparative advantage says all countries gain from trade, but not that all countries become wealthy. As we saw in Chapters 3 though 6, the standard of living in a country depends on its absolute productivity. In our example, Eurasia is more productive than Oceania and so has a better standard of living (compare the level of onions per capita in each country). However, both Eurasia and Oceania will have higher standards of living under trade, compared to self-sufficiency.

(b) While both Eurasia and Oceania benefit from trade, they do not benefit equally. The greater the price of garlic in world trade, the greater the gains for Oceania and the less the gains for Eurasia. The key concept here is the terms of trade—the ratio of the price of a country's exports to its imports. The higher the terms of trade, the more the country benefits from trade.

(c) Comparative advantage only says that a country gains from trade in the aggregate. It does not say that every citizen benefits. For example, garlic producers in Eurasia will not benefit from trade with Oceania. We will examine the distributional implications of free trade in detail later.

Figure 8.4, taken from a seminal study, shows empirical support for comparative advantage. The figure shows, for a variety of industries, the relative productivity of the United States (compared to the United Kingdom) and the relative amount of exports from the United States in each industry. The scale shows that for every industry, productivity in the United States was greater than in the United Kingdom. In other words, the United States had an absolute productivity advantage in all industries. Yet the United Kingdom still managed to export more than the United States in several industries (where the ratio of U.S. to U.K. exports is less than 1). Figure 8.4 shows that the United Kingdom out-exported the United States in those industries in which the U.S. productivity advantage was least pronounced. In other words, the United States focused its export performance on those industries in which its productivity advantage was greatest compared to the United Kingdom (pig iron and motor cars). This left the United Kingdom to specialize in those industries in which its productivity deficit was smallest (beer and textiles)—exactly what comparative advantage implies. One implication of comparative advantage is that industries in a country are not just in competition with the same industry overseas, but also with other industries in their own country.

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