Absolute Advantage, Comparative Advantage, and Opportunity Costs
A country has an absolute advantage in producing a good if it can either produce a product with fewer resources or with a lower cost of resources. The opportunity cost of a product or service is the difference in value between the value of what is actually produced with a given set of resources minus the maximum value that can be produced with those resources. A country has a comparative advantage in producing a good if it has a lower opportunity cost of producing the good compared to whatever else it could do with its resources.
The differences between absolute and comparative advantage can easily be seen in a simple example. Take a model who makes $10,000 a day modeling but who is also very efficient at mowing her large yard around her mansion. If she cuts her grass herself, she can do it in one day. Or she can hire a lawn service that takes 2 days to mow the lawn and charges $400. Thus, the model has an absolute advantage in both working as a model and mowing her own lawn, but, she would, nonetheless, still hire the lawn service, because if she mowed her own lawn, she would have to give up a day of modeling, which means her earnings would be $10,000 less. By hiring the lawn service, she earns $10,000 a day as a model and pays the lawn service $400, for a net gain of $9,600. Hence, the $9,600 is her opportunity cost for mowing her own lawn. If the lawn service does not mow the model's lawn, then it will not get the $400 that it charges the model, but it will have time to mow other people's lawns for the same amount of money. Therefore, the lawn service's maximum opportunity cost of not mowing the model's lawn is only $400, which gives it a comparative advantage over the model.
Because countries differ in their absolute or comparative advantage in producing specific products or services, the world benefits by allowing free trade. However, trade is often restricted on the specious grounds of preserving jobs or because politically powerful people want to increase their wealth at the expense of the public.
In the early 19th century, Corn Laws, which consisted of tariffs, subsidies, and restrictions on the trading of corn and other grains, were enacted by British Parliament so that the landowners in the House of Lords could increase their own wealth at the expense of the public, by discouraging imports and encouraging exports of grain, particularly corn.
In 1817, David Ricardo published Principles of Political Economy and Taxation in which he advanced the idea of absolute and comparative advantage by comparing the production of wine and cloth in England and Portugal. If, in England, it took the labor of 100 men working for 1 year to produce a given amount of cloth and 120 man-years to produce an equal value of wine, while, in Portugal, it took only 80 man-years to produce wine and 90 man-years to produce cloth of equivalent value, then Portugal has an absolute advantage in producing both wine and cloth because it can produce them with less labor than England. However, Portugal only has a comparative advantage in producing wine because the opportunity cost of producing cloth in England is less than the opportunity cost of producing cloth in Portugal. This is because England would have to sacrifice an extra 20 man-years to make wine while Portugal would only have to sacrifice 10 more man-years to make cloth. If England exported cloth for the wine, then it needs only the 100 man-years to create the cloth to exchange for the equivalent value of wine; if it produced itself, it would need 120 man-years. Likewise, for Portugal to make its own cloth, it would have to sacrifice 90 man-years, but by exchanging wine for cloth, it can receive the equivalent value of cloth for only 80 man-years. Hence, both England and Portugal benefit by trading wine for cloth.
(Here, it would seem that Portugal has the lower opportunity cost since it only has to sacrifice 10 man-years instead of 20. However, it only makes sense to compare opportunity costs using the same resources, which means that an individual or a country can only compare what it can do with its own resources, since that individual or country is one of the resources. Hence, a country is only going to produce at its own lowest opportunity cost, and whether it will import or export will depend on those opportunity costs. So if Portugal, in the above example, can produce both wine and cloth at the cost of 80 man-years, then it will export both and import neither.)
Several years after the publication of his book, Ricardo became a member of Parliament where he presented his ideas as to why the Corn Laws should be repealed, arguing that specialization and free trade will benefit all trading partners, even those who are less efficient at producing.
Some economists make a distinction between natural and acquired comparative advantages. A natural comparative advantage exists within a country that has natural resources that are required to produce a product, while an acquired comparative advantage is the advantage gained by an individual or a country by spending a lot of time or resources producing a product. For instance, Saudi Arabia has a natural comparative advantage with its huge reserves of oil. Since Saudi Arabia has few other resources, without trade, it would be extremely poor; because of trade, it is extremely wealthy. Japan, on the other hand, has few natural resources, but it has an acquired comparative advantage in its manufacturing and business know-how, which it has developed over the years.
Terms of Trade
The terms of trade is the ratio at which a country can exchange domestic products for imported products. If the imported costs of the products are less than the opportunity costs for the countries to produce the product themselves, then they will continue to trade the products. So, referring to the above example, Portugal would continue to import cloth from England as long as its opportunity cost of producing cloth itself is higher than the opportunity cost of producing wine that can be exported in exchange for the cloth.