How to calculate comparative advantage?

Comparative advantage is an economy’s ability to produce a particular good or service at a lower opportunity cost than its trading partners.To check, whether there can be international trade between countries, economists first determine the absolute advantage. If there is no absolute advantage for each country, economists calculate the comparative advantage. To calculate comparative advantage, we should calculate the opportunity cost for each product by each country.

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How to calculate comparative advantage?

Comparative advantage formula

To calculate comparative advantage, we should calculate the opportunity cost for each product by two countries. The comparative advantage formula is based on the opportunity cost.

How to calculate comparative advantage in 5 steps

Step 1: Calculate the absolute advantage of both products

Step 2: Calculate opportunity cost comparative advantage

Step 3: Summarize the comparative advantage calculation by comparing opportunity cost

Step 4: Calculate terms of trade comparative advantage

Step 5: comparative advantage graphs of both countries

Comparative advantage calculation example

Assume that Italy and Germany can produce watches and cameras. Following table 1 shows how many watches or cameras can be produced by each country using one hour of labour.

Step 1: Calculate the absolute advantage of both products

According to the above example, Italy can produce 4 cameras within a labour hour while Germany can produce 20 cameras within a labour hour. So, Germany can produce more cameras than the Italy within a labour hour. That means Germany has the absolute advantage of producing Cameras.

The Italy can produce 6 watches within a labour hour while Germany can produce 10 watches within a labour hour. So, Germany can produce more watches than the Italy within a labour hour. That means Germany has the absolute advantage of producing watches.

Germany has the absolute advantage of producing both goods. But still these two countries can engage in international trade by obtaining mutual benefits.

Let’s check the comparative advantage of producing cameras and watches.

Step 2: Calculate opportunity cost comparative advantage

Calculate the opportunity cost of both products: To find comparative advantage, we should calculate the opportunity cost for each product by each country.

The opportunity cost of producing a camera

The opportunity cost of producing a camera = Number of watches production within a labour hour/ Number of cameras production within a labour hour

Germany = 10/ 20 = 0.5 watches

Italy = 6/4 = 1.5 watches

The opportunity cost of producing a watch

The opportunity cost of producing a watch = Number of cameras production within a labour hour/ Number of watches produced within a labour hour

Germany = 20/ 10 = 2 cameras

Italy = 4/6 = 0.67 cameras

Step 3: Summarize the comparative advantage calculation by comparing opportunity cost

The opportunity cost of producing cameras and watches can be summarized as follows.

A country has a comparative advantage when it can produce a particular good at a lower opportunity cost than another country. According to the above table, Germany has a lower opportunity cost of producing cameras when compared with Italy. Italy has a lower opportunity cost of producing watches when compared with Germany.

So, when engaging in international trade, Germany should produce more and export the cameras by importing watches from Italy. Italy should produce more and export the watches by importing cameras from Germany.

Step 4: Calculate terms of trade comparative advantage

Calculate the internal exchange rates and external exchange rate

Internal exchange rates

The rate at which goods are exchanged between countries before the trade is the internal exchange rate. As mentioned in table 2, we can identify the internal exchange rate of Germany and Italy as follows.

In Germany, the opportunity cost of producing a camera is 0.5 watches. That means, when Germany produces a camera, it has to sacrifice the production of 0.5 watches.  

The opportunity cost of producing a camera in Italy is 1.5 watches. That means, when Italy produces a camera, it has to sacrifice the production of 1.5 watches.

In Germany, opportunity cost of producing a watch is 2 cameras. That means, when Germany produces a watch, it has to sacrifice the production of 2 cameras. 

The opportunity cost of producing a watch in Italy is 0.67 cameras. That means, when Italy produces a watch, it has to sacrifice the production of 0.67 cameras.

External exchange rate

External exchange rate is the rate at which goods are exchanged between countries as a result of entering into trade.

So, the international trade to be beneficial between both countries, Germany should import more than 0.5 watches when it exports one camera to Italy. Italy should export less than 1.5 watches to Germany when it imports a camera.

Italy should import more than 0.67 cameras when it exports one watch to Germany. Germany should export less than 2 cameras to Italy when it imports a watch.

Terms of trade comparative advantage: We assume that Italy and Germany enter into trade under the external exchange rate of 1 camera to 1 watch rate. Then both countries will reach a higher consumption level than before trade.

Step 5: comparative advantage graphs of both countries

Table 1 shows how many watches or cameras can be produced by each country using one hour of labour. Let’s assume that both countries have 100 labour hours. Following table 3 shows the production possibility of Germany and Italy.

The following comparative advantage graph show how production possibility and purchasing power of Germany after they engage in international trade.

The following comparative advantage graph show how production possibility and purchasing power of Italy after they engage in international trade.