Comparative advantage explained with two onion and grape growers in Nashik

Opportunity cost, the starting point. The opportunity cost of a good is the amount of another good that has to be given up to produce one more unit of it. The principle of comparative advantage is built on this idea.

Absolute and comparative advantage.

• A producer has an absolute advantage in a good if it can produce more of it from its resources than another producer can; better technology, more labour or richer natural resources can give a country such an advantage.
• A producer has a comparative advantage in a good if it can produce that good at a lower opportunity cost than the other producer. The concept is David Ricardo's.
• One producer can hold the absolute advantage in both goods, but not the comparative advantage in both: each has a comparative advantage in one good or the other.

The principle. Each producer should specialise in the good in which its opportunity cost is lower, even where one of them is better at producing both goods, and then trade for the other good. Because each good is then produced by the person who gives up least to produce it, total output rises, and both sides can gain from trade.

Example: two growers in Nashik. Our own figures. In a season, Kavita's land can yield either 400 quintals of onions or 100 quintals of grapes; Nitin's land can yield either 150 quintals of onions or 50 quintals of grapes.

• Advantages. Kavita grows more of both crops, so she has the absolute advantage in both. But a quintal of grapes costs Nitin only 3 quintals of onions against 4 for Kavita, so Nitin's comparative advantage is in grapes; a quintal of onions costs Kavita only 0.25 quintal of grapes against 0.33 for Nitin, so Kavita's comparative advantage is in onions.
• Without specialisation. Each puts half the land under each crop: Kavita grows 200 onions and 50 grapes, Nitin 75 onions and 25 grapes. Total: 275 quintals of onions and 75 of grapes.
• With specialisation. Nitin grows only grapes (50). Kavita puts 70% of her land under onions (280) and 30% under grapes (30). Total: 280 quintals of onions and 80 of grapes, more of both crops from the same land.
• The trade. Nitin gives Kavita 22 quintals of grapes for 77 quintals of onions, a rate of 3.5 onions per quintal of grapes, which lies between his opportunity cost (3) and hers (4).

What the example shows. Both growers end with more of both crops than they could have had on their own, although Kavita is the better grower of both. The gain rests on two conditions: their opportunity costs differ (if each gave up the same amount of onions per quintal of grapes, specialising would add nothing), and the rate of exchange lies between the two opportunity costs, so that each buys a crop more cheaply than she or he could grow it.

Conclusion. The principle of comparative advantage says that what decides who should produce what is the lower opportunity cost, not the larger output. When each party specialises in the good it produces at the lower opportunity cost and trades at a rate between the two costs, total output rises and every party gains.