Absolute and Comparative Advantages

Absolute Advantage

¤ Absolute advantage – a country has an absolute advantage in a good if with the same quantity of resources it can produce more of that good than another country.

Theory of Absolute Advantage

¤ According to the theory of absolute advantage, if countries specialize in and export the good in which they have an absolute advantage (can produce with fewer resources), the result is increased production and consumption in both countries.

Which country has an absolute advantage in each good?

Practice Quiz

Country A Country B

Example 1 Good X 6 3

Good Y 2 3

Example 2 Good X 3 8

Good Y 6 4

Who has the absolute advantage in good x and good y in each example? Draw the PPF’s. Who should make what?

Comparative Advantage

¤ Comparative advantage – when one country has a lower opportunity cost in the production of a good than another country.

¤ Opportunity cost - the value of the next best alternative that must be given up to obtain something.

Theory of Comparative Advantage

¤ Theory of Comparative Advantage - As long as the opportunity costs differ in two countries, it is possible for both countries to gain by specializing in and exporting the good in which they have a comparative advantage.

Which country has an comparative advantage in each good?

Practice Quiz

Country A Country B

Example 1 Good X 3 6

Good Y 1 6

Example 2 Good X 1 2

Good Y 4 4

Who has the comparative advantage in good x and good y in each example? Calculate the opportunity costs and draw the PPFs

Using the last example….

¤ Show points of possible production and consumption for each of the two countries after specialization and trade according to comparative advantage.

Parallel PPCs – No gains from trade

With the same opportunity costs, there is no comparative advantage. Countries cannot specialize and trade.

Causes of Comparative Advantage

¤ What are possible reasons for comparative advantage?

Why do countries have comparative advantages?

¤ Differences in factors of production (land, labor, capital , entrepreneurship)

¤ Differences in technology

Comparative Advantage

¤  The theory of comparative advantage forms the basis of trade policies in many countries today.

¤  It’s conclusion that trade increases production and consumption and gives us a better allocation of resources, has been leading to increased trade liberalization (free trade) in recent years (especially since the 1990’s).

Problems with the Theory

Factors of production are immobile and fixed

¤  In the real world, factors of production (such as workers and machines) often move between countries

Problems with the Theory

Technology is fixed

¤  In the real world, technology is always changing

There is perfect competition

¤ This is rarely true

Problems with the Theory

There is full employment of resources

¤ This is never true. For example, all countries have some unemployment.

Problems with the Theory

Imports and Exports Balance Each Other

¤ Most countries import or exports different amounts. This can be a problem in places that import a lot more than they export.

Problems with the Theory

There is free trade

¤ Every countries controls trade to some extent.

There are no transportation costs

¤ The cost of moving goods will change their relative prices.

Problems with the Theory

Specialization may not allow for needed change

Trade using comparative advantage may lead to excessive specialization

¤ Countries may become vulnerable on factors beyond their control.