Comparative and Absolute Advantage

Principle of Absolute Advantage

• Absolute Advantage: one country would have an absolute advantage over if it can produce same amount of goods with fewer resources
• This is then the ability of a country to produce more goods than its competitors using same or less resources

Principle of Comparative Advantage

• A nation has comparative advantage in the production of a product when it can produce the product at a lower domestic opportunity cost than can a trading partner 
• It is also the basis for all trade
• If the two nations specialize according to comparative advantage, then to get the other product, they must trade

Chapter 29-Specialization and Trade

1. Specialization and international trade improve a producer's productivity and allow it to achieve greater output than it could otherwise

           a) Specialization occurs when productive agents (such as persons or nations) use their available resources to focus on producing one or a few products at which they are best suited

               i) Economic resources needed to efficiently produce particular goods aren't evenly distributed among producers

              ii) Thus, some producers are better suited to produce certain items than other

          b) International trade occurs when buyers and sellers in two nations exchange with one another

              i) A nation has a closed economy when it neither imports nor exports products (this is the situation represented by the basic market model)

              ii) A nation has an open economy when it both imports and exports products. By trading products they specialize in for those they don't, a nation with an open economy can obtain more of both.

          c) Cost ratios provide a method of comparing opportunity costs of production certain items between producers

              i) The lower a nation's cost ration, the lower its opportunity cost in producing certain items-in other words, the lower the cost ratio, the greater the cost advantage. 

                     (a) Like per-unit opportunity costs, cost ratios measure how much of one good must be surrendered for every unit of another good gained-opportunity costs compare different production possibilities within a single opportunity cost compare different production possibilities within a single nation whereas cost ratios compare national production between nations

                     (b) Cost ratios can be compared between different nations for the same item OR between different items within the same nation

            ii) Cost ratios can be calculated using output or input data-both approaches lead to the same results if done correctly

            iii) In general, producers should specialize in making a product only when their cost ratio of doing so is less than that of their trading partners

  

  2) Output problem approach is based on the most of an item each producer should make if it specializes using a set amount of resources (generally, all its resources)-these problems are stated in terms of output per resource unit (apples per acre, widgets per hour, etc.)

        a) Determine the maximum amount of each item each producer can make if they use all their resources and arrange the data in a table with the producers as rows and the products as columns 

          b) Divide each producer's output data in the following manner: Divide its OUTPUT data of the OTHER item OVER the data for the one whose cost ratio you wish to find

           c) Reduce the fractions to the lowest common denominator

           d) Compare cost ratios for each product between the two producers and select the nation that has the lowest cost ratio for each product-in general, divide across rows and compare up-and-down columns

   3) Input problem approach is based on the least resources each producer needs to make a set amount of an item (generally one unit)-these problems are stated in terms or resources per output unit (minutes per waffle, cups of flour per dozen loaves, etc.)

         a) Determine the minimum amount of resources each producer needs to make one unit of an item if they specialize ad list the data in a table with the producers as rows and the products as columns

           b) Divide each producer's input data in the following manner: Divide the INPUT data of the other item INTO (i.e., place it beneath the line as a denominator) the data for the item whose cost ratio you INTEND to find

             c) Reduce the fractions to the lowest common denominator

             d) Compare cost ratios for each product between the two nations and select the nation that has the lowest cost ratio for each product

     4) Rules of specialization-these hold true for both input and output problems 

            a) In general, producers should specialize in making a product only when their cost ratio of doing so is less than that of their trading partners

            b) The no advantage rule states that nations should not specialize or trade if neither trading partner possesses a cost advantage in producing either product

• Though Funkytown produces greater total output, neither has an advantage when cost ratios are compared

            c) The absolute advantage rule (Adam Smith) states that two countries should specialize and trade when each partner has an output advantage over the other

• This rule isn't always a reliable guide because having an output advantage doesn't guarantee a cost advantage (in terms of cost ratios)

                d) The comparative advantage rule (David Ricardo) states that two countries should specialize and trade, even if one produces more output of both products, as long as each partner has a cost advantage over the other

Example: 

• Though Boogieland has an absolute advantage in both products, each nation still enjoys a cost advantage over the other and therefore should specialize and trade.

     5) Trade possibilities curves provide an alternative way of solving output problems

              a) The trade possibilities curve (TPC) shows the amount of two items a country can obtain by specializing in one and trading for the other.

                     i) The production possibilities curve (PPC) assumes a closed economy where trade-offs must be made in how a nation uses its own resources

                    ii) The TPC assumes an open economy where a nation is free to specialize its own production and trade with other nations

               b) Comparing the TCPs of different economies reveals their absolute and comparative advantage

                    i) The slope of the trade possibilities curve, which may be found using the slope formula (y1-y0)/(x1-x0), provides the opportunity cost of producing one more unit of a particular good.

Examples (Note: Use the absolute values to simplify the comparisons)

Opportunity cost of good X for TCP1 = (30-0) / (0-25) = |6/5|

Opportunity cost of good X for TCP2 = (50-0) / (0-50) = |1|

Opportunity cost of good Y for TPC1 = (25-0) / (0-30) = |5/6|

Opportunity cost of good Y for TCP2 = (50-0) / (0-50) = |1|

                       ii) The nation with the lower opportunity cost has a comparative advantage in that particular item-in the above example, though nation 2 has the absolute advantage in producing both goods, nation 2 has a comparative advantage in producing good X (1<6/5) while nation 1 has the comparative advantage in producing good Y (5/6<1)