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33 1 Absolute and Comparative Advantage Principles of Economics 3e

It can get more food from its neighbor by trading it for oil than it could produce on its own. Countries like China and South Korea have made major productivity gains by specializing their economies in certain export-focused industries, where they had a comparative advantage. But what if your roommate is a veritable Martha Stewart, able to cook and clean faster and better than you? The answer is to look not at her absolute advantage, but at your opportunity costs.

England would receive more value by exporting products that required skilled labor and machinery. Comparative advantage is the ability of a country to produce a good or service for a lower opportunity cost than other countries. Competitive advantage refers to a company, economy, country, or individual’s ability to provide a stronger value to consumers as compared with its competitors.

In country A, the workforce could make 1,000 rice cakes, or they could bake 3,000 loaves of banana bread. Or, they could split the workforce in comparative advantage example half, and make 500 rice cakes and 1,500 loaves of banana bread. Consumers in each country like to eat a mixture of rice cakes and banana bread.

  1. Taking a broader perspective, there has been work about the benefits of international trade.
  2. Comparative advantage is used to explain why companies, countries, or individuals can benefit from trade.
  3. This is because it only has to give up 0.1 of a truck to produce a car.
  4. Now naturally, both countries can produce both goods, but the quality of China’s cars does not match that of Germany, and cell phone production costs would be extremely high in Germany.
  5. According to the law of comparative advantage, an individual should produce the goods with the lowest opportunity costs, the value and benefits that individual sacrifices when selecting one option over another.
  6. When we transfer a marginal unit of labor away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same.

However, the difference between what I make per hour and what you make per hour cleaning is only $5, compared to a whopping $90 difference between our wages working as a lawyer. I’m ‘least bad’  at cleaning your house, in other words I have a comparative advantage at cleaning, so both of us would be better off if you paid me to clean your house and devoted all your time to earning the big bucks at that fancy law firm. You may be better than me at everything, but I still have the comparative advantage at cleaning your house – ha!

Comparative Advantage in International Trade

Oil-producing nations, for example, have a comparative advantage in chemicals. Their locally-produced oil provides a cheap source of material for the chemicals when compared to countries without it. A lot of the raw ingredients are produced in the oil distillery process. As a result, Saudi Arabia, Kuwait, and Mexico became competitive with U.S. chemical production firms in the early 1980s. Comparative advantage is a key principle in international trade and forms the basis of why free trade is beneficial to countries.

Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Adam Smith is often considered to be the father of modern economics. By contrast, India can produce either 80 kilograms of wheat or 100 kilograms of potatoes. Cristiano Ronaldo, a famous soccer star has a clear advantage over the average person in his ability. For instance, he is consistently rated as one of the best players in the world.

What is the approximate value of your cash savings and other investments?

This is in sharp contrast to absolute advantage because a nation can have a comparative advantage but not actually be more efficient than other countries. In Table 33.1, Saudi Arabia has an absolute advantage in producing oil because it only takes an hour to produce a barrel of oil compared to two hours in the United States. Skeptics of comparative advantage have underlined that its theoretical implications hardly hold when applied to individual commodities or pairs of commodities in a world of multiple commodities. Deardorff argues that the insights of comparative advantage remain valid if the theory is restated in terms of averages across all commodities.

The theory of comparative advantage is attributed to political economist David Ricardo, who wrote the book Principles of Political Economy and Taxation (1817). Now that we’ve explored the law of comparative advantage, we need to make an important distinction. When a person or country has an absolute advantage, that means they can produce more of a good or service with the same amount of resources than other people or countries can. Another way to say it is they can produce it more cheaply than anybody else. This is a measure of how productive a person or country is when they produce a good or service. For example, let’s say that country A can produce a ton of wheat in less time than any other nation with the same amount of resources.

The primary fear for nations entering free trade is that they will be out-produced by a country with an absolute advantage in several areas, which would lead to imports but no exports. Comparative advantage stipulates that countries should specialize in a certain class of products for export, but import the rest – even if the country holds an absolute advantage in all products. In this example, the US makes 30 million cars and 10 million trucks, whilst Japan produces 25 million cars and 2.5 million trucks. Although it is 1.2 times better than Japan in producing cars, it is 4 times better at producing trucks.

Critical factors in the concept of comparative advantage include resources, specialization, efficiency, and time. John makes hats more efficiently, and Mason makes t-shirts more efficiently. By calculating each opportunity cost, John has the lower opportunity cost. The comparative advantage number represents the opportunity cost, and therefore Carl has a comparative advantage as he has the lower number.

The differentiation between the varying abilities of companies and nations to produce goods efficiently is the basis for the concept of absolute advantage. As such, absolute advantage looks at the efficiency of producing a single product. It also looks at how to produce goods and services at a lower cost by using fewer inputs during the production process compared to the competition.

A nation with a comparative advantage makes the trade-off worthwhile. This means the benefits of buying its good or service outweigh the disadvantages. The country may not be the best at producing something, but the good or service has a low opportunity cost for other countries to import.

Generally, people should do the action that they’re the least bad at, working to their comparative advantage. According to Ricardo, a properly structured international trade agreement could work out for both countries, even if country A is more efficient at making both banana bread and rice cakes. But the motive may no less exist, where one of the two countries has facilities superior to the other in producing both commodities. One critique of the textbook model of comparative advantage is that there are only two goods.

Identifying Comparative Advantage

He concluded that some nations may have a complete absolute advantage in many industries, but still face a level of opportunity cost. So whilst France is better at producing wine and cheese, it may be more productive in making wine. In other words, nations still trade if they have an absolute advantage because there is an element of opportunity cost. By contrast, comparative advantage is where a country can produce a specific good at a lower opportunity cost. It is for this reason that the US has a comparative advantage in producing trucks. Yet, Japan has an opportunity cost advantage in the production of cars.

How Do You Calculate Absolute Advantage?

In terms of corn, notice that Saudi Arabia gives up the least to produce a barrel of oil. Absolute advantage is when an individual can produce a single good more efficiently than another individual. Comparative advantage is the more complex side of absolute advantage. Comparative advantage is when two individuals each produce two or more goods, but one has a comparative advantage over the other by calculating opportunity costs. According to the law of comparative advantage, an individual should produce the goods with the lowest opportunity costs, the value and benefits that individual sacrifices when selecting one option over another. The underlying reason why trade benefits both sides is rooted in the concept of opportunity cost, as the following Clear It Up feature explains.

When you first met the production possibility frontier (PPF) in the chapter on Choice in a World of Scarcity we drew it with an outward-bending shape. This shape illustrated that as we transferred inputs from producing one good to another—like from education to health services—there were increasing opportunity costs. In the examples in this chapter, we draw the PPFs as straight lines, which means that opportunity costs are constant. When we transfer a marginal unit of labor away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same.

He defined it as a state by which one nation was more efficient at producing a certain good than another. However, unlike absolute advantage, comparative advantage considers opportunity cost. One factor in America’s comparative advantages is its vast landmass bordered by two oceans.

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