2 5: Definitions- Absolute and Comparative Advantage

Figure 33.2 illustrates what each country is capable of producing on its own using a production possibility frontier (PPF) graph. Table 33.1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good. The Theory of Absolute Advantage is one of the earliest economic theories that explains the benefits of specialisation and international trade between countries. The concept of absolute advantage was first introduced in 1776 in the context of international trade by Adam Smith, a Scottish philosopher considered the father of modern economics. Thirdly, Smith applies the same principles of opportunity costs and specialization to international economic policy, and the principle of international trade. He explains that it is better to import goods from abroad where they can be manufactured more efficiently because it allows the importing country to put its resources into its own most productive and efficient industries.

From the table above, Indonesia has an absolute advantage in producing clothing and shoes. Indonesia produces 6 shoes and 3 clothes per hour, more than Malaysia, which only makes 1 shoe and 2 clothes per hour. Opportunity cost becomes a crucial explanation because we are dealing with scarce resources. When we use resources – such as land, labor, or capital, to produce certain goods, they are not available to produce other goods. For instance, Indonesia uses its land to produce rice because it has an absolute advantage in this aspect.

  1. 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.
  2. Skylar Clarine is a fact-checker and expert in personal finance with a range of experience including veterinary technology and film studies.
  3. This shape illustrated that as inputs were transferred from producing one good to another—like from education to health services—there were increasing opportunity costs.
  4. His theory stated that a nation’s wealth shouldn’t be judged by how much gold and silver it had but rather by the living standards of its people.

Starting at point C, which shows Saudi oil production of 60, reduce Saudi oil domestic oil consumption by 20, since 20 is exported to the United States and exchanged for 20 units of corn. This enables Saudi to reach point D, where oil consumption is now 40 barrels absolute advantage theory and corn consumption has increased to 30 (see Figure 20.3). Notice that even without 100% specialization, if the “trading price,” in this case 20 barrels of oil for 20 bushels of corn, is greater than the country’s opportunity cost, the Saudis will gain from trade.

To be at point C’, the U.S. economy devotes 40 worker hours to produce 20 barrels of oil and it can allocate the remaining worker hours to produce 60 bushels of corn. Thus, before trade, the Saudi Arabian economy will devote 60 worker hours to produce oil, as Table 33.3 shows. Given the information in Table 33.1, this choice implies that it produces/consumes 60 barrels of oil. British economist David Ricardo later built on Smith’s concepts by more broadly introducing comparative advantage in the early 19th century.

2: Absolute and Comparative Advantage

Comparative advantage focuses on the range of possible mutually beneficial exchanges. In economics, absolute advantage refers to the capacity of any economic agent, either an individual or a group, to produce a larger quantity of a product than its competitors. Swedish economist https://1investing.in/ Steffan Linder developed the country similarity theory in 1961, as he tried to explain the concept of intraindustry trade. Linder’s theory proposed that consumers in countries that are in the same or similar stage of development would have similar preferences.

By the mid-twentieth century, the theories began to shift to explain trade from a firm, rather than a country, perspective. These theories are referred to as modern and are firm-based or company-based. Both of these categories, classical and modern, consist of several international theories.

As some have argued, “geography is destiny.” Chile will provide copper and Guatemala will produce coffee, and they will trade. When each country has a product others need and it can be produced with fewer resources in one country over another, then it is easy to imagine all parties benefitting from trade. However, thinking about trade just in terms of geography and absolute advantage is incomplete. Let’s say that before trade occurs, both countries produce and consume at point C or C’. Thus, before trade, the Saudi Arabian economy will devote 60 worker hours to produce oil, as shown in Table 3. Given the information in Table 1, this choice implies that it produces/consumes 60 barrels of oil.

With trade, the United States can consume more of both goods than it did without specialization and trade. Given their current production levels, if the United States can trade an amount of corn fewer than 60 bushels and receive in exchange an amount of oil greater than 20 barrels, it will gain from trade. Table 20.5 illustrates the range of trades that would benefit both sides.

Understanding Absolute Advantage

The idea of absolute advantage was developed by Scottish economist Adam Smith, who explained how countries can profit by only specializing in the goods and services they can produce efficiently. Smith suggested that countries can open up trade with others for products they can’t make efficiently on their own. The benefit of reaching absolute advantage when it comes to producing a single good or service boils down to pure economics and profit. Making a product that others need (and can’t produce) allows you to initiate a trade relationship for goods and services you need but can’t produce yourself. This will enable you to profit from the sale of your (specialized) goods and still be able to enjoy the goods you import from your trading partner(s). Zambia has an absolute advantage in copper production due to its abundant copper reserves and low cost of production.

Smith thus emphasizes that a difference in technology between nations is the primary determinant of international trade flows around the globe. The purpose of the theory of absolute advantage is to demonstrate the benefits of specialisation and international trade between countries. By specialising in the production of goods and services in which they have an absolute advantage, countries can increase their output through better resource allocation. This, in turn, can lead to economic growth and higher living standards.

The theory of comparative advantage was developed by David Ricardo, who built on Adam Smith’s work to argue that, in fact, a country doesn’t have to have an absolute advantage for beneficial trade to occur. Adam Smith assumes that we will get constant returns as production scales, meaning there are no economies of scale. For example, if it takes 2 hours to make one loaf of bread in country A, then it should take 4 hours to produce two loaves of bread. To calculate absolute advantage, examine the output of the product in question between two entities. Let’s say that with the exact same resources, Worker A produces 60 glue sticks and 25 large foam pads per hour, and Worker B produces 20 glue sticks and 35 foam pads per hour.

Comparative Advantage

The Blue country has an Absolute Advantage in the production of Good A (2 hours). Blue county has an absolute advantage because it takes fewer hours to produce a unit of Good A than Red country, which takes 10 hours. Scottish economist Adam Smith helped originate the concepts of absolute and comparative advantage in his book, The Wealth of Nations. Smith argued that countries should specialize in the goods they can produce most efficiently and trade for any products they can’t produce as well.

Thus the United States generates more pounds of cheese per hour of work. Consider another example, such as when the United States and Saudi Arabia start at C and C’, respectively, as Figure 20.2 shows. Consider another example, such as when the United States and Saudi Arabia start at C and C’, respectively, as Figure 33.2 shows. In 1817, David Ricardo, a businessman, economist, and member of the British Parliament, wrote a treatise called On the Principles of Political Economy and Taxation. In this treatise, Ricardo argued that specialization and free trade benefit all trading partners, even those that may be relatively inefficient. To see what he meant, we must be able to distinguish between absolute and comparative advantage.

This, Smith believed, was the root source of the eponymous “Wealth of Nations.” Porter’s theory, along with the other modern, firm-based theories, offers an interesting interpretation of international trade trends. Nevertheless, they remain relatively new and minimally tested theories. People or entities trade because they believe that they benefit from the exchange.

To simplify, let’s say that Saudi Arabia and the United States each have 100 worker hours (see Table 2). We illustrate what each country is capable of producing on its own using a production possibility frontier (PPF) graph, shown in Figure 1. Recall from Choice in a World of Scarcity that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers, and its level of technology. Consider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. Further assume that consumers in both countries desire both these goods. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country.

So that France has the comparative advantage in cheese production relative to the United States. There are several good examples of this in the Chinese economy and the Canadian Economy. The Chinese economy exports low-cost manufactured goods, and takes advantage of their low unit labor costs. As you can see from our example, it makes sense for businesses and countries to trade with one another. All countries engaged in open trade benefit from lower costs of production. Therefore Red Country has an Absolute Advantage in the production of Good B.

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