At the end of this section, you can:
- Show the relationship between production costs and comparative advantage.
- Identify mutually beneficial negotiation situations.
- Identify business benefits considering opportunity costs
What happens to trade opportunities when one country has an absolute advantage in everything? This is typical of high-income countries, which generally have a well-trained workforce, technologically advanced equipment, and state-of-the-art production processes. These high-income countries can produce all the products with fewer resources than a low-income country. If the high-income country is more productive overall, will there still be trade gains? Ricardo's good students understand that trade is a mutually beneficial exchange. Even if one country has an absolute advantage in all products, both parties can benefit from trade. This is because trade gains result from specialization in one's own comparative advantage.
Consider the example of trade between the United States and Mexico described inTabla 8. In this example, it takes four American workers to produce 1,000 pairs of shoes, but five Mexican workers to do so. It takes one American worker to produce 1,000 refrigerators, but it takes four Mexican workers to do it. The United States has an absolute productivity advantage in both shoes and refrigerators; That is, fewer workers are needed in the United States than in Mexico to produce a given number of shoes and a given number of refrigerators.
|Tierra||Number of workers needed to produce 1,000 units — Footwear||Number of workers needed to produce 1,000 units - Refrigerators|
|USA||4 workers||1 worker|
|Mexico||5 workers||4 workers|
|Tabla 8.Resources needed to make shoes and coolers|
The absolute advantage compares this simplyproductivityof an employee in all countries. Answer the question: "How many inputs do I need to produce shoes in Mexico?" Comparative advantage asks the same question a little differently. Instead of comparing how many workers it takes to produce a good, ask, "How much do I have to give up to produce that good in this country?" Another way of looking at this is that comparative advantage identifies the good in which the producer's absolute advantage is relatively greater or the producer's absolute productivity disadvantage is relatively less. The United States can produce 1,000 shoes with four-fifths the number of workers in Mexico (four versus five), but it can produce 1,000 refrigerators with only one-fourth the number of workers (one versus four). Thus, the comparative advantage of the United States, where its absolute productivity advantage is relatively greater, is in refrigerators, and the comparative advantage of Mexico, where its absolute productivity disadvantage is less, is in the manufacture of footwear.
When nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. Again, the production possibilities frontier is a useful tool for visualizing this benefit.
Imagine a situation where the United States and Mexico have 40 workers each. for example likeTabla 9shows that if the United States divides its labor so that 40 workers make shoes, as it takes four workers in the United States to make 1,000 shoes, a total of 10,000 shoes will be produced. (If four workers can make 1,000 shoes, then 40 workers will make 10,000 shoes.) If 40 workers in the United States make refrigerators and each worker can produce 1,000 refrigerators, then a total of 40,000 refrigerators will be produced.
Production of refrigerators - with 40 workers
|Tierra||Footwear production - with 40 workers|
|USA||10,000 shoes||o||40,000 refrigerators|
|Mexico||8,000 shoes||o||10,000 refrigerators|
|Tabla 9.Full Specialization Pre-Trade Production Opportunities|
As always, the slope of each country's production possibilities frontier equals the opportunity cost of a refrigerator in terms of lost shoe output if labor shifts from the latter to the former production (seeillustration 1).
Suppose that, in the pre-trade situation, each nation prefers to produce the pair of shoes and refrigerators shown in point A.Tabla 10shows the production of each good for each country and the total production for the two countries.
|Tierra||Current footwear production||Current production of refrigerators.|
|Tabla 10.Total production at point A before trade|
Continuing with this scenario, each country transfers part of its labor force to its zone of comparative advantage. For example, the United States sends six shoe industry workers to produce refrigerators. As a result, US shoe production falls by 1,500 units (6/4 × 1,000), while refrigerator production increases by 6,000 (ie, 6/1 × 1,000). Mexico is also shifting production to its area of comparative advantage, shifting 10 workers from refrigerators to shoe manufacturing. As a result, the production of refrigerators in Mexico falls by 2,500 (10/4 × 1,000), but the production of shoes increases by 2,000 pairs (10/5 × 1,000). Note that when both countries shift production toward their respective comparative advantages (even though they are relatively better), their combined production of both goods increases, as shown inTabla 11. The reduction in shoe production of 1,500 pairs in the United States is more than offset by the gain of 2,000 pairs of shoes in Mexico, while the reduction of 2,500 refrigerators in Mexico is more than offset by the additional 6,000 refrigerators produced in the United States .
|Tierra||shoe production||production of refrigerators|
|Tabla 11.Shifting production to comparative advantage increases overall performance|
This numerical example illustrates the remarkable finding of comparative advantage: even if one country has an absolute advantage in all goods and another country has an absolute disadvantage in all goods, both countries can still benefit from trade. Although the United States has an absolute advantage in the production of refrigerators and shoes, it makes economic sense to specialize in the good for which it has a comparative advantage. The United States will export refrigerators and import shoes in return.
This example shows that both parties can benefit from specializing in their comparative and commercial advantages. Using the opportunity cost in this example, it is possible to identify the range of possible deals that would benefit each country.
Before specialization and trade, Mexico began with the production of 4,000 pairs of shoes and 5,000 refrigerators (cf.illustration 1miTabla 10). So, in the given numerical example, Mexico shifted production to its comparative advantage and produced 6,000 pairs of shoes, but only 2,500 refrigerators. So if Mexico canExportno more than 2,000 pairs of shoes (if 2,000 pairs of shoes are sold) in exchangeimportedof at least 2,500 refrigerators (a profit of 2,500 refrigerators), he will be able to consume more of both goods than before the trade. Mexico will definitely be better. By contrast, before specialization and trade, the United States began producing 5,000 pairs of shoes and 20,000 refrigerators. In the example, you shifted production to your comparative advantage, producing only 3,500 shoes but 26,000 refrigerators. If the United States cannot export more than 6,000 refrigerators in exchange for importing at least 1,500 pairs of shoes, it will be able to consume more of both goods and obviously be better off.
The variety of professions that can benefit both nations is illustrated inTabla 12. For example, a trade in which the US exports 4,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes would benefit both parties, in the sense that both countries could consume more of both goods than they would in a world without trade.
|The US economy will benefit after specialization if:||After specialization, the Mexican economy will benefit if:|
|Exportless than 6,000 coolers||importedat least 2,500 refrigerators|
|importedat least 1500 pairs of shoes||Exportno more than 2,000 pairs of shoes|
|Tabla 12.The commercial offer that benefits the United States and Mexico|
Trade allows each country to benefit from lower opportunity costs in the other country. If Mexico wants to produce more refrigerators without trade, it will have to face its internal opportunity cost and reduce the production of footwear. If, instead, Mexico produces more shoes and then sells refrigerators to the United States, whereopportunity costsproduction of refrigerators is lower, Mexico can really benefit from the lower opportunity cost of refrigerators in the United States. On the other hand, if the United States specializes in its comparative advantage of producing refrigerators and marketing Mexican shoes, international trade allows the United States to take advantage of the lower opportunity cost of producing shoes in Mexico.
The theory of comparative advantage explains why countries trade: they have different comparative advantages. It shows that the gains from international trade result from the search for comparative advantages and production with lower opportunity costs. The Work It Out function below shows how to calculate absolute and comparative advantage and how to apply it to a country's output.
Calculation of Absolute and Comparative Advantage
In Canada, a worker can produce 20 barrels of oil or 40 tons of lumber. In Venezuela, a worker can produce 60 barrels of oil or 30 tons of wood.
- Who has an absolute advantage in the production of oil or wood? As you know?
- Which country has a comparative advantage in oil production?
- Which country has a comparative advantage in timber production?
- In this example, is absolute advantage the same as comparative advantage or not?
- What product should Canada specialize in? What product should Venezuela specialize in?
Step 1. Make a table likeTabla 13.
Step 2. To calculate the absolute benefit, consider the larger of the numbers for each product. A worker in Canada can produce more wood (40 tons vs. 30 tons), so Canada has the absolute advantage in wood. A worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who can only produce 20.
Step 3. To calculate comparative advantage, find the opportunity cost of producing a barrel of oil in both countries. The country with the lowest opportunity cost has the comparative advantage. With the same amount of labor, Canada can produce 20 barrels of oil or 40 tons of lumber. Thus, 20 barrels of oil correspond to 40 tons of wood: 20 oil = 40 wood. Divide both sides of the equation by 20 to find the opportunity cost of a barrel of oil in Canada. 20/20 oil = 40/20 wood. 1 oil = 2 wood. Producing an additional barrel of oil in Canada has an opportunity cost of 2 lumber. Do the same for Venezuela: 60 oil = 30 wood. Divide both sides of the equation by 60. An oil in Venezuela has an opportunity cost of 1/2 wood. Since 1/2 wood < 2 wood, Venezuela has a comparative advantage in oil production.
Step 4. Calculate the opportunity cost of a lumber by reversing the numbers, with lumber on the left side of the equation. In Canada, the labor time of 40 pieces of wood is equivalent to 20 barrels of oil: 40 pieces of wood = 20 oils. Divide each side of the equation by 40. The opportunity cost of a piece of wood is 1/2 oil. In Venezuela, the equivalent labor time will produce 30 wood or 60 oil: 30 wood = 60 oil. Divide each side by 30. One wood has an opportunity cost of two oils. Canada has the lowest opportunity cost of timber production.
Step 5. In this example, absolute advantage is the same as comparative advantage. Canada has the absolute and comparative advantage in timber; Venezuela has an absolute and comparative advantage in oil.
Step 6. Canada should specialize in what has a relatively lower opportunity cost, ie timber, and Venezuela should specialize in oil. Canada will export wood and import oil, and Venezuela will export oil and import wood.
To gain an intuitive understanding of how comparative advantage can benefit all parties, set aside for a moment examples involving national economies and consider the situation of a group of friends who decide to go camping together. The six friends have a wide range of skills and experiences, but one person in particular, Jethro, has been camping a lot and is also a great athlete. Jethro has an absolute advantage in all aspects of the camp: he is faster at backpacking, gathering firewood, rowing a canoe, setting up tents, cooking, and washing dishes. So here's the question: Since Jethro has an absolute productivity advantage in everything, should he be doing all the work?
Of course not! While Jethro is willing to work like a mule while everyone else sits, like most mortals he only has 24 hours a day. If everyone sits back and waits for Jethro to do everything, Jethro will not only be an unlucky camper, but there won't be much production for his group of six friends to consume. Comparative advantage theory suggests that everyone will benefit from discovering their areas of comparative advantage, that is, the area of the camp where their productivity disadvantage compared to Jethro is the least. For example, Jethro can be 80% faster than anyone else at starting a fire and cooking, but only 20% faster at gathering firewood and 10% faster at setting up tents. In this case, Jethro should focus on lighting fires and cooking, letting others handle the other tasks depending on where his productivity handicap is least. When campers coordinate their efforts to gain a comparative advantage, everyone can benefit.
Even if a country has high levels of productivity across all goods, it can still benefit from trade. Trade gains result from comparative advantages. By specializing in a commodity that sacrifices less to produce, a country can produce more and offer that extra output for sale. If other countries also specialize and trade in their area of comparative advantage, the high-productivity country can benefit from lower opportunity costs of production in other countries.
In Germany, it takes three workers to make a television and four workers to make a video camera. In Poland it takes six workers to make a television and twelve workers to make a video camera.
- Who has the absolute advantage in the manufacture of televisions? Who has the absolute advantages in the production of video cameras? As you know?
- Calculate the opportunity cost of producing an additional television in Germany and Poland. (Your calculation may include fractions, which is fine.) Which country has a comparative advantage in manufacturing televisions?
- Calculate the opportunity costs of producing a video camera in Germany and Poland. Which country has a comparative advantage in the production of video cameras?
- In this example, is absolute advantage the same as comparative advantage or not?
- What product should Germany specialize in? What product should Poland specialize in?
- Is it possible to have a comparative advantage in the production of a good but not an absolute advantage? Explain.
- How does comparative advantage lead to business gains?
critical thinking questions
- You just heard your friend say the following: “Poor countries like Malawi do not have absolute advantages. They have poor soils, little investment in formal education, and therefore low-skilled labor, no capital, and no significant natural resources. Since they have no advantage, they cannot benefit from trade.” How would you react?
- To seeTabla 10. Is there a set of operations that do not generate benefits?
- You just got a job in Washington, D.C. to receive. You move into an apartment with some friends. However, all of her roommates are lazy and don't clean. You, on the other hand, can clean faster than any of them. You'll find it's 70% faster when washing dishes and 10% faster when vacuuming. All these tasks must be done on a daily basis. What chores should you assign to your roommates to have more free time? Suppose you have the same number of hours to clean. Now that you're faster, you seem to finish faster than your roommate. What kind of problems can this cause? Can you think of a negotiation-related analogy for this problem?
- In Japan, a worker can produce 5 tons of rubber or 80 spokes. In Malaysia, a worker can make 10 tons of rubber or 40 spokes.
- Who has the absolute advantages in the production of rubber or spokes? As you know?
- Calculate the opportunity cost of producing an additional 80 radios in Japan and Malaysia. (Your calculation may include fractions, which is fine.) Which country has a comparative advantage in manufacturing radios?
- Calculate the opportunity cost of producing an additional 10 tons of rubber in Japan and Malaysia. Which country has a comparative advantage in rubber production?
- In this example, does each country have an absolute advantage and a comparative advantage in the same good?
- What product should Japan specialize in? What product should Malaysia specialize in?
- See numbers from Canada and VenezuelaTabla 13which describes how many barrels of oil and tons of wood the workers can produce. Use those numbers to answer the rest of this question.
- Draw a production possibilities line for each country. Suppose there are 100 workers in each country. Canadians and Venezuelans want oil and wood. The Canadians want at least 2,000 tons of wood. Mark a point in their production capacities where they can get at least 3000 tons.
- Expect the Canadians to fully specialize because they found they have a comparative advantage in lumber. You are willing to give up 1,000 tons of wood. How much oil should they charge for this wood to be as good as it was without trade? How much should they charge if they want to profit from trade with Venezuela?observation: We can think of this “order” as the relative price or commercial price of wood.
- Are the Canadian "questions" you identified in (b) also beneficial to Venezuelans? Use the production possibility limits graph for Venezuela to show that Venezuelans can benefit from trade.
- emproblem 2Is there a "question" where Venezuelans can say "no thanks" to trade with Canada?
BernsteinWilliam J.A Glorious Exchange: How Trade Shaped the World. Atlantic Monatspresse. Nueva York. 2008.
Answers to self-control questions.
- In Germany, fewer workers are needed to make a television or video camera. Germany has an absolute advantage in the production of both goods.
- Three workers are needed to produce another television in Germany. The transfer of these three German workers will reduce the production of video cameras by 3/4 of a camera. Producing an additional television in Poland requires six workers, and relocating those workers from other merchandise reduces the output of the video camera by 6/12 of a camera, or half. Therefore, the opportunity cost of TV production in Poland is lower, giving Poland a comparative advantage in TV production.observation: Don't worry about fractions like 3/4 camera or 1/2 video camera. If one of the countries were to expand television production by a significant amount, ie by much more than one unit, we would be talking about whole cameras and not individual cameras. You can also see this conclusion in the fact that Poland's absolute disadvantage in televisions is relatively minor, since Poland needs twice as many workers to produce a television, but three times as many to produce a video camera, the product with which that the relatively minor absolute disadvantage is Poland's comparative advantage.
- Four workers are needed to produce a video camera in Germany, and taking those four workers out of television production has an opportunity cost of 4/3 televisions. Producing a video camera in Poland requires 12 workers, and taking those 12 workers out of television production has an opportunity cost of two televisions. Therefore, the opportunity cost of producing video cameras in Germany is lower, and video cameras will be Germany's comparative advantage.
- In this example, absolute advantage differs from comparative advantage. Germany has an absolute advantage in the production of both goods, but Poland has a comparative advantage in the production of televisions.
- Germany should at least partially specialize in the production of video cameras, export video cameras and import television sets. On the contrary, Poland should specialize, at least partially, in the manufacture of televisions, export televisions and import video cameras.
What happens when a country has an absolute advantage in all goods? ›
Even when one country has an absolute advantage in all products, trade can still benefit both sides. This is because gains from trade come from specializing in one's comparative advantage.Can a country have absolute advantage in all goods? ›
However, a country can have an absolute advantage in all goods. An absolute advantage exists when a country is simply the best (most efficient) in producing a product or service. It is in the best interest of countries to produce the goods and services in which they have the highest comparative advantage.What is absolute advantage in microeconomics? ›
Absolute Advantage in Microeconomics
Absolute advantage is an advantage that a producer gains when they can manufacture goods more efficiently than other producers. A person or a business has an absolute advantage when they can produce more goods within a specified time with the same amount of resources.
Terms in this set (22) A country has an absolute advantage when it can produce a good with less resources than another. As such, having an absolute advantage makes for lower costs and greater profit.What is an example of absolute advantage in economics? ›
One real-world example of absolute advantage is in oil production. Nations in the Middle East have an absolute advantage when it comes to producing oil. In oil-rich nations, businesses can use simple, inexpensive techniques to drill for the resource and get it in large quantities.What is absolute advantage in economics quizlet? ›
Absolute Advantage. refers to a country's ability to produce a good at a lower cost or using fewer resources than its trading partners. Comparative Advantage. refers to a country's ability to produce a particular good at a lower opportunity cost than its trading partners.What does absolute advantage describe? ›
absolute advantage, economic concept that is used to refer to a party's superior production capability. Specifically, it refers to the ability to produce a certain good or service at lower cost (i.e., more efficiently) than another party.What does it mean for a country to have an absolute advantage and what does it mean to have a comparative advantage? ›
A country has an absolute advantage if it produces a large number of goods with the same resources as provided to another country whereas the country has a comparative advantage if the Country can produce a particular product with better quality at a lower price than another country.How does absolute advantage affect imports and exports? ›
Absolute advantage encourages a nation to specialize their exports and diversify their imports.How do you have an absolute advantage quizlet? ›
A country has an absolute advantage in producing a good over another country if it uses fewer resources to produce that good.
What is absolute advantage and how is it related to resource use quizlet? ›
Absolute advantage is when someone can produce more of a good using a given quantity of inputs while comparative advantage is when someone can produce a good at a lower opportunity cost. allowing resources to specialize in the tasks for which they have a comparative advantage.What is an absolute advantage Why does it result in more global trade quizlet? ›
Absolute advantage is when a country can produce more goods effectively and at a lower cost, It does result in more global trade because it makes it easier. Most countries have their own currencies and typically only accept their own currency for business exchanges.In what cases does a country have absolute advantage? ›
A country has an absolute advantage in producing a good over another country if it uses fewer resources to produce that good. Absolute advantage can be the result of a country's natural endowment.What does it mean if one country has an absolute advantage over another country? ›
A country has an absolute advantage over another country if it can produce a given product using fewer resources than the other country needs to use.Which of the following is an example of absolute advantage quizlet? ›
Which of the following is an example of absolute advantage? The United States makes software more efficiently than any other country.What are the reasons for absolute advantage? ›
An absolute advantage is achieved through low-cost production. In other words, it refers to an individual, company, or country that can produce at a lower marginal cost. Such an advantage is established when (compared to competitors): Fewer materials are used to produce a product.Who has absolute advantage in each good quizlet? ›
Terms in this set (17)
a country has an absolute advantage in producing a good or service is the country can produce more output per worker than other countries. Likewise, an individual has an absolute advantage in producing a good or service if he or she is better at producing it than other people.
The United States has an absolute advantage in productivity with regard to both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators.What is the conclusion of absolute advantage theory? ›
In conclusion, absolute advantage means ability a country has an absolute advantage over another in producing a good, if it can produce those good using resources than another country.Can a country with absolute advantage in both goods benefit from trade? ›
Even a country that is more efficient (has absolute advantage) in everything it makes would benefit from trade. Consider an example: Country A: One hour of labor can produce either three kilograms of steel or two shirts.
Which statement describes the concept of absolute advantage quizlet? ›
Which statement describes an absolute or comparative advantage correctly? A country has an absolute advantage in producing a good over another country if it uses fewer resources to produce that good.What is the benefit in reaching the absolute advantage in the production of one good quizlet? ›
if a nation has an absolute advantage in the production of a good, it can produce that good using fewer resources than its trading partner. If a nation has a comparative advantage in the production of a good, it can produce that good at a lower opportunity cost than its trading partner.What does it mean for one country to have an absolute advantage? ›
Absolute advantage refers to the uncontested superiority of a country or business to produce a particular good better. Comparative advantage introduces opportunity cost as a factor for analysis in choosing between different options for production diversification.What does it mean for a country to have an absolute advantage over another country? ›
absolute advantage, economic concept that is used to refer to a party's superior production capability. Specifically, it refers to the ability to produce a certain good or service at lower cost (i.e., more efficiently) than another party.What is the benefit is reaching the absolute advantage in the production of one good? ›
The benefit of achieving an absolute advantage in producing one good is purely economic. Having an abundance of goods others do not is essential for lucrative trade, and this is especially true when you're the best at producing something.What is absolute advantage and why is this important? ›
Absolute advantage is the economic principle that one company can more efficiently create and distribute the same goods as another company. It refers to an organization's production level. One company's greater access to resources can make its design and manufacturing processes more efficient.What is the impact of absolute advantage? ›
Absolute advantage leads to unambiguous gains from specialization and trade only in cases where each producer has an absolute advantage in producing some good.