Absolute and Comparative Advantage

Absolute and Comparative Advantage

“To Trade or not to Trade, that is the question.”

As we say in economics, it depends and it’s all

relative


O The US produces some bananas for domestic consumption, but not enough to satisfy total demand for bananas.

O Question: Could we produce enough IF we REALLY wanted to? Yes, we could probably even produce MORE bananas than, say, Guatemala where they grow easily. We have the technology and know-how BUT is it a good idea to use our scare resources to do so?


O Guatemala produces some medicines for domestic consumption, but not enough to satisfy total demand for medicines.

O Question: Could they produce enough IF they REALLY wanted to? Yes, they probably could produce enough for domestic consumption BUT is it a good idea to use their scare resources to do so?


O A BETTER IDEA!!O Why don’t the US and Guatemala specialize

in what they produce MORE efficiently rather than use scarce societal resources to produce something they are not so good at producing, and then TRADE with each other?

O THIS is the fundamental principle behind the concept of COMPARATIVE ADVANTAGE

O Are you ready to see how this works???


O What follows is an analysis of 2 economies---Country “A” and Country “B”. Assume they produce just 2 goods:O ClothO Wine

O Assume each country has different resources that vary in quantity and quality to produce these 2 goods

Given its resource endowment, if Country “A” allocates all it resources to the production of Cloth, it can produce 10 yards of cloth.

Given its resource endowment, if Country “A” allocates all it resources to the production of Wine, it can produce 20 gallons of Wine.

If we connect these two extreme points will have a Straight Line PPF. Country “A” has the ability to produce combinations of Cloth and Wine anyplace ON this PPF

Let’s assume Country “A” chooses to produce a balance of Cloth and Wine with their given resources. They make the Allocative Efficiency decision to produce 5 yards of Cloth and 10 gallons of Wine

Given its resource endowment, if Country “B” allocates all it resources to the production of Cloth, it can produce 20 yards of cloth.

Given its resource endowment, if Country “B” allocates all it resources to the production of Wine, it can produce 20 gallons of Wine.

If we connect these two extreme points will have a Straight Line PPF. Country “B” has the ability to produce combinations of Cloth and Wine anyplace ON this PPF

Let’s assume Country “B” chooses to produce a balance of Cloth and Wine with their given resources. They make the Allocative Efficiency decision to produce 10 yards of Cloth and 10 gallons of Wine

The first concept we want to define is ABSOLUTE ADVANTAGE.

Absolute Advantage: Given its respective societal resources which country, in absolute terms, can produce more of one good than the other country.

Look at cloth production for each country. “A” can produce 10 yards of cloth if it allocated all of its scarce resources to the production of cloth. “B” can produce 20 yards of cloth if it allocates all of its scarce resources to the production of cloth.

Country “B” can ABSOLUTELY produce more cloth than “A”

Country “B” is said to have the ABSOLUTE ADVANTAGE in the production of Cloth

Look at wine production for each country. “A” can produce 20 gallons of Wine if it allocated all of its scarce resources to the production of wine. “B” can produce 20 gallons of Wine if it allocates all of its scarce resources to the production of Wine.

In this case NEITHER country has produces more Wine that the other

Neither country is said to have the ABSOLUTE ADVANTAGE in the production of Wine

Currently each country is in a state of “Autrarky”. This is a fancy way of saying they are Closed Economys and they do not engage in trade---they are “self-sufficient”

Assume each country is exploring the possibility of engaging in trade with each other. However, they are not sure which good, cloth or wine, they are better (or more efficient) at producing relative to the other country.

In other words, is there one good that each country would be better off specializing in and then trading some of it away for the good they are not so efficient at producing?

To help them decide, we are going to (1) calculate their “internal” opportunity costs of producing each good and (2) then compare those Opportunity Costs relative to EACH OTHER across their borders.

The first thing we want to do is organize our production data for each country. I like to use this graphic organizer below. Notice I have put each countries production data (from the Graphs) in the appropriate category and inserted blank boxes where we are going to calculate our Internal Opportunity Costs. We will then use those Opportunity Costs to compare each country across borders---The RED line represents the border between Country “A” and “B”.

Our first calculation will be to calculate Country “A”’s Opportunity Cost of producingCloth in terms of Wine.

In other words, to get cloth how much in wine production does “A” have to give up.

Below we set 10 Cloths “10C” to 20 Wines “20W”

If we divide both sides by 10 we will reduce our ratio to a single unit on the left side. ThisIs what we want---to see how much of the other good (Wine) we have to give up in order to get ONE yard of Cloth. When we divide “20W” by 10 we get “2W” or 2 Wines.

So, for Country “A” to produce 1 yard of Cloth they must give up 2 gallons of Wine.

Now, we want to move to the Right and calculate Country “A”’s Opportunity Cost of Producing Wine in terms or Cloth---this IS just the reciprocal of what we just did for Cloth in terms of Wine.

We set the ratio “20W = 10C”

If we divide both sides by 20 we will reduce our ratio to a single unit on the left side. ThisIs what we want---to see how much of the other good (Cloth) we have to give up in order to get ONE gallon of Wine. When we divide “10C” by 20 we get “.5W” or .50 (half) Wines.

So, for Country “A” to produce 1 gallon of Wine they must give up .5 yards of Cloth.

Now, lets move ACROSS the border to Country “B” and perform the SAME math as we did forCounty “A”. Remember, we are calculating each countries internal Opportunity Costs of Producing one good in terms of the other.

Country “B”’s Opportunity Cost of Producing Cloth in terms of Wine is “20C = 20W”

Divide each side by 20 and we are left with a simplified ratio of:

“1C = 1W”

Country “B”’s Opportunity Cost of producing 1 yard of Cloth is 1 gallon of Wine given up

Move over to the Right side and calculate Country “B”’s Opportunity Cost of Producing Wine in terms of Cloth---remember, it is the reciprocal of the left side.

“20W = 20C” Divide each side by 20

Divide each side by 20 and we are left with a simplified ratio of:

“1W = 1C”

Country “B”’s Opportunity Cost of producing 1 yard of Cloth is they have to give up 1 gallon of Wine

Ok, we have calculated the INTERNAL Opportunity Costs for producing Cloth and Wine for both “A” and “B”. What’s next?

Comparative Advantage

Now, we want to “Head for the Border” and compare each countries Opportunity Costs for producing a good.

Let’s look just at Cloth right now…

To Determine which country has the Comparative Advantage in the production of Cloth, you want to ask yourself the following question:

Which country produces Cloth at the LOWEST OPPORTUNITY COST?

Look at the TWO Opportunity Cost ratios we have calculated. Country “A” produces a yard of cloth at the expense of 2 gallons of WineCountry “B” produces a yard of cloth at the expense of 1 gallon of Wine.

Given there respective resource endowment, which country can produce cloth at the lowest Opportunity Cost?

….That would be Country “B”. To produce 1 yard of Cloth they have to give up only 1 gallon of Wine whereas Country “A” produces 1 yard of Cloth they have to give up 2 gallons of Wine. So, just in terms of resources given up:

COUNTRY “B” IS MORE EFFICIENT AT PRODUCING CLOTH THAN COUNTY “A” therefore….

Country “B” should NOT produce Wine at all and SPECIALIZE in the production of CLOTH. They should EXPORT Cloth and IMPORT WineCountry “B” is said to have the Comparative Advantage in the

Production of Cloth…

Are you STILL not sure how to find the Country with the Lowest Opportunity Cost in CLOTH?

Let me give you a hint. Just look at the numbers to the RIGHT of the equal sign.

Which one is SMALLER---”2W” or 1W”???

Easy Cheesy! “1W” is smaller so Country “B” produces Cloth at the Lower Opportunity Cost

Now, lets look at Wine. Same analysis as for Cloth.

Which country produces Wine at the LOWEST OPPORTUNITY COST?Look at the TWO Opportunity Cost ratios we have calculated on the Right Country “A” produces a gallon of Wine at the expense of .50 yards of ClothCountry “B” produces a gallon of Wine at the expense of 1 yard of Cloth

Given there respective resource endowment, which country can produce wine at the lowest Opportunity Cost?

….That would be Country “A”. To produce 1 gallon of WIne they have to give up only .50 yards of Cloth whereas Country “B” produces 1 gallon of Wine they have to give up 1 Cloth So, just in terms of resources given up: COUNTRY “A” IS MORE EFFICIENT AT PRODUCING WINE THAN

COUNTY “B” therefore….Country “A” should NOT produce CLOTH at all and SPECIALIZE

in the production of WINE. They should EXPORT Wine and IMPORT Cloth

Country “A” is said to have the Comparative Advantage in the Production of Wine…

Are you STILL not sure how to find the Country with the Lowest Opportunity Cost in WINE?

Let me give you a hint. Just look at the numbers to the RIGHT of the equal sign.

Which one is SMALLER---”.50C” or 1C”???

Easy Cheesy! “.50C” is smaller so Country “A” produces Wine at the Lower Opportunity Cost

What now?

We have determined that Country “A” has the Comparative Advantage in the production of Cloth. They should specialize

in producing Cloth and give up the production of Wine.

We have determined that Country “B” has the Comparative Advantage in the production of Wine. They should specialize

in producing Wine and give up the production of Cloth.

On the above graphs, we illustrate this SPECIALIZATION. The RED circles show the amount the country is going to produce and there is a RED line through the amount of the good the country is NO LONGER going to produce

Look just at Country “A”. They now produce 20 gallons of Wine BUT they only Want to CONSUME 10 gallons. This means they have a SURPLUS of 10 gallons Of Wine leftover that is available to trade away (EXPORT)---IF the price is right!

5 Gallons of WineTo trade away

Look just at Country “B”. They now produce 20 yards of Cloth BUT they only Want to CONSUME 10 yards of Cloth. This means they have a SURPLUS of 10 yardsOf Cloth leftover that is available to trade away (EXPORT)---IF the price is right!


10 yards of clothTo trade away

Now that these two countries are “ALL IN” in terms of Specialization, they must settle onsome acceptable TERMS OF TRADE.

In other words, they have to agree on a PRICE that works for each country to commit to specialize and make it worthwhile for them to SELL what they produce and BUY what they don’t produce.

Read the following 2 points CAREFULLY:(1) If I produce something, I want to SELL it for MORE than what it costs me to produce it.(2) If I am going to BUY something, I want to BUY it for LESS than what I can produce it for.

15Gallons of WineTo trade away




Determining Acceptable Terms of Trade

Lets look at CLOTH. Country “B” produces 1 yard of Cloth at a cost of 1 Wine.

If they can sell a yard of Cloth for MORE than 1 Wine then they are better off.

Country “A” produces a yard of Cloth at a cost of 2 Wines. If they can BUY a yard of ClothFor LESS than the 2 Wines if costs them to produce then they are better off.

BOTTOMLINE: An Acceptable TERM OF TRADE will by ANY ratio of Cloth to Wine BETWEENThe 2 countries Opportunity Costs of producing Cloth.

A Term of Trade ABOVE “1C=1W” and BELOW “1C = 2W”



Determining Acceptable Terms of TradeLets look at CLOTH. Country “B” produces 1 yard of Cloth at a cost of 1 Wine.

If they can sell a yard of Cloth for MORE than 1 Wine then they are better off.

Country “A” produces a yard of Cloth at a cost of 2 Wines. If they can BUY a yard of ClothFor LESS than the 2 Wines if costs them to produce then they are better off.

BOTTOMLINE: An Acceptable TERM OF TRADE will by ANY ratio of Cloth to Wine BETWEENThe 2 countries Opportunity Costs of producing Cloth.

A Term of Trade ABOVE “1C=1W” and BELOW “1C = 2W”

**Use the SAME methodology for Wine**Country “A” has the Comparative Advantage in the production of Wine.An Acceptable Term of Trade will be a ratio of Wine to Cloth Between “1W=.50C” for Country “B” and “1W = 1C” for Country “A”



GOT THAT????Lets go back to Cloth and see how this works for Country “B”.

Assume the Terms of Trade are “1C = 1.5W”Notice this is IN BETWEEN each countries Opportunity Costs.

If Country “B” trades away the SURPLUS 10 yards of Cloth it has theywill receive 1.5 gallons of Wine for each Cloth

So, after Country “B” sells their Cloth to Country “A” they will now Be able to “consume” 15 gallons of Wine (10 yards of Cloth X 1.5 Wines)



Country “B” STILL consumes 10 yards of cloth they produced,

BUT they trade (export) away the surplus 10 yards for 1.5 Wines each for a total of 15

gallons of Wine (Import). They nowAre consuming a combination of Cloth and Wine OUTSIDE of their ability to produce

it WITHOUT Specialization and Trade.

The people of Country “B” are clearly better off because they get to enjoy the amount of

cloth they want to consume PLUS extra Wine!

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“B”

How is this going to work our for Country “A”?

Acceptable Terms of Trade will be a ratio of Wine to Cloth between “1 W =.50C” And “1W = 1C”.

Hint: If we take the RECIPROCAL of the terms of trade we used for Cloth it will fall in between the ratio we are looking for here.

The Reciprocal of “1C = 1.5W” is:

“1W = .67C”

Country “A” can SELL 1 gallon of Wine and get .67 yards of cloth for each gallon.

If Country “A” sells (EXPORTS) its surplus 5 gallons of Wine (it still keeps 5 gallons for its own consumption) and can receive .67 Cloths for each gallon (IMPORT) then it can consume 6.7 yards of Cloth (10 Wines X .67Cloths) It can now CONSUME a combination of Cloth and Wine (Point “A”) GREATER than it could before specialization and trade.

Country “A” is better off as well!!6.70

“A”

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“B”6.70

“A”

REMEMBER: The Terms of Trade MUST fall in between each countries Opportunity Cost of producing the goods.

If is falls outside, on the low side or the high side, then trade will not Be advantageous for BOTH countries.

Example follows



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“B”6.70

“A”

Assume the Terms of Trade were “1C = 3W” or “1W = .33C” (reciprocals)

This means Country “B could sell 10 yards of Cloth and get 30 Wines.

They are CLEARLY better off because they consumer 10 yards of Cloth And 30 gallons of Wine

What about Country “A”?



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“B”6.70

“A”

Assume the Terms of Trade were “1C = 3W” or “1W = .33C” (reciprocals)

Country “A” at the current terms of trade would sell it surplus 5 yards of ClothFor .33 gallons of Wine for a total of 1.65 gallons of Wine.

WITHOUT TRADE, Country “A” produces 5 gallons of wine with its resources.

These terms of trade are NOT Advantageous to “A” so trade will not occur

6.70“B”

“A”

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Summation:Even if a country, given its resource endowment, can produce more of a good relative to what another country can produce with its resource endowment, BOTH countries can benefit by specializing in the production of the good in which they have the COMPARATIVE ADVANTAGE.

“Do what you do best and trade for the rest”

Absolute and Comparative Advantage

Economy & Finance

Transcript of Absolute and Comparative Advantage