📚 > 🤑> 💸3 min read•september 12, 2020  AP Macroeconomics 🤑Bookmarked 4.8k • 98 resources
The concepts of absolute and comparative advantage are used to illustrate how individual countries or entities interact and trade with each other. These concepts also focus on how people specialize in what they are good at producing, and how they trade for goods and services that they are not as efficient at producing. There are two types of problems within these concepts: output and input. Output problems focus on data associated with what each party can produce with a given set of resources, as well as who should specialize in each good. Input problems focus on how much of a resource is needed to produce one unit of a particular good or service. The rules for these problems are:
Using the table above, we would determine that Japan has an absolute advantage in steel (1200 > 1000) and Canada has an absolute advantage in coal (500 > 300). The per unit opportunity cost for steel in Canada is 1/2 a unit of coal (500/1000). The per unit opportunity cost for steel in Japan is 1/4 a unit of coal (300/1200). Since 1/4 is less than 1/2, Japan has comparative advantage in steel. The per unit opportunity cost for coal in Canada is 2 units of steel (1000/500). The per unit of opportunity cost for coal in Japan is 4 units of steel (1200/300). Since 2 is less than 4, Canada has comparative advantage in coal. Japan will export steel to Canada and import coal from Canada. Terms of Trade Terms of trade are determined by looking at the two opportunity costs and choosing a number that falls between the opportunity costs in order for it to be beneficial to both countries. Acceptable terms of trade for this situation would be:
Input Problems The rules for these problems are:
Terms of trade are determined by looking at the two opportunity costs and choosing a number that falls between the opportunity costs in order for it to be beneficial to both countries. Acceptable terms of trade for the situation described above would be:
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Absolute advantage and comparative advantage are two important concepts in economics and international trade. They largely influence how and why nations and businesses devote resources to the production of particular goods and services. Absolute advantage describes a scenario in which one entity can manufacture a product at a higher quality and a faster rate for a greater profit than another competing business or country can accomplish. Comparative advantage, on the other hand, takes into consideration the opportunity costs involved when choosing to manufacture multiple types of goods with limited resources.
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 when compared to the competition. This analysis helps countries avoid producing goods and services that would yield little to no demand, which would ultimately lead to losses. A country’s absolute advantage (or disadvantage) in a particular industry can play an important role in the types of products it chooses to produce. Some of the factors that can lead an entity to absolute advantage include:
As an example, if Japan and Italy can both produce automobiles, but Italy can produce sports cars of a higher quality and at a faster rate with greater profit, then Italy is said to have an absolute advantage in that particular industry. On the other hand, Japan may be better served to devote limited resources and labor to other types of vehicles (such as electric cars) or another industry altogether. This may help the country enjoy an absolute advantage rather than trying to compete with Italy's efficiency.
While absolute advantage refers to the superior production capabilities of one entity versus another in a single area, comparative advantage introduces the concept of opportunity cost. Comparative advantage takes a more holistic view of production. In this case, the perspective lies in the fact that a country or business has the resources to produce a variety of goods and services rather than focus on just one product. The opportunity cost of a given option is equal to the forfeited benefits that could have been achieved by choosing an available alternative in comparison. In general, when the profit from two products is identified, analysts would calculate the opportunity cost of choosing one option over the other. For example, let's assume that China has enough resources to produce either smartphones or computers such that China can produce either 10 computers or 10 smartphones. Computers generate a higher profit. The opportunity cost is the difference in value lost from producing a smartphone rather than a computer. If China earns $100 for a computer and $50 for a smartphone then the opportunity cost is $50. If China has to choose between producing computers over smartphones it will probably select computers because the chance of profit is higher.
Adam Smith is often considered to be the father of modern economics. 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. Smith described specialization and international trade as they relate to absolute advantage. He suggested that England can produce more textiles per labor hour and Spain can produce more wine per labor hour so England should export textiles and import wine and Spain should do the opposite. Smith made a number of basic assumptions in order for his theory to work, including:
British economist David Ricardo later built on Smith's concepts by more broadly introducing comparative advantage in the early 19th century. He became well-known throughout history for his musings on comparative advantage. According to Ricardo, nations can benefit from trading even if one of them has an absolute advantage in producing everything. In other words, countries must choose to diversify the goods and services they produce which requires them to consider opportunity costs.
Scottish economist Adam Smith is credited with developing the theory behind absolute and creative advantage. He wrote about them in his book, The Wealth of Nations. According to Smith, countries should focus on goods they can produce efficiently and should use trade as a way to acquire anything they aren't able to make themselves.
There are many examples of absolute advantage, especially in the real world. For instance, Saudi Arabia's oil reserves are abundant, giving it an absolute advantage. That's one reason why it exports the commodity to other nations around the world.
In order to calculate absolute advantage, examine the output of the product in question between two entities. The one with the larger output has the absolute advantage. To demonstrate, let's use this example. Let's say 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. Worker A has the absolute advantage for glue sticks while Worker B has the absolute advantage for foam pads.
Comparative advantage is often contrasted with absolute advantage. Where absolute advantage refers to the ability of an entity to produce a greater quantity of a product or service, comparative advantage refers to the ability to produce goods and services at a lower opportunity cost compared to the competition.
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 themselves) allows you can initiate a trade relationship for goods and services that you need but can't produce yourself. This allows you to profit from the sale of your (specialized) good and still be able to enjoy the goods you import from your trading partner(s). 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 concept is often contrasted with comparative advantage, which was explored after Smith by economists like David Ricardo. He suggested that countries produce goods and services not necessarily at a greater volume or quality but at lower opportunity costs. Although these ideas have evolved since they were first developed, the fundamental basis is still prevalent in production and international trade today. |
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