Absolute advantage and comparative advantage

Hi people, the above topic came up in my 100 level macroeconomics course, so I said I should take time out to explain it to you. We start with absolute advantage. A country is said to have an absolute advantage in the production of a good when it is more efficient than another country in the production of the said good. i.e when it can produce more of a particular good with a given amount of resources than another  country. It is a fairly common situation for one country to be more efficient than another in the production of a particular good; absolute advantage is evident when a country has the lowest cost per unit in the production of a certain good as compared with other countries producing the same good.

Let’s take an example: Assuming Country Y produces flour more efficiently than country X, while country X has an absolute advantage in producing motorbike, a simple arithmetical example can illustrate the potential gains from trade. The table below shows the amount of Motorbike and flour each country can produce, assuming that each country has an equal quantity of resource and devotes half of its resources to motorbike production and the other half to flour production.

		Motorbike  (000’s)		Flour (Tons)
Country  X		20		100
Country  Y		10		150
Total		30		350

The relative or comparative cost of motorbike production is lower in country X than country Y; but the situation is reversed in the case of flour production. Country X has an absolute advantage in motorbike production and country Y has an absolute advantage in flour production.

Greater specialization will however, increase total output. If each country specializes in the production of the good in which it is most efficient, i.e. possesses absolute advantage, then total output would be shown below.

		Motorbike  (000’s)		Flour (Tons)
Country X		40		0
Country Y		0		300
Total		40		300

 

By specializing, total world output is now greater with ten more motorbikes and 50 tons more flour now available for consumption. In order to obtain the benefits of specialization, these countries must exchange some part of their individual output. It is not possible to specify the exact rate of exchange but the limits of the exchange rate must be somewhere between the domestic opportunity cost ratios of the two countries. One country will not benefit from international trade if the exchange rate is not between these ratios.

Comparative Advantage

If two countries both produce the same basket of goods, let us say two different goods to be precise, and each as an absolute advantage over the other in either of the goods, then from the above analysis of absolute advantage, it becomes quite palpable that each country would benefit more from specialization In the good it as an absolute advantage, as this would increase their combined output.

It is not always a fairy tale as per the above example whereby each country has its own absolute advantage in the production of one of the two goods. A situation might occur when only one of the countries has an absolute advantage in the production of the both goods. Although one country has an absolute advantage in the production of both goods, specialization and trade can still be mutually beneficial. This would be the case if each country has a comparative advantage in the production of one good. This is summed up in the law of comparative advantage (or comparative costs) which states that two countries can gain from trade when each concentrates on the production of that good in which it has the greatest comparative advantage. Comparative costs of relates to the opportunity costs of producing the goods and not the absolute cost.

The principle of comparative costs can be shown by an arithmetical example. From the previous example, It is now assumed that country x is more efficient in the production of both motorbike and flour. If each country devotes half of its resources to each industry, the assumed production totals are shown below.

		Motorbike  (000’s)		Flour (Tons)
Country X		20		200
Country Y		10		150
Total		30		350

In terms of resources used, the costs of production in both industries are lower in country x. If we consider the opportunity cost however, we get a different perspective to it. In country X the cost of one Motorbike is 10 tons of flour, i.e. in devoting resources to the production of one motorbike in country X, there is a sacrifice in terms of ten tons of flour forgone.

The opportunity cost of one motorbike in country Y is fifteen tons of flour. Country X therefore has a comparative advantage in the production of motorbikes. In country X the cost of a ton of flour is 1/10 of a motorbike, while in country Y the cost is 1/15 of a motorbike. In terms of the output of motorbike forgone, flour is cheaper in country Y than in country X. Country Y has a comparative advantage in flour production. If each country specializes in the production of goods where it has a comparative advantage; the figures below show total output of motor bike increase, and total output of flour fall.

		Motorbike  (000’s)		Flour (Tons)
Country X		40		0
Country Y		0		300
Total		40		300

The figure above shows that the world total of motorbike production has risen by ten motorbikes but that of flour has fallen by fifty tons. It is possible to show that the increase of output in the output of motor bikes more than offsets the fall in the output of flour. This is not necessary however because by only partial specializing in the more efficient country (country X) it is possible to have more of both commodities. If for example country X devotes 80% of its resources to the production of motorbikes, and 20% in the production of flour, while country Y specializes completely in flour, the total output will be shown as follows:

		Motorbike  (000’s)		Flour (Tons)
Country X		32		80
Country Y		0		300
Total		32		380

The figure shows that the total output of both goods is greater than that which is obtained when both countries where producing only for domestic consumption. Since the opportunity ratios are different in the two countries, beneficial trade is possible. If the opportunity cost ratios were the same in the two countries, then the countries would not benefit from specialization and international trade.

Recommended Reading

Timothy Taylor., The instant economics: Everything you need to know about how the economy works.