Absolute and Comparative Advantage
What Happens When a Country Has an Absolute Advantage in All Goods
Intra-industry Trade between Similar Economies
The Benefits of Reducing Barriers to International Trade
Absolute and comparative advantage
David Ricardo (1817) argued that specialization and free trade benefit all trading partners, even those
that may be relatively inefficient
absolute advantage in producing a good over another country if it uses fewer resources to produce
comparative advantage when a good can be produced at a lower cost in terms of other goods
Could be a result of country’s natural endowment
“What do we give up to produce this good?”
The companies that produce either copper or corn tell you that it takes 10 hours to mine a ton of copper
and 20 hours to harvest a bushel of corn. This means the opportunity cost of producing a ton of copper
is 2 bushels of corn.
Production possibilities frontier
Saudi Arabia can produce 100 barrels of oil at maximum and zero corn (point A), or 25 bushels of corn and zero oil (point B). It can also produce other combinations of oil and corn
if it wants to consume both goods, such as at point C. Here it chooses to produce/consume 60 barrels of oil, leaving 40 work hours that can be allocated to producing 10 bushels
If the United States produces only oil, it can produce, at maximum, 50 barrels and zero corn (point A'), or at the other extreme, it can produce a maximum of 100 bushels of corn
and no oil (point B'). Other combinations of both oil and corn are possible, such as point C'. All points above the frontiers are impossible to produce given the current level of
resources and technology.
Comparative and absolute advantage
Saudi Arabia – CA in oil
US – CA in corn
Gains from trade
When a country can consume more of a good or service as a result of trade, than it could
Absolute advantage: it takes fewer workers in one country compared to another to produce
both a given number of one good and another
Absolute advantage simply compares the productivity of a worker between countries.
The slope of the production possibility frontier for each country is the opportunity cost of one
good in terms of foregone production of another
Opportunity costs and the boundaries of trade
Trade allows each country to take advantage of lower opportunity costs in the other country.
Producing and consuming with trade
With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes.
With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. All other
points on the production possibility line are possible combinations of the two goods that can be produced given current resources. Point
A on both graphs is where the countries start producing and consuming before trade. Point B is where they end up after trade.
Trade mostly between similar countries
A high proportion of trade, however, is intra-industry trade—that is, trade of goods within the same
industry from one country to another
(1) The division of labor leads to learning, innovation, and unique skills; and
(2) economies of scale.
Economies of scale
Production Plant S, has an average cost of production of $30 per toaster oven. Production plant M has an average cost of production of $20 per toaster
oven. Production plant L has an average cost of production of only $10 per toaster oven. Production plant V would still have an average cost of
production of $10 per toaster oven. Thus, production plant M can produce toaster ovens more cheaply than plant S because of economies of scale, and
plants L or V can produce more cheaply than S or M because of economies of scale. However, the economies of scale end at an output level of 150.
Plant V, despite being larger, cannot produce more cheaply on average than plant L.
Gains from specialization
splitting up the value chain.
The value chain describes how a good is produced in stages.
E.g., the production of the iPhone involves the design and engineering of the phone in the
United States, parts supplied from Korea, the assembly of the parts in China, and the
advertising and marketing done in the United States
Benefits of reducing trade barriers
Tariffs are taxes that governments place on imported goods for a variety of reasons.
Some of these reasons include protecting sensitive industries, for humanitarian reasons, and
protecting against dumping
WTO negotiations – Doha Round increase size of world economy between $160B to $385B per
year (world economy - $30T)
Low-income countries benefit more from trade than high-income countries do
Q 8. What is absolute advantage? What is comparative advantage?
Q 9. Under what conditions does comparative advantage lead to gains from trade?
Solution: Absolute advantage is when one country is able to produce more of a good than another.
Comparative advantage is when a country has a lower opportunity cost to produce the good than
Solution : Comparative advantage leads to gains from trade when countries specialize and produce
mainly what they do best.
Q 11. Is it possible to have a comparative advantage in the production of a good but
not to have an absolute advantage? Explain.
Solution : Yes. Comparative advantage is defined by what you have to give up to produce a good. If the
opportunity cost of production is low, a country will still have a comparative advantage even when at an
Q 10. What factors does Paul Krugman identify that supported the expansion of
international trade in the 1800s?
Solution: The improvements in transportation that came with steamships and railroads and created