Absolute Advantage & Comparative Advantage

In economics, principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more of a good or service than competitors, using the same amount of resources. Smith first described the principle of absolute advantage in the context of international trade, using labor as the only input.

Since absolute advantage is determined by a simple comparison of labor productivities, it is possible for a party to have no absolute advantage in anything;[7] in that case, according to the theory of absolute advantage, no trade will occur with the other party.[8] It can be contrasted with the concept of comparative advantage which refers to the ability to produce a particular good at a lower opportunity cost.

In economics, the law of comparative advantage says that two countries (or other kinds of parties, such as individuals or firms thereas) will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods. Even if one country is more efficient in the production of all goods (absolute advantage) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies.

For example, if, using machinery, a worker in one country can produce both shoes and shirts at 6 per hour, and a worker in a country with less machinery can produce either 2 shoes or 4 shirts in an hour, each country can gain from trade because their internal trade-offs between shoes and shirts are different. The less-efficient country has a comparative advantage in shirts, so it finds it more efficient to produce shirts and trade them to the more-efficient country for shoes. Without trade, its opportunity cost per shoe was 2 shirts; by trading, its cost per shoe can reduce to as low as 1 shirt depending on how much trade occurs (since the more-efficient country has a 1:1 trade-off). The more-efficient country has a comparative advantage in shoes, so it can gain in efficiency by moving some workers from shirt-production to shoe-production and trading some shoes for shirts. Without trade, its cost to make a shirt was 1 shoe; by trading, its cost per shirt can go as low as 1/2 shoe depending on how much trade occurs.

The net benefits to each country are called the gains from trade.

An example, a rabbi and a priest are in a field of strawberries dotted with tall apple trees. In order to meet their Maker, they must thoroughly harvest their hectare. The priest is 7 feet tall; the rabbi is a pisher (5 feet tall, for those of you not fluent in Yiddish). Who should do what?

Duh. The tall guy picks the apples; the short guy harvests the strawberries. Easy call. That’s comparative advantage – the rabbi is vertically-challenged so he has a comparative advantage picking things low whereas the priest is high so he may pick unforbidden fruit.

The notion follows that countries have similar advantages: Kiwi grows easily in New Zealand, and not so easily in Saudi Arabia. Now Saudi gardeners could probably build shade, import soil, and mist-ify water to try and replicate the natural conditions of New Zealand but… why? Why not just let the Kiwis grow their kiwis and ship ‘em (on boats powered by Saudi oil…).

Before we get too carried away, let's stop for the four key terms you're going to need to master to fully understand international trade:

Absolute advantage refers to a country’s ability to produce a certain good more efficiently than another country.

Specialization refers to a country’s decision to specialize in the production of a certain good or list of goods because of the advantages it possesses in their production.

Opportunity cost refers to what you sacrifice in making an economic choice. In this instance, it refers to the value of the goods you sacrifice in deciding to produce one good instead of another.

Comparative advantage refers to a country’s ability to produce a particular good with a lower opportunity cost than another country.

Did we lose you around opportunity cost?

Let’s think about these in terms of individuals instead of nations and choices we all understand... like trying to decide whether to become a fry cook or a heart surgeon. (That's a debate we have internally just about every single day.)

Let’s say you're a wonderful fry cook and a talented heart surgeon. Your neighbor is a pretty good fry cook and (since he is near-sighted and has a severe hand tremor) an absolute butcher as a surgeon.

You have an absolute advantage over your neighbor as a fry cook. He just can’t hang with you around a pan of sizzling lard. And you also possess an absolute advantage over him as a surgeon—your patients actually survive their surgeries occasionally.

Which career should you pursue? To become a fry cook, you must sacrifice your far more lucrative work as a heart surgeon; your opportunity cost is very high. On the other hand, your moderately skilled fry-cooking neighbor has a relatively low opportunity cost—to pursue a career as a fry cook he only has to sacrifice his malpractice-suit-waiting-to-happen career as a surgeon. Therefore your neighbor has a comparative advantage in fry cooking... even though you're objectively a better fry cook than he is.

The real world is far more complicated than this. But David Ricardo, an early nineteenth-century British economist, argued that these simple principles can be used to explain international trade. Countries, not just individuals, possess certain advantages. Climate, geography, the skills and size of their labor force, the ability to grow or not grow kiwi fruit—these all contribute to make a country good at producing certain things. And countries, like individuals, also have to make certain sacrifices in deciding which of the goods that they can produce they should produce—to produce corn instead of wheat, cars instead of boats, computer chips instead of refrigerators. Being rational operators, they eventually produce those products in which they have a comparative advantage, those goods having a comparatively low opportunity cost.

As a result, we have international marketplace filled with all sorts of good stuff. Countries identify their comparative advantages and sell the resulting goods in the international market. Brazil sells coffee, Estonia builds ships, and Palau exports coconuts.

Why It Matters Today

Do you know what you want to be when you grow up? Choosing a career is one of the most important choices you'll make in your entire life. If don't want to make the wrong choice, you'd better think about comparative advantage—both your own as an individual and your country's in the international market.

If you're living in the United States, it really doesn't matter if you're the world's most talented stitcher of men's underpants. Other nations where labor is much cheaper (hey there, Indonesia!) have such a strong comparative advantage over the high-wage United States in the underwear assembly industry that you'll never be able to find and keep a job in that field.

Date: 2014-12-21; view: 1227