You are on page 1of 26

Absolute and Comparative

Advantage

You could saythat globalization, driven not by


human goodness but by the profit motive, has
done far more good for far more people than
all the foreign aid and soft loans ever
provided by well-intentioned governments and
international agencies.
Paul Krugman,
2008 Nobel Laureate
in Economic Sciences

The Mercantilists- Earliest Trade Theories


What is wealth?
How can precious metals be obtained?
Extraction from naturally occurring stocks
Earn precious metals through exports of goods and
services
Since payment for exports is made with precious metals,
exporting causes precious metals to flow into a country
Similarly, since payment for imports is also made with
precious metals, importing causes precious metals to flow
out of country
The natural conclusion exports must exceed imports for a
country to become wealthy!
23

Are precious metals wealth?


To the Mercantilists, yes.
Modern measures of wealth are based on a
countrys ability to produce the goods and
services that improve quality of life.
Hence, the Mercantilist conclusion is based a
definition of wealth the differs significantly from
modern notions of wealth.
This distinction leads to very different conclusions
about how to become a wealthy nation.

24

Absolute advantage
Built on the ideas of Adam Smith (1770)
Absolute advantage exists between nations when
they differ in their ability to produce goods.
More specifically, absolute advantage exists when one
country is good at producing one item, while another
country is good at producing another item.
Same input => more output
Same output => less input

25

One Person Per Day of Labor Produces


Country

Machines

Cloth

EU

5 machines

(or)

10 sq. meters

India

2 machines

(or)

15 sq. meters

Absolute Advantage: Production Conditions When


Each Country Is More Efficient in the
Production of One Commodity

EU workers are more productive in


producing machines

The EU has an absolute advantage in


machine production

Indian workers are more productive in

Assume TWO Persons per day, so that each product can be fully produced

Two Persons Per Day of Labor Produces


Country

Machines

EU

5 machines

India

2 machines

World Output

7 machines

Cloth
(and)
(and)
(and)

10 sq. meters
15 sq. meters
25 sq. meters

This is a condition under Autarky: (The complete absence of trade). However,


if each country produces to their absolute advantage below

Two Persons Per Day of Labor Produces


Country

Machines

EU

10 machines

India

0 machines

World Output

10 machines

Cloth
0 sq. meters

30 sq. meters
(and)

30 sq. meters

Specialization and trade advantage both countries

Therefore, the best policy is to allow producers


and consumers in both countries unfettered access
to goods from both countries to maximize the
number of advantageous trades that can occur.

In other words, laissez-faire.


The policy of minimum government interference with
economic activity.

What if one country is better at


everything?
The theory of comparative advantage provides
this answer.
8

David Ricardo: Principles of Political


Economy (1817)
Extended free trade argument
Should import even if the country is more
efficient in the products production than
country from which it is buying.
Look to see how much more efficient. If only
comparatively efficient, then import.

One Person Per Day of Labor Produces


Country

Machines

Cloth

U.S.

5 machines

15 sq. meters

India

1 machine

5 sq. meters

U.S. has bigger Absolute Advantage in production of Machines


US - Opportunity Costs

India - Opportunity Costs

1 Machine = 3 cloth
1 Cloth
= 0.33 machine

1 Machine = 5 cloth
1 Cloth = 0.2 machine

The U.S. has a greater absolute advantage


in producing machines than it does in
producing cloth (5x more efficient in
machines only 3x more efficient in
cloth)

Indias absolute disadvantage/opportunity


cost is smaller in producing cloth than
in producing machines

Thus the U.S. has a comparative advantage


in machines and India has a comparative
advantage in cloth

Even though U.S. has an absolute


advantage in both goods, India has a
comparative advantage in cloth
production
Even if U.S. has an absolute advantage
in both goods, beneficial trade is
possible
If both countries specialize according
to their comparative advantage, they
both can gain from this specialization
and trade

Since we are dealing with Opp. Costs, we will compare across 15


sq. meters of cloth
One person Per Day of Labor Produces
Country

Machines

Cloth

U.S.

5 machines

15 sq. meters

India

1 machine

5 sq. meters

Let us allow India to produce cloth up to the level that the U.S. can

One Person Per Day of Labor Produces


Country

Machines

Cloth

U.S.

5 machines

-15 sq. meters

India (3 days)

-3 machines

15 sq. meters

World Output

+2 machines

(per)

0 cloth
.

Country
Japan
Malaysia

Output per hour of team


Cars
Steel (tons)
2
2
0.5
1

Do you see any Absolute Advantages?


Do you see any Comparative Advantages?

Japan - Opportunity Costs

Malaysia - Opportunity Costs

1 car = 1 steel
1steel = 1 car

1 car = 2 steel
1steel = 0.5 car

One Person Per Day of Labor Produces


Country
Japan
Malaysia

Cars

Steel (tons)

0.5

Let us allow Malaysia to produce steel up to the level that Japan can

One Person Per Day of Labor Produces


Country

Cars

Steel (tons)

Japan

-2

Malaysia (2 days)

-1

World Output

+1

Laissez-faire still holds

Gains need not be equal

Hours of work traded need not be


equal but the advantage still exists

Trade is based on the existence of


relative not absolute production
advantages

16

Domestic jobs are lost.

Domestic income is lost.

National security.

Nations dumping goods trying to


drive out domestic competition.

Other nations dont treat their


workers fairly.

Factor Endowments
Some countries have more capital => cheaper
rent => comparative advantage in capital
intensive products
Some countries have a larger labor force
=>cheaper wage => comparative advantage in
labor intensive products

18

Economies of Scale
Increase in production leads to lower
average cost, and vice versa
Choice of specialization is completely
accidental

19

US$

Car (Toyota Corolla)

Rice (100 tonnes)

Cambodia

20,000

40,000

Japan

10,000

30,000

How much can an arbitrager earn


- if he borrows 10,000$ to import one car into Cambodia and import
rice into Japan?
- if he borrows 30,000$ to import 100 tonnes of rice into Cambodia
and import one car into Japan?
How do we find comparative advantage?

20

Corn Sunscreen
Mexico
300

150

France

150

200

1.

Type of problem (output or input)?:

2.

Which nation has the absolute advantage in


producing corn?

3.

Sunscreen?

Which nation has the comparative advantage in the


production of each good?

(What is the

opportunity cost for each nation of producing one


unit of corn
4.

and sunscreen

What would be a favorable term of trade?

?)

Wheat Cloth
United States
1 hour 2 hours
Canada 3 hours 4 hours
1.

What type of problem is this? (output/input)

2.

Who has the absolute advantage in producing


wheat?

3.

Who has the lowest opportunity cost producing


wheat?

4.

In producing cloth?

In producing cloth?

Favorable terms of trade?

Alpha

Beta

Guns

Guns

400

300

200
Butter

Significance of guns and butter?

100

Butter

Labor Hours Needed to


Produce a Unit of:
Wheat

Cloth

Portugal
England

10
20

20
60

Soybeans

Mexico

16

USA

Avocados

6
8

Soybeans

Mexico

Avocados

15
60

USA

30
90