Comparative vs.

Absolute
Advantage
Students will be able to understand the difference between absolute and comparative
advantage (in theory and graphically), calculate opportunity cost of two nations production
of the same 2 goods, and determine terms of international trade

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 The theory of comparative
advantage

 The theory of comparative advantage, first developed by

English economist David Ricardo in 1817, is a theory about
the potential gains from trade for companies, countries and
people that arise on account of differences in factor
endowments or technological progress.

 Comparative advantage is an economic law referring to the

ability of any given economic actor to produce goods and
services at a lower opportunity cost than other economic actors.
 Absolute vs. Comparative
Advantage
 Absolute Advantage:
 Either: A) a individual/firm/country can produce more of a good with the
same input as another country
 B) Can produce a certain output using a fewer amount of resources as another
(mainly illustrated in terms of time)
 LEBRON HAS ABSOLUTE ADVANTAGE IN MOWING HIS LAWN!

 Comparative Advantage:
 Whoever can produce a good with a lower opportunity cost!!!
 More influential in production than absolute advantage!
 FELIX HAS COMPARATIVE ADVANTAGE IN MOWING LEBRON”S LAWN!
He has the gold, now what?
“yeah, I like that
mower, gotta buy
that mower” Sorry,
it’s my confidence
talking.
1. Should a nation produce everything it wants?

No

2. If Country A is better than Country B at

producing everything, would Country A gain

anything by trading with Country B?

Yes

3. When a new home is built, why doesn’t one

person do the carpentry, electrical, plumbing,

and landscaping?

Because they don’t have the specialized skills to do the job well and in a timely manner.
Terms to Know:

1. Absolute Advantage:

The ability to produce something using fewer resources than other

producers.

2. Comparative Advantage:

The ability to produce something at a lower

opportunity cost than other producers.

3. Law of Comparative Advantage:

An individual, firm, region or country, with the

lowest opportunity cost of producing that good

should specialize in that good.

4. Specialization:
A situation in which people produce a narrower
range of goods and services than they consume.
Specialization increases productivity; it also requires trade
and increases interdependence.
5. Gains from Trade:
The increased output from trade; with trade, each
individual, region or nation is able to concentrate on
producing goods and services that it produces efficiently,
while trading to obtain goods and services it does not
produce.

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Lebron James Example:

1. Lebron James is a great basketball player and lawn mower.

2. He has a young neighbor who is willing to mow his lawn.

3. Lebron can mow his lawn in two hours. He could also make a Nike
commercial in this time and make $50,000.00.

4. Scotty can mow Lebron’s lawn in four hours and make $10/hour.
 Adam Smith Says:

 In 1776s The Wealth of Nations Smith describes what you just

witnessed
 18th century pin factory, where rather than 10 workers making a
pin from start to finish, each worker should specialize in one of
the tasks in completing one pin…
 “those 10 persons, therefore, could make among them upwards of
forty-eight thousand pins in a day. But, if they had all wrought
separately and independently…they certainly could not each of
them have made twenty.”
 Why Comparative Advantage is
Key

 Suppose that an American worker can produce 50 shirts or 200 bushels

of wheat per day. A Chinese worker can produce only 25 shirts or 50
bushels of wheat.
 The U.S. has an absolute advantage in shirt production since a U.S.
worker can produce more shirts than a Chinese worker.
 The U.S. has an absolute advantage in wheat production since a U.S.
worker can produce more wheat than a Chinese worker.

 Issue to resolve: Does it worth for the U.S to trade with China?
Why Comparative Advantage is
Key

 To understand how each country decides which good to

produce when they interact, we calculate opportunity cost:
 U.S.: 1 shirt costs 4 bushels of wheat—1 wheat costs ¼ shirt
 China: 1 shirt costs 2 bushels of wheat –1 wheat costs ½ shirt

 Therefore, China should specialize in shirts and the U.S. in

wheat.
 Absolute and Comparative
Advantage Illustrated
 Which is which?
 Country B—Absolute in
both
 Country A—Comparative in
car production
 Input Model

 Told about what resources are needed to produce one unit of a good in order to
calculate opportunity cost.
 “…required to produce…”
 “…per hour…”

 Input model--- number goes “under”

 Output Model

 Given final data on the amount of a good that can be produced with
a given amount of input to calculate opportunity cost.

 Output model---number goes “over”

 Gains From Trade
Suppose the U.S. has 150 million workers and China 800 million.
Without trade, each nation produces and consumes on their own based on their
preferences.
Let us assume the U.S. produces 5 billion shirts and 10 billion wheat.
Let us assume China produces 10 billion shirts and 20 billion wheat.
Alone, they are inefficient because…
When specialized, producing the good they have a comparative advantage
in total production increases. See below…
Gains From Trade
 Terms of Trade

 We can use all the information we can now calculate to

determine a fair “price” for different producers to seek when
trading. Use their opportunity costs.

 Keep in mind: There is room for trade as long as the two

countries differ in their opportunity costs to produce a good
and they set a “trading price” that falls between those
opportunity costs.
 Terms of Trade

 After specialization, assume the two countries agree to trade 20 billion bushels of wheat for
7.5 billion T-shirts. Are the outcomes going to be an improvement for both countries?
 In our example from yesterday,
 U.S.: 1 shirt costs 4 bushels of wheat—1 wheat costs ¼ shirt
 China: 1 shirt costs 2 bushels of wheat –1 wheat costs ½ shirt

So,

 the price at which China and the U.S are willing to trade T-shirts must fall between China’s
opportunity cost for producing T-shirts and U.S.’s opportunity cost for producing T-shirts.

 China is the country that specializes in T-shirts, and it cannot charge a price greater than the
U.S.’s opportunity cost.

 Conversely, China must receive a price that covers its opportunity costs for making T-shirts,
or it will not be willing to trade.
 Terms of Trade
 From our original example: US producing 200 wheat and 50 shirts, while China
produces 50 wheat and 25 shirts…
 US opportunity costs: 1 wheat costs ¼ shirt—1 shirt costs 4 wheat
 China opportunity cost: 1 wheat costs ½ shirt—1 shirt costs 2 wheat; therefore,

 USA (wheat): before trade, the opportunity cost of making a T-shirt in the U.S
was 4 bushels of wheat. Thus USA has no incentive to trade unless USA can get
1 T-shirt from China for less than 4 bushels of their wheat production

 CHINA (T-shirts): before trade, China’s opportunity cost of making 1 T-shirt

was 2 bushels of wheat. Thus China will not be willing to trade their T-shirts for
U.S.’s wheat unless they can receive more than 2 bushels of wheat in exchange
for 1 of their T-shirts.

 Thus the mutually beneficial terms of trade for 1 T-shirt (1T) is:

 Terms of Trade for T-shirts: “ 2W < 1T < 4W ”

 Remember…

 NO country has comparative advantage in everything and

every country has comparative advantage in something…
 This fact deems trade essential for “efficient” production
 What is this interaction called?
 What are its implications on the world and it’s people?
 Economic Literacy Assignment #1