Absolute and Comparative Advantage
Definition
Absolute advantage: the ability of a country to produce more of a good than another country from the same quantity of resources.
Comparative advantage: the ability of a country to produce a good at a lower opportunity cost than another country.
Core Idea
- Countries trade because they differ in what they can produce relatively cheaply, so specialisation lets each focus where its costs are lowest.
- Absolute advantage compares the physical output obtained from a given quantity of resources.
- Comparative advantage compares the opportunity cost of one good measured in units of the other.
- To find a country's opportunity cost of one good, divide the output of the other good by the output of this good; the country with the lower ratio for a good holds the comparative advantage in it.
- The law of comparative advantage states that both countries gain when each specialises in the good with the lower opportunity cost, so trade is positive-sum, not zero-sum.
Key Idea
- Comparative advantage rests on opportunity cost, not on absolute output.
- A country can still gain from trade even when it holds an absolute advantage in both goods.
- Specialisation by comparative advantage raises total world output, so both partners can consume more.
Worked Example
- Two economies, Germany and Vietnam, each have one worker who can make machinery or textiles.
- The output figures below fix each country's absolute advantage and its opportunity-cost ratios.
- We read off absolute advantage first, then divide the outputs to find opportunity cost.
Example
- Per worker, Germany can make 80 machines or 40 textiles.
- Per worker, Vietnam can make 30 machines or 30 textiles.
- Germany makes more of both goods, so it has an absolute advantage in both.
- In Germany, the opportunity cost of 1 machine in textiles is:
- So 1 machine costs Germany 0.5 textiles, and therefore 1 textile costs 2 machines.
- In Vietnam, the opportunity cost of 1 machine in textiles is:
- So 1 machine costs Vietnam 1 textile, and 1 textile costs 1 machine.
- Germany's opportunity cost of machinery (0.5 textiles) < Vietnam's (1 textile), so Germany specialises in machinery.
- Vietnam's opportunity cost of textiles (1 machine) < Germany's (2 machines), so Vietnam specialises in textiles.
Absolute Versus Comparative
- Germany holds an absolute advantage in both machinery and textiles.
- Its workers are limited, so producing more machinery forces it to give up textiles.
- Because Germany sacrifices only 0.5 textiles per machine while Vietnam sacrifices 1, Germany's comparative advantage lies in machinery.
- So the more productive country still gains by concentrating on its lowest opportunity-cost good and importing the rest.
Note
- David Ricardo set out the theory in 1817 using England and Portugal trading cloth and wine.
- Portugal could make both goods with less labour, yet both nations gained once each specialised by comparative advantage.
- This is why advanced economies still import goods they could make themselves, exporting where their opportunity cost is lowest.
Gains From Specialisation
- After each country specialises, it produces more of its lower opportunity-cost good than before.
- Combined output of machinery and textiles across both countries therefore rises.
- Trading at a rate between the two opportunity-cost ratios (between 0.5 and 1 textile per machine) lets both consume beyond their own production frontier.
- This mutual gain is the core case for trade, though it depends on the ratios differing and on the model's assumptions holding.
Exam technique
- Always calculate the opportunity cost of each good in each country before deciding who specialises.
- Assign each good to the country with the lower opportunity cost in that good.
- Support the judgement by showing that total output rises after specialisation.
Common Mistake
- Do not assume the country with an absolute advantage in both goods should make both.
- Gains from trade depend on opportunity cost, and arise only if the opportunity-cost ratios differ between countries.
Self review
- Define absolute advantage.
- Define comparative advantage.
- How do you identify which good a country should specialise in?
- Can a country with an absolute advantage in both goods still gain from trade?
- What happens to total world output after specialisation by comparative advantage?
