Economics Absolute and Comparative Advantage

Absolute/Comparative Advantage

Absolute Advantage

Economists use the term absolute advantage when comparing the productivity of one person, firm, or nation to that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.

Put another way, if two people (or firms) received the same amount of inputs, whoever could produce the most units of the good would have the absolute advantage.

Absolute Advantage

Do not let the way the information is presented in the question confuse you in determining who has the absolute advantage. If the number of outputs is given, simply look at who produces more (all other variables constant).

If the number of inputs are given, then look at who needs fewer inputs to determine who has the absolute advantage.

Multiple Choice

Country "A" can produce 12 cars or 8 computers. Country "B" can produce 15 cars or 5 computers. Which country has the absolute advantage in terms of cars?

• Country "A"

• Country "B"

• Neither

• Both

Multiple Choice

Country "A" can produce 12 cars or 8 computers. Country "B" can produce 15 cars or 5 computers. Which country has the absolute advantage in terms of computers?

• Country "A"

• Country "B"

• Neither

• Both

Multiple Choice

Country "C" can produce shirt in 30 minutes or 1 chair in 60 minutes. Country "D" can produce a shirt in 45 minutes or 1 chair in 45 minutes. Which country has the absolute advantage in terms of shirts?

• Country "C"

• Country "D"

• Neither

• Both

Explanation

In the first two questions, the number of outputs was given, so the answer depended on who could produce the most of the desired good. The last question however, gave the number of inputs (in this case, time) that was needed to produce one unit of the good. So the answer was the country that needed the fewest inputs (the less time) to produce the desired good.

Production and Trade

Country "G" can produce 20 hamburgers or 80 hot dogs. Country "H" can produce 14 hamburgers or 28 hot dogs.

You might notice that Country "G" has an absolute advantage in both hamburgers and hot dogs. Does this mean that Country "G" should not trade with Country "H" because they can already produce more by themselves? NO! Both countries would be better off with trade (meaning they'd be able to consume more than their current resources would allow), and to understand why, we must look at who has the comparative advantage.

Comparative Advantage

Economists use the term comparative advantage when describing the opportunity costs faced by two producers. The producer who gives up less of other goods to produce Good "X" has the smaller opportunity cost of producing Good "X" and is said to have a comparative advantage in producing it. 

So the first step in determining who has the comparative advantage is to calculate the opportunity cost for each country, with each good.

Comparative Advantage and Opportunity Cost

The opportunity cost means what is the country (in this case) giving up in order to produce ONE UNIT of the chosen good. This can be calculated using simple algebra to see how much one unit of the desired good "costs" in terms of the other good.

Multiple Choice

Country "G" can produce 20 hamburgers or 80 hot dogs. Country "H" can produce 14 hamburgers or 28 hot dogs. What is the opportunity cost for Country "G" to produce 1 hamburger?

• 60 hot dogs

• 40 hot dogs

• 4 hot dogs

• 4 hamburgers

Multiple Choice

Country "G" can produce 20 hamburgers or 80 hot dogs. Country "H" can produce 14 hamburgers or 28 hot dogs. What is the opportunity cost for Country "G" to produce 1 hot dog?

• 4 hot dogs

• 1/4 hot dogs

• 4 hamburgers

• 1/4 hamburger

Multiple Choice

Country "G" can produce 20 hamburgers or 80 hot dogs. Country "H" can produce 14 hamburgers or 28 hot dogs. What is the opportunity cost for Country "H" to produce 1 hamburger?

• 2 hot dogs

• 1/2 hot dogs

• 1.5 hot dogs

• 15 hot dogs

Multiple Choice

Country "G" can produce 20 hamburgers or 80 hot dogs. Country "H" can produce 14 hamburgers or 28 hot dogs. What is the opportunity cost for Country "H" to produce 1 hot dog?

• 12 hamburgers

• 2 hamburgers

• 1/2 hamburger

• 3 hamburgers

Opportunity Cost Summary

From the last four questions, we saw that for Country "G"

the opportunity cost of 1 hamburger was 4 hot dogs

the opportunity cost of 1 hot dog was 1/4 hamburger.

For country "H"...

the opportunity cost of 1 hamburger was 2 hot dogs

the opportunity cost of 1 hot dog was 1/2 hamburger.

*Perhaps you notice the opportunity costs of two goods for the same country are reciprocals.

Now that we know the opportunity costs for each country and each good, we can determine who has the comparative advantage...

Comparative Advantage and Specialization

Country "G"

the opportunity cost of 1 hamburger was 4 hot dogs

the opportunity cost of 1 hot dog was 1/4 hamburger.

Country "H"

the opportunity cost of 1 hamburger was 2 hot dogs

the opportunity cost of 1 hot dog was 1/2 hamburger.

Who has the lower opportunity cost for hamburgers? Country "H" because they only "give up" 2 hots dogs as opposed to 4. This means Country "H" has the comparative advantage in hamburgers.

Comparative Advantage and Specialization

Country "G"

the opportunity cost of 1 hamburger was 4 hot dogs

the opportunity cost of 1 hot dog was 1/4 hamburger.

Country "H"

the opportunity cost of 1 hamburger was 2 hot dogs

the opportunity cost of 1 hot dog was 1/2 hamburger.

Who has the lower opportunity cost for hot dogs? Country "G" because they only "give up" 1/4 hamburger instead of 1/2. This means Country "G" has the comparative advantage in producing hot dogs.

Comparative Advantage and Specialization

If you remember, Country "G" had the absolute advantage in BOTH hamburgers and hot dogs, but it only has the comparative advantage in producing hot dogs.

This highlights the point that even if a country has an absolute advantage in two goods, they can only have a comparative advantage in one good.

Country "H" did not have an absolute advantage in either good, but still has the comparative advantage in producing hamburgers. This is all because they had the lower opportunity cost in producing them.

Comparative Advantage and Specialization

This now means that each country should specialize in only producing the good for which they have the comparative advantage. All of their resources should be used to only produce one good.

Country "G" has the comparative advantage in hot dogs.

Country "H" has the comparative advantage in hamburgers.

After they have produced the good in which they specialized, they can then trade with one another, to benefit both countries.

Terms of Trade

For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs. This means we need to compare opportunity costs again (for either good) and find a number in between both opportunity costs for the countries. As a reminder...

Country "G"

the opportunity cost of 1 hamburger was 4 hot dogs

the opportunity cost of 1 hot dog was 1/4 hamburger.

Country "H"

the opportunity cost of 1 hamburger was 2 hot dogs

the opportunity cost of 1 hot dog was 1/2 hamburger.

Terms of Trade

Let's only compare the opportunity costs for hamburgers:

Country "G"

the opportunity cost of 1 hamburger was 4 hot dogs

Country "H"

the opportunity cost of 1 hamburger was 2 hot dogs

What is (conveniently) a number between 2 and 4? How about 3. This means they should trade 1 hamburger for 3 hot dogs.

Terms of Trade

Let's say that the countries agree to trade 1 hamburger for 3 hot dogs.

Country "G" specializes in hot dogs, produces 80 of them, and exports them to Country "H."

Country "H" specializes in hamburgers, produces 14, and exports them to Country "G."

The table on the next slide shows you how each country benefits from trade (along these terms) because they are able to have more of both goods than if they tried to be self sufficient.

Multiple Choice

Andy can produce a pillow in 15 minutes or a blanket in 20 minutes, and Barbara can produce a pillow in 20 minutes or a blanket in 30 minutes.

Who has the absolute advantage in making blankets?

• Andy

• Barbara

• Neither

• Both

Multiple Choice

Andy can produce a pillow in 15 minutes or a blanket in 20 minutes, and Barbara can produce a pillow in 20 minutes or a blanket in 30 minutes.

Who has the comparative advantage in making blankets?

• Andy

• Barbara

• Neither

• Both

Multiple Choice

A country should specialize in production of the good in which they have an absolute advantage.

• True

• False

Multiple Choice

The opportunity cost for Timmy to produce one desk is 4.5 chairs. The opportunity cost for Lauren to produce one desk is 6 chairs. Knowing this, who should specialize in producing desks?

• Lauren, because she has the higher opportunity cost

• Timmy, because he has the lower opportunity cost

• There is not enough information to know.

Multiple Choice

A country currently produces coffee and bread. If new technology was discovered that increased the production of coffee, how would the opportunity cost of bread be affected?

• It would decrease because more coffee could be produced instead.

• It would not be affected.

• It would increase because more coffee could be produced instead.

Multiple Choice

The opportunity cost for Timmy to produce one desk is 4.5 chairs. The opportunity cost for Lauren to produce one desk is 6 chairs. Knowing this, who should specialize in producing desks?

• Lauren, because she has the higher opportunity cost

• Timmy, because he has the lower opportunity cost

• There is not enough information to know.