international-trade

The Model of Comparative Advantage

• International trade decreases prices and increases the variety of goods/services available to a nation

  • This results in a higher standard of living

• Comparative advantage is the theory developed by David Ricardo in 1817 which states that a country should specialise in the goods/services that it can produce at the lowest opportunity cost

  • By specialising, the volume of production increases

  • Excess production can be exported

  • Goods/services which are not produced in the country can be imported

The assumptions of comparative advantage

• As with any economic model, there are underlying assumptions to the theory of comparative advantage: 

1. Transport costs are zero: it does not account for moving goods or services between countries. Depending on a nation’s location, this is more or less of a problem

2. There is perfect knowledge: each country knows what it has a comparative advantage in and also the comparative advantages of other countries

3. Factor substitution is easily achieved: economies can quickly adjust to changing global market conditions by switching from capital to labour – and vice versa

4. Constant costs of production: the theory does not take into account the economies of scale that can be achieved with an increase in output

Comparative & Absolute Advantage

• Absolute advantage occurs when a country is able to produce a product using fewer factors of production than another country

  • A country may well have absolute advantage but still not have comparative advantage

    • It should produce goods/services in which it has comparative advantage

• Production possibility frontiers can be used to illustrate comparative and absolute advantage

Diagram: Production Possibility Frontier for T-shirts & Computers 

Diagram analysis

• Country A has an absolute advantage as it can produce more of both products

• Country A can produce either 200,000 t-shirts or 100,000 computer chips

  • To produce 100,000 computer chips, it gives up production of 200,000 t-shirts
     

  • The opportunity cost of producing 1 computer chip is

     =  = 2 t-shirts

  • The opportunity cost of producing 1 t-shirt is

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