specialisation-and-trade

Absolute & 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

• 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

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 the goods/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

Using production possibility frontiers to Illustrate comparative and absolute advantage

• Production possibility frontiers can be used to illustrate these concepts

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 0.5 computer chip

• Country B can produce either 80,000 t-shirts or 80,000 computer chips

  • To produce 80,000 computer chips it gives up production of 80,000 t-shirts

  • The opportunity cost of producing 1 computer chip is <img alt=”fraction numerator straight t minus shirts over denominator computer space chips end fraction space equals space fraction numerator 80 comma 000 over denominator 80 comma 000 end fraction space equals space” data-mathml='<math style=”font-family:Arial” ><semantics><mstyle mathsize=”14px”><mfrac><mrow><mi mathvariant=”normal”>t</mi><mo>-</mo><mi>shirts</mi></mrow><mrow><mi>computer</mi><mo> </mo><mi>chips</mi></mrow></mfrac><mo> </mo><mo>=</mo><mo> </mo><mfrac><mrow><mn>80</mn><mo>,</mo><mn>000</mn></mrow><mrow><mn>80</mn><mo>,</mo><mn>000</mn></mrow></mfrac><mo> </mo><mo>=</mo><mo> </mo></mstyle><annotation encoding=”application/vnd.wiris.mtweb-params+json”>{“language”:”en”,”fontFamily”:”Times New Roman”,”fontSize”:”18″}</annotation></semantics></math>’ height=”39″ role=”math” src=”data:image/svg+xml;charset=utf8,%3Csvg%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg%22%20xmlns%3Awrs%3D%22http%3A%2F%2Fwww.wiris.com%2Fxml%2Fmathml-extension%22%20height%3D%2239%22%20width%3D%22200%22%20wrs%3Abaseline%3D%2224%22%3E%3C!–MathML%3A%20%3Cmath%20xmlns%3D%22http%3A%2F%2Fwww.w3.org%2F1998%2FMath%2FMathML%22%20style%3D%22font-family%3AArial%22%3E%3Cmstyle%20mathsize%3D%2214px%22%3E%3Cmfrac%3E%3Cmrow%3E%3Cmi%20mathvariant%3D%22normal%22%3Et%3C%2Fmi%3E%3Cmo%3E-%3C%2Fmo%3E%3Cmi%3Eshirts%3C%2Fmi%3E%3C%2Fmrow%3E%3Cmrow%3E%3Cmi%3Ecomputer%3C%2Fmi%3E%3Cmo%3E%26%23xA0%3B%3C%2Fmo%3E%3Cmi%3Echips%3C%2Fmi%3E%3C%2Fmrow%3E%3C%2Fmfrac%3E%3Cmo%3E%26%23xA0%3B%3C%2Fmo%3E%3Cmo%3E%3D%3C%2Fmo%3E%3Cmo%3E%26%23xA0%3B%3C%2Fmo%3E%3Cmfrac%3E%3Cmrow%3E%3Cmn%3E80%3C%2Fmn%3E%3Cmo%3E%2C%3C%2Fmo%3E%3Cmn%3E000%3C%2Fmn%3E%3C%2Fmrow%3E%3Cmrow%3E%3Cmn%3E80%3C%2Fmn%3E%3Cmo%3E%2C%3C%2Fmo%3E%3Cmn%3E000%3C%2Fmn%3E%3C%2Fmrow%3E%3C%2Fmfrac%3E%3Cmo%3E%26%23xA0%3B%3C%2Fmo%3E%3Cmo%3E%3D%3C%2Fmo%3E%3Cmo%3E%26%23xA0%3B%3C%2Fmo%3E%3C%2Fmstyle%3E%3C%2Fmath%3E–%3E%3Cdefs%3E%3Cstyle%20type%3D%22text%2Fcss%22%3E%40font-face%7Bfont-family%3A’math1bc47192a93218c4df62d953d2d’%3Bsrc%3Aurl(data%3Afont%2Ftruetype%3Bcharset%3Dutf-8%3Bbase64%2CAAEAAAAMAIAAAwBAT1MvMi7iBBMAAADMAAAATmNtYXDEvmKUAAABHAAAAERjdnQgDVUNBwAAAWAAAAA6Z2x5ZoPi2VsAAAGcAAABJmhlYWQQC2qxAAACxAAAADZoaGVhCGsXSAAAAvwAAAAkaG10eE2rRkcAAAMgAAAAEGxvY2EAHTwYAAADMAAAABRtYXhwBT0FPgAAA0QAAAAgbmFtZaBxlY4AAANkAAABn3Bvc3QB9wD6AAAFBAAAACBwcmVwa1uragAABSQAAAAUAAADSwGQAAUAAAQABAAAAAAABAAEAAAAAAAAAQEAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAACAgICAAAAAg1UADev96AAAD6ACWAAAAAAACAAEAAQAAABQAAwABAAAAFAAEADAAAAAIAAgAAgAAACwAPSIS%2F%2F8AAAAsAD0iEv%2F%2F%2F9X%2Fxd3xAAEAAAAAAAAAAAAAAVQDLACAAQAAVgAqAlgCHgEOASwCLABaAYACgACgANQAgAAAAAAAAAArAFUAgACrANUBAAErAAcAAAACAFUAAAMAA6sAAwAHAAAzESERJSERIVUCq%2F2rAgD%2BAAOr%2FFVVAwAAAQBV%2F2QA1QCAAAoAADM1MxUUBgcnPgE3VYAvLxseHgGAej1RFCkONDEAAgCAAOsC1QIVAAMABwBlGAGwCBCwBtSwBhCwBdSwCBCwAdSwARCwANSwBhCwBzywBRCwBDywARCwAjywABCwAzwAsAgQsAbUsAYQsAfUsAcQsAHUsAEQsALUsAYQsAU8sAcQsAQ8sAEQsAA8sAIQsAM8MTATITUhHQEhNYACVf2rAlUBwFXVVVUAAQCAAVUC1QGrAAMAMBgBsAQQsQAD9rADPLECB%2FWwATyxBQPmALEAABMQsQAG5bEAARMQsAE8sQMF9bACPBMhFSGAAlX9qwGrVgAAAAEAAAABAADVeM5BXw889QADBAD%2F%2F%2F%2F%2F1joTc%2F%2F%2F%2F%2F%2FWOhNzAAD%2FIASAA6sAAAAKAAIAAQAAAAAAAQAAA%2Bj%2FagAAF3AAAP%2B2BIAAAQAAAAAAAAAAAAAAAAAAAAQDUgBVATMAVQNWAIADVgCAAAAAAAAAACgAAABSAAAA3AAAASYAAQAAAAQAXgAFAAAAAAACAIAEAAAAAAAEAADeAAAAAAAAABUBAgAAAAAAAAABABIAAAAAAAAAAAACAA4AEgAAAAAAAAADADAAIAAAAAAAAAAEABIAUAAAAAAAAAAFABYAYgAAAAAAAAAGAAkAeAAAAAAAAAAIABwAgQABAAAAAAABABIAAAABAA