20.1 Absolute and Comparative Advantage

International trade is built on the principles of absolute and comparative advantage. These concepts explain why countries specialize in producing certain goods and services, even when they're not the best at making everything.

Comparative advantage, based on opportunity costs, drives trade more than absolute advantage. When countries focus on what they do best relative to others, they can produce more overall. This specialization leads to increased efficiency and economic gains for all trading partners.

Absolute and Comparative Advantage

Absolute vs comparative advantage

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• Absolute advantage occurs when a country can produce a good using fewer resources (labor, capital, land) than another country
  • Example: If the US can produce 1,000 cars with the same resources China uses to produce 800 cars, the US has an absolute advantage in car production
• Comparative advantage occurs when a country has a lower opportunity cost of producing a good compared to another country
  • Opportunity cost is the amount of one good that must be given up to produce an additional unit of another good
  • Example: If the opportunity cost of producing one car in the US is 2 computers and in China it is 3 computers, the US has a comparative advantage in car production, even if China has an absolute advantage in producing both cars and computers
  • Comparative advantage is influenced by factor endowments, such as natural resources, labor, and technology

Specialization and trade gains

• When countries specialize in producing goods for which they have a comparative advantage, they can produce a larger total output with the same resources
  • Countries can then trade with each other to obtain the goods they do not produce domestically (international trade)
  • Specialization and trade allows both countries to consume more than they could without trade, leading to gains from trade
• Example: If the US specializes in producing aircraft (comparative advantage) and China specializes in producing electronics (comparative advantage), the total output of both goods will be higher than if each country tried to produce both goods domestically
  • The US can trade some of its aircraft to China in exchange for electronics, and both countries will end up with more of both goods than they would have without specialization and trade
• This process leads to production efficiency, as resources are allocated to their most productive uses

Opportunity costs in comparative advantage

• To calculate the opportunity cost, divide the amount of the good given up by the amount of the other good produced
  • The country with the lower opportunity cost in producing a good has the comparative advantage in that good
• Example: If the US can produce either 1,000 cars or 5,000 computers, and Japan can produce either 800 cars or 6,000 computers:
  1. In the US, the opportunity cost of producing one car is $\frac{5,000 \text{ computers}}{1,000 \text{ cars}} = 5$ computers per car
  2. In Japan, the opportunity cost of producing one car is $\frac{6,000 \text{ computers}}{800 \text{ cars}} = 7.5$ computers per car
  3. The US has a lower opportunity cost ($5 < 7.5$) in producing cars, so it has a comparative advantage in car production
  4. Japan has a lower opportunity cost in producing computers ($\frac{1}{7.5} < \frac{1}{5}$), so it has a comparative advantage in computer production
• Even if one country has an absolute advantage in producing both goods (Japan in this example), it will still benefit from specializing in the good for which it has a comparative advantage and trading for the other good

International Trade and Economic Interdependence

• Specialization based on comparative advantage leads to increased trade between countries
• The terms of trade determine the relative prices at which goods are exchanged between countries
• As countries engage in trade, they become economically interdependent, relying on each other for goods and services