Absolute & Comparative Advantage (HL IB Economics)

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 Sources of Comparative Advantage

• The sources of comparative advantage can vary from country to country, but some common factors include

Common sources of comparative advantage
 

Natural Resources

• Countries with abundant natural resources, such as minerals, energy sources, fertile land, or water bodies, may have a comparative advantage in industries that utilise these resources

  • E.g. The Ukraine has very fertile farm field and a climate conducive to growing grain
     

Labor Force

• The quality, skills, and cost of labor can be a significant source of comparative advantage

  • Countries with a skilled workforce in specific industries, such as technology, engineering, or manufacturing, may have a competitive edge in those sectors

  • Countries with lower labor costs may have a comparative advantage in labor-intensive industries
     

Technology

• Access to advanced technology, innovation, and research capabilities can create a comparative advantage
   

Capital and Infrastructure

• The availability and quality of capital and infrastructure, such as transportation networks, communication systems, and reliable utilities, can contribute to a comparative advantage

  • Well-developed infrastructure facilitates efficient production, distribution, and connectivity, giving countries an edge in international trade
     

Economies of Scale

• Companies or countries that can achieve economies of scale in production have a comparative advantage

  • Spreading fixed costs over a larger output, reduces per-unit costs and allows firms to offer competitive prices in the global market
     

Government Policies and Support

• Government policies, such as trade agreements, subsidies, tax incentives, and intellectual property protections, can influence a country's comparative advantage

  • Strategic government support can help industries develop and compete in the global market

Using PPC to Illustrate the Gains from Trade

• Production possibility frontiers can be used to illustrate these concepts and the gains from international trade
    

The production possibility frontiers for 2 countries who both produce t-shirts & computer chips

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 1 t-shirts 
    

• The opportunity cost of producing 1 t-shirt is 1 computer chip
  

• To produce 1 computer chip Country A gives up 2 t-shirts and Country B gives up 1 t-shirt

  • Country B has a comparative advantage in producing computer chips as it is giving up fewer t-shirts and so it should specialise in computer chip production
    

• To produce 1 t-shirt Country A gives up 0.5 computer chips and Country B gives up 1 computer chip

  • Country A has a comparative advantage in producing t-shirts as it is giving up fewer computer chips and so it should specialise in t-shirt production
     

The Gains from Trade

• By specialising, the volume of production increases

• Excess production can be exported (Country A exports T-shirts and Country B exports computer chips)

• Goods/services which are not produced in the country can be imported (Country A imports computer chips and Country B imports T-shirts)

Limitations to the Theory of Comparative Advantage

• Comparative advantage does drives a nation's manufacturing in a global economy, but the theory has several limitations
  

The Limitations of Comparative Advantage Theory