ECON310 Global Managerial Economics - Colorado Technical University

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In the Mercantile period, from the 16th through the end of the 18th centuries, trade was driven by a need to accumulate gold and silver. Nations worked to restrict imports and drive exports. With the advent of the Industrial Age, classical economists began to look at trade and international commerce in a different light.

In his seminal work The Wealth of Nations, Adam Smith discussed the idea that the basis of trade could be seen in light of what he called absolute advantage. His contemporary, David Ricardo, took a different and modified approach and laid out a framework called comparative advantage.

This latter theory is the basis for all modern views of international trade.

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Define absolute and comparative advantage.

Absolute and comparative advantage

Absolute advantage refer's to a country or company's ability to produce a good/provide a service at a lower cost per unit than another entity. This is straightforward, but many more important economic insights come from understanding comparative advantage in addition to absolute advantage, so I will discuss that in more detail.

Comparative advantage is one of the basic elements of international trade theory - and I always found it one of the most fun to get your head around.

Compare the two views on trade.

Two views on trade

Absolute and comparative advantage is best understood through an analysis of two countries trading two goods. Countries A and B are each capable of producing two goods, apples and bananas. Country A can produce 10 apples or 25 bananas in a day (or any linear combination of the two). Country B can produce 8 apples or 17 bananas in a day (or any linear combination of the two). This relationship is described in the following chart:

In order to produce an additional apple, Country A must forego producing 2.5 bananas while Country B must forego producing 2 bananas. Similarly, to produce an additional banana country A must forego .4 apples while country B must forego .5 apples. The opportunity cost is lower for Country B to produce apples and country A to produce bananas, so we say that Country B has a comparative advantage in the production of apples and country A has a comparative advantage in the production of bananas.

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How does the concept of opportunity cost factor into comparative advantage?

Opportunity cost factor into comparative advantage

Here is an example: If you have an office space dedicated to a specific activity and you reconfigure the space to accommodate a new activity, the allocation of space to the new activity may come with an opportunity cost of reduced operational efficiency due to the reduced space now allocated to the first activity (Brecher, et al., 2002). Or, not allocating part of the space to the new activity could have an opportunity cost if it would have supported operational goals or competitive advantage leading to increased profit, for instance. The comparative advantage here is based on real or perceived opportunity cost associated with the decision to re-allocate currently used space for a new activity; it is a form of cost/benefit analysis.

It starts with the notion of "absolute advantage" - which is subtly misleading: you have an "advantage" over someone else so by definition the term implies a comparison. Suppose you and I both produce cheese; in one working day, you can produce 3 pounds of cheese, whereas I can only produce 2 pounds. Then you have an "absolute advantage" in cheese production over me; you are more productive as a cheesemaker.

This implies you have a comparative advantage over me at winemaking over cheese making; conversely, I have a comparative advantage over you at cheese making over winemaking (my absolute disadvantage is smaller at cheese making than at winemaking).

In other words, comparative advantage implies a double comparison: across producers and across products.

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Discuss why you think comparative advantage has become the fundamental and accepted theory of trade.

Comparative advantage has become the fundamental and accepted theory of trade

The main implication is that it is best for countries to specialize in the production of the goods (or services) where they have a comparative advantage. To keep the example simple, suppose prices are such that 1 pound of cheese costs as much as a liter of wine. Over the course of a day, you could devote the morning to winemaking and the afternoon to cheese making, and by dinner time you would have 3 liters of wine and 1.5 pounds of cheese. Alternatively, you could spend the whole day winemaking, produce 6 liters of wine, and by evening trade 3 liters of wine for 3 pounds of cheese (same price). You would still have 3 liters of wine left, but also 3 pounds of cheese instead of just.

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