Absolute and Comparative Advantage

Absolute and Comparative Advantage

The principle of absolute advantage
The concept was developed by Adam Smith, a Scottish economist, in the 18th century. Absolute advantage exists when a country can produce a product with lesser resources than another country. In other words, one country can produce more units of one product than another using the same amount of resources. Every country should specialise in the production of good in which they have absolute advantage and then exchange with each other. In the end each country will get more of each good than if there was no specialisation. The ratio of exchange should be between the opportunity cost ratios for the countries involved.  Opportunity cost ratio is the amount of one product that will be given up in order to produce a unit of another product. In Table 1 below, Japan has to give up 3 units of electronics in order to produce each unit of car (3,000/1,000). The opportunity cost ratio, therefore, is 1 car to 3 electronics.

Let us assume there are two countries, Japan and Germany, that use half of their resources to produce each of two goods, cars and electronics.  Japan can produce 1,000 units of cars and 3,000 units of electronics. Germany, on the other hand, can produce 2,000 units of cars and 1,000 units of electronics (see Table 1 below).  Japan can produce more electronics than Germany while Germany can make more cars than Japan. It means that Japan has absolute advantage over Germany in electronics production.  But Germany has absolute advantage in car production. It can also be said that Japan has absolute disadvantage in car production since it produces fewer cars than Germany. Likewise, Germany has an absolute disadvantage in electronics production because it produces lesser electronics. 

These countries can mutually benefit from trade because each country has a product it can produce more than the other. They should specialise and exchange. In this case, Japan should produce only electronics  while Germany should concentrate on car production. After specialisation, If Japan will double its output to 6000 units of electronics because all its resources are now used to produce only electronics (Table 1 below). In the same manner, Germany will produce 4,000 cars instead of 2,000.  The total output of the two goods has increased following specialisation. car production gained 1,000 while electronics gained 2,000. 


Table 1: A numerical example of absolute advantage

 Before specialisationAfter specialisationGains
CarsElectronicsCars ElectronicsCarsElectronics
Japan1,0003,00006,000-1,0003,000
Germany2,0001,0004,00002,000-1,000
Total3,0004,0004,0006,0001,0002,000

 


Principle of comparative advantage

It was propounded by David Ricardo, an British economist, in 1817. According to this principle, a country has a comparative advantage if it can produce a good at a lower opportunity cost than another country, i.e. it sacrifices fewer units of another good in order to produce it. This implies that it is cheaper for the country to produce the good. Even if a country does not have an absolute advantage in any good, trade can still be mutually beneficial it if can produce one of the goods at a lower opportunity cost than the other country. 

 

Table 2: A numerical example of comparative advantage

 Before specialisationAfter specialisationGains
Crude oil (barrelsCocoa (tonnes)Crude oil (barrels Cocoa (tonnes)Crude oil (barrelsCocoa (tonnes)
Nigeria10,0006,00020,000010,000-6,000
Ghana7,0005,000010,000-7,0005,000
Total17,00011,00020,00010,0003,0001,000

 

Table 2 above shows the production possibilities for Nigeria and Ghana. Nigeria, for example, can produce 10,000 barrels of crude oil and 6,000 tonnes of cocoa by using half of its resources for each of them. Nigeria has absolute advantage in the production of the two goods because it can produce a higher quantity of each good than Ghana. Ghana cannot be discarded because it is possible that Ghana can produce one of the goods at a lower opportunity cost than Nigeria. Trade can still be mutually beneficial if each party has a cost advantage in production of one good.  The opportunity cost is calculated for both countries as follows:

Opportunity cost for Nigeria
The opportunity cost of 1 barrel of crude oil is 0.6  tonne of cocoa given up (6,000/10,000).
The opportunity cost of 1 tonne of cocoa is 1.67 barrels of crude oil sacrificed (10,000/6,000)

Opportunity cost for Ghana
The opportunity cost of 1 barrel of crude oil is 0.71 tonne of cocoa foregone (5,000/7,000).
The opportunity cost of 1 tonne of cocoa is 1.4 barrels of crude oil (7,000/5,000). 


Nigeria has a comparative advantage in crude production because it has a lower opportunity cost (0.6 tonne of cocoa). Ghana has a comparative advantage in the production of cocoa with a lower opportunity cost of 1.4 barrels of crude oil compared to Nigeria’s 1.67 barrels of crude oil. Nigeria has a comparative disadvantage in cocoa production while Ghana has a comparative disadvantage in crude oil production. Therefore, Nigeria should produce only crude oil; Ghana should concentrate all its resources on cocoa production. After specialisation, Nigeria can produce 20,000 barrels of crude because it uses all (not half) of its resources in its production. Ghana can now produce 10,000 tonnes of cocoa compared to 5,000 it produces before specialisation.  The exchange rate for 1 barrel of crude oil has to be between the opportunity cost for the two countries, i.e. between 0.6 and 0.71 tonne of cocoa. The countries could agree an exchange rate of 1 barrel of crude oil to 0.68 tonne of cocoa. Nigeria will get more cocoa than it could produce without specialisation and Ghana will get more crude oil than it could produce if it has not specialised.


Limitations of the principle of comparative advantage

There are more than two countries producing different goods
There are more two countries in the world. And two countries may not produce the same two goods.

Transport cost is ignored
Transport cost add to the cost of the good in reality. Transport cost can make a product not price competitive even if it is produced at a lower cost in a particular country. 


There are no trade barriers
It is assumed that there are no barriers to trade such as tariffs. Many countries restrict trade using barriers to protect domestic businesses, prevent job loss or raise revenue. 


Barter system has been abolished

According to the principle, the countries involved in trade exchange with each other after specialisation. This direct system of exchanging goods for goods is no longer adopted in the world. Money is now being used as a measure of  the value of goods and a medium of exchange.


Constant opportunity cost
Costs are different because scale of production are not the same. Some countries have a lower cost due to economies of scale.


Trade agreements
Countries do have trade agreements with one another. A country may buy from a particular country even though there are others with lower cost because of the existence of agreements. An example is economic union where members buy from each other and impose tarriffs on goods from external countries.


Perfect knowledge
The theory assumes that there is perfect knowledge among buyers and sellers. In reality, countries find it difficult to ascertain the country with the lowest priced products.