What does it mean to have a comparative advantage How is it different than an absolute and which should dictate the price or availability of trade?

Learning Objectives

1. Who can produce more?
2. How does that relate to cost?
3. Can a nation be cheaper on all things?

Ann produces chopped vegetables because her opportunity cost of producing vegetables, at half of one hors d’oeuvre, is lower than Bob’s. When one good has a lower opportunity cost over another, it is said to have a comparative advantageCondition that exists when one good has a lower opportunity cost over another.. That is, Ann gives up less to produce chopped vegetables than Bob, so in comparison to hors d’oeuvres, she has an advantage in the production of vegetables. Since the cost of one good is the amount of another good forgone, a comparative advantage in one good implies a comparative disadvantageCondition that exists when one good has a higher opportunity cost over another.—a higher opportunity cost—in another. If you are better at producing butter, you are necessarily worse at something else—and, in particular, the thing you give up less of to get more butter.

To illustrate this point, let’s consider another party planner. Charlie can produce one hors d’oeuvre or 1 ounce of chopped vegetables per minute. His production is strictly less than Ann’s; that is, his production possibilities frontier lies inside of Ann’s. However, he has a comparative advantage over Ann in the production of hors d’oeuvres because he gives up only 1 ounce of vegetables to produce an hors d’oeuvre, while Ann must give up 2 ounces of vegetables. Thus, Ann and Charlie can still benefit from trade if Bob isn’t around.

When one production possibilities frontier lies outside another, the larger is said to have an absolute advantageCondition that exists when one production possibilities frontier can produce more of all goods than another.—it can produce more of all goods than the smaller. In this case, Ann has an absolute advantage over Charlie—she can, by herself, have more—but not over Bob. Bob has an absolute advantage over Charlie, too; but again, not over Ann.

Diminishing marginal returns implies that the more of a good that a person produces, the higher the cost is (in terms of the good given up). That is to say, diminishing marginal returns means that supply curves slope upward; the marginal cost of producing more is increasing in the amount produced.

Trade permits specialization in activities in which one has a comparative advantage. Moreover, whenever opportunity costs differ, potential gains from trade exist. If Person 1 has an opportunity cost of c1 of producing good x (in terms of y, that is, for each unit of x that Person 1 produces, Person 1 gives up c1 units of y), and Person 2 has an opportunity cost of c2, then there are gains from trade whenever c1 is not equal to c2 and neither party has specialized. Suppose c1 < c2. Then by having Person 1 increase the production of x by Δ, c1Δ less of the good y is produced. Let Person 2 reduce the production of x by Δ so that the production of x is the same. Then there is c2Δ units of y made available, for a net increase of (c2 – c1)Δ. The net changes are summarized in Table 6.1 "Construction of the gains from trade".

Table 6.1 Construction of the gains from trade

Whenever opportunity costs differ, there are gains from reallocating production from one producer to another, gains which are created by having the low-cost producers produce more, in exchange for greater production of the other good by the other producer, who is the low-cost producer of this other good. An important aspect of this reallocation is that it permits production of more of all goods. This means that there is little ambiguity about whether it is a good thing to reallocate production—it just means that we have more of everything we want.

How can we guide the reallocation of production to produce more goods and services? It turns out that, under some circumstances, the price system does a superb job of creating efficient production. The price system posits a price for each good or service, and anyone can sell at the common price. The insight is that such a price induces efficient production. To see this, suppose we have a price p, which is the number of units of y that one has to give to get a unit of x. (Usually prices are in currency, but we can think of them as denominated in goods, too.) If I have a cost c of producing x, which is the number of units of y that I lose to obtain a unit of x, I will find it worthwhile to sell x if p > c, because the sale of a unit of x nets me p – c units of y, which I can either consume or resell for something else I want. Similarly, if c > p, I would rather buy x (producing y to pay for it). Either way, only producers with costs less than p will produce x, and those with costs greater than p will purchase x, paying for it with y, which they can produce more cheaply than its price. (The price of y is 1/p—that is, the amount of x one must give to get a unit of y.)

Thus, a price system, with appropriate prices, will guide the allocation of production to ensure the low-cost producers are the ones who produce, in the sense that there is no way of reallocating production to obtain more goods and services.

Key Takeaways

• A lower opportunity cost creates a comparative advantage in production.
• A comparative advantage in one good implies a comparative disadvantage in another.
• It is not possible to have a comparative disadvantage in all goods.
• An absolute advantage means the ability to produce more of all goods.
• Diminishing marginal returns implies that the more of a good that a person produces, the higher is the cost (in terms of the good given up). That is to say, diminishing marginal returns means that supply curves slope upward; the marginal cost of producing more is increasing in the amount produced.
• Trade permits specialization in activities in which one has a comparative advantage.
• Whenever opportunity costs differ, potential gains from trade exist.
• Trade permits production of more of all goods.
• A price system, with appropriate prices, will guide the allocation of production to ensure the low-cost producers are the ones who produce, in the sense that there is no way of reallocating production to obtain more goods and services.

Exercises

1. Graph the joint production possibilities frontier for Ann and Charlie, and show that collectively they can produce 80 of each if they need the same number of each product. (Hint: First show that Ann will produce some of both goods by showing that, if Ann specializes, there are too many ounces of vegetables. Then show that, if Ann devotes x minutes to hors d’oeuvres, 60 + x = 2(60 – x).)
2. Using Manning’s production possibilities frontier in Exercise 1 in Section 6.1 "Production Possibilities Frontier", compute the marginal cost of trusses in terms of cabinets.
3. Using Alarm & Tint’s production possibilities frontier in Exercise 2 in Section 6.1 "Production Possibilities Frontier", compute the marginal cost of alarms in terms of window tints.

Difference Between Absolute Advantage vs Comparative Advantage

Absolute Advantage is the country’s inherent ability that allows that country to produce specific goods efficiently and effectively at a relatively lower marginal cost. A country has an absolute advantage in producing a good if it can produce that good at lower marginal cost, lesser workforce, lesser time and lesser cost without compromising the quality. Comparative Advantage refers to the country’s capability to produce the specific good at lower marginal cost and opportunity cost compared to other countries. In absolute advantage where the emphasis is only on marginal cost, comparative advantage considers both marginal and opportunity cost.

Example of Absolute Advantage

Let’s take the example of two countries (Country 1 and Country 2), which are manufacturing cars. Assuming County 1 produces 3 cars per hour with 10 employees and Country 2 produces 5 cars with 10 employees.

So in this case, Country 2 has an absolute advantage over Country 1 as Country 2 can produce several cars per hour than County 1 with the same number of employees.

Example of Comparative Advantage

Let’s take the example of Country 1 and Country 2. Country 1 can produce either 10 cars or 20 computers whereas Country 2 can produce 22 cars or 30 computers with available resources.

Opportunity Cost of Production

• The opportunity cost of producing 1 unit of the computer is higher for Country 2 than Country 1 and opportunity cost for producing 1 unit of a car is lower for country 1 than a country
• According to the comparative advantage concept, Country 1 should produce computers, and Country 2 should produce cars to optimize their cost.

Absolute Advantage vs Comparative Advantage (Infographics)

Below is the top 8 difference between Absolute Advantage vs Comparative Advantage

Key Differences Between Absolute Advantage vs Comparative Advantage

Both Absolute Advantages vs Comparative Advantage are popular choices in the market; let us discuss some of the major Difference

• Both Absolute advantages vs Comparative advantage are important concepts of international trade that help countries make decisions on domestic productions of goods, resource allocation, import, export, etc.
• The Absolute Advantage is the country’s inherent ability to produce specific goods efficiently and effectively at a relatively lower marginal cost. However, Comparative Advantage refers to the country’s capability to produce the specific good at lower marginal cost and opportunity cost.
• The absolute advantage concept is based on a lower marginal cost of production of a specific good. However, comparative advantage deals with the lower opportunity cost of production of a specific good compared to competitor Country.
• Countries with an absolute advantage of producing a good focus on maximizing production with the same available resources. However, Countries with comparative advantage take into account the production of multiple goods in the country while deciding the production of a specific good and resource allocation.
• The comparative advantage concept is more effective in helping countries in the decision-making of resource allocation, production, and trade compared to absolute advantage.
• Trades transactions between countries having the absolute advantage are not mutually beneficial in nature. Trades decisions based on comparative advantage are mutually beneficial in nature.
• Absolute advantage may not be very effective and beneficial for the economy as it focuses on maximizing production without considering the opportunity cost of production. However, comparative advantage is more effective in helping Countries taking decisions related to resource allocation, domestic productions, and import/export of goods.

Absolute Advantage vs Comparative Advantage Comparison Table

Below is the topmost comparison between Absolute Advantage vs Comparative Advantage

Conclusion

The concept of Absolute Advantage vs Comparative Advantage is related to economics and trade which helps countries make logical decisions on resource allocation for the production of specific goods, import and export of goods while considering the marginal cost and opportunity cost of producing goods. Absolute advantage focuses on the marginal cost of producing a good, whereas comparative advantage specifically focuses on the opportunity cost of production. Trade decisions based on comparative advantage between countries are always mutually beneficial. Comparative advantage helps in more effective decision-making for countries for resource allocation and production hence more beneficial for economies than an absolute advantage.

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