Countries benefit when they specialize in producing goods for which they have a comparative advantage and engage in trade for other goods.
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International trade is the exchange of capital, goods, and services across international borders or territories. Trading-partners reap mutual gains when each nation specializes in goods for which it holds a comparative advantage and then engages in trade for other products. In other words, each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations. International Trade: Countries benefit from producing goods in which they have comparative advantage and trading them for goods in which other countries have the comparative advantage. In addition to comparative advantage, other reasons for trade include:
To summarize, international trade benefits mostly all incumbents and generates substantial value for the global economy.
The production possibility frontier shows the combinations of output that could be produced using available inputs.
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In economics, the production possibility frontier (PPF) is a graph that shows the combinations of two commodities that could be produced using the same total amount of the factors of production. It shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology. PPFs are normally drawn as extending outward around the origin, but can also be represented as a straight line. An economy that is operating on the PPF is productively efficient, meaning that it would be impossible to produce more of one good without decreasing the production of the other good. For example, if an economy that produces only guns and butter is operating on the PPF, the production of guns would need to be sacrificed in order to produce more butter. If production is efficient, the economy can choose between combinations (i.e., points) on the PPF: B if guns are of interest, C if more butter is needed, or D if an equal mix of butter and guns is required. Production Possibilities Frontier: If production is efficient, the economy can choose between combinations on the PPF. Point X, however, is unattaible with existing resources and technology if trade does not occur. If the economy is operating below the curve, it is operating inefficiently, because resources could be reallocated in order to produce more of one or both goods without decreasing the quantity of either. Points outside the curve are unattainable with existing resources and technology if trade does not occur with an outside producer. The PPF will shift outwards if more inputs (such as capital or labor ) become available or if technological progress makes it possible to produce more output with the same level of inputs. An outward shift means that more of one or both outputs can be produced without sacrificing the output of either good. Conversely, the PPF will shift inward if the labor force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock of physical capital. Without trade, each country consumes only what it produces. In this instance, the production possibilities frontier is also the consumption possibilities frontier. Trade enables consumption outside the production possibility frontier. The world PPF is made up by combining countries’ PPFs. When countries’ autarkic productions are added (when there is no trade), the total quantity of each good produced and consumed is less than the world’s PPF under free trade (when nations specialize according to their comparative advantage). This shows that in a free trade system, the absolute quantity of goods available for consumption is higher than the quantity available under autarky.
A country has an absolute advantage in the production of a good when it can produce it more efficiently than other countries.
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Absolute advantage refers to the ability of a country to produce a good more efficiently than other countries. In other words, a country that has an absolute advantage can produce a good with lower marginal cost (fewer materials, cheaper materials, in less time, with fewer workers, with cheaper workers, etc.). Absolute advantage differs from comparative advantage, which refers to the ability of a country to produce specific goods at a lower opportunity cost. A country with an absolute advantage can sell the good for less than a country that does not have the absolute advantage. For example, the Canadian economy, which is rich in low cost land, has an absolute advantage in agricultural production relative to some other countries. China and other Asian economies export low-cost manufactured goods, which take advantage of their much lower unit labor costs. China and Consumer Electronics: Many consumer electronics are manufactured in China. China can produce such goods more efficiently, which gives it an absolute advantage relative to many countries. Imagine that Economy A can produce 5 widgets per hour with 3 workers. Economy B can produce 10 widgets per hour with 3 workers. Assuming that the workers of both economies are paid equally, Economy B has an absolute advantage over Economy A in producing widgets per hour. This is because Economy B can produce twice as many widgets as Economy B with the same number of workers. Absolute Advantage: Party B has an absolute advantage in producing widgets. It can produce more widgets with the same amount of resources than Party A. If there is no trade, then each country will consume what it produces. Adam Smith said that countries should specialize in the goods and services in which they have an absolute advantage. When countries specialize and trade, they can move beyond their production possibilities frontiers, and are thus able to consume more goods as a result.
A country has a comparative advantage over another when it can produce a good or service at a lower opportunity cost.
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In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (has an absolute advantage in all goods) than another, both countries will still gain by trading with each other. More specifically, countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally. Specialization according to comparative advantage results in a more efficient allocation of world resources. Larger outputs of both products become available to both nations. The outcome of international specialization and trade is equivalent to a nation having more and/or better resources or discovering improved production techniques.
Imagine that there are two nations, Chiplandia and Entertainia, that currently produce their own computer chips and CD players. Chiplandia uses less time to produce both products, while Entertainia uses more time to produce both products. Chiplandia enjoys and absolute advantage, an ability to produce an item with fewer resources. However, the accompanying table shows that Chiplandia has a comparative advantage in computer chip production, while Entertainia has a comparative advantage in the production of CD players. The nations can benefit from specialization and trade, which would make the allocation of resources more efficient across both countries. Comparative Advantage: Chiplandia has a comparative advantage in producing computer chips, while Entertainia has a comparative advantage in producing CD players. Both nations can benefit from trade. For another example, if the opportunity cost of producing one more unit of coffee in Brazil is 2/3 units of wheat, while the opportunity cost of producing one more unit of coffee in the United States is 1/3 wheat, then the U.S. should produce coffee, while Brazil should produce wheat (assuming Brazil has the lower opportunity cost of producing wheat).
It is important to distinguish between comparative advantage and competitive advantage. Though they sound similar, they are different concepts. Unlike comparative advantage, competitive advantage refers to a distinguishing attribute of a company or a product. It may or may not have anything to do with opportunity cost or efficiency. For example, having good brand recognition or relationships with suppliers is a competitive advantage, but not a comparative advantage. In the context of international trade, we more often discuss comparative advantage.
Absolute advantage refers to differences in productivity of nations, while comparative advantage refers to differences in opportunity costs.
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Absolute advantage compares the productivity of different producers or economies. The producer that requires a smaller quantity inputs to produce a good is said to have an absolute advantage in producing that good. The accompanying figure shows the amount of output Country A and Country B can produce in a given period of time. Country A uses less time than Country B to make either food or clothing. Country A makes 6 units of food while Country B makes one unit, and Country A makes three units of clothing while Country B makes two. In other words, Country A has an absolute advantage in making both food and clothing. Absolute Advantage: Country A has an absolute advantage in making both food and clothing, but a comparative advantage only in food. Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another. Even if one country has an absolute advantage in producing all goods, different countries could still have different comparative advantages. If one country has a comparative advantage over another, both parties can benefit from trading because each party will receive a good at a price that is lower than its own opportunity cost of producing that good. Comparative advantage drives countries to specialize in the production of the goods for which they have the lowest opportunity cost, which leads to increased productivity. For example, consider again Country A and Country B in. The opportunity cost of producing 1 unit of clothing is 2 units of food in Country A, but only 0.5 units of food in Country B. Since the opportunity cost of producing clothing is lower in Country B than in Country A, Country B has a comparative advantage in clothing. Thus, even though Country A has an absolute advantage in both food and clothes, it will specialize in food while Country B specializes clothing. The countries will then trade, and each will gain. Absolute advantage is important, but comparative advantage is what determines what a country will specialize in.
Specialization leads to greater economic efficiency and consumer benefits.
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Whenever a country has a comparative advantage in production it can benefit from specialization and trade. However, specialization can have both positive and negative effects on a nation’s economy. The effects of specialization (and trade) include:
Of course, there are also some potential downsides to specialization:
As a whole, economists generally support specialization and trade between nations.
Comparative advantage is the driving force of specialization and trade.
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Specialization refers to the tendency of countries to specialize in certain products which they trade for other goods, rather than producing all consumption goods on their own. Countries produce a surplus of the product in which they specialize and trade it for a different surplus good of another country. The traders decide on whether they should export or import goods depending on comparative advantages. Imagine that there are two countries and both countries produce only two products. They can both choose to be self-sufficient, because they have the ability to produce both products. However, specializing in the product for which they have a comparative advantage and then trading would allow both countries to consume more than they would on their own. One might assume that the country that is most efficient at the production of a good would choose to specialize in that good, but this isn’t always the case. Rather than absolute advantage, comparative advantage is the driving force of specialization. When countries decide what products to specialize in, the essential question becomes who could produce the product at a lower opportunity cost. Opportunity cost refers to what must be given up in order to obtain some item. It requires calculating what one could have gotten if one produced another product instead of one unit of the given product. For example, the opportunity cost to Bob of 1 bottle of ketchup is 1/2 bottle of mustard. This means that in the same amount of time that Bob could produce one bottle of ketchup, he could have produced 1/2 bottle of mustard. Tom could have produced 1/3 bottle of mustard during the time that he was making one bottle of ketchup. Tom will have the comparative advantage in producing ketchup because he has to give up less mustard for the same amount of ketchup. In sum, the producer that has a smaller opportunity cost will have the comparative advantage. It follows that Bob will have a comparative advantage in the production of mustard. Comparative Advantage: Tom has the comparative advantage in producing ketchup, while Bob has the comparative advantage in producing mustard. There is one case in which countries are not better off trading: when both face the same opportunity costs of production. This doesn’t mean that both countries have the same production function – one could still be absolutely more productive than the other – but neither has a comparative advantage over the other. In this case, specialization and trade will result in exactly the same level of consumption as producing all goods domestically. Key Points
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