Comparative Advantage Vs. Opportunity Costs

According to Colander, "The reason two countries trade is that trade can make both countries better off" (2004, p. 416). In economics, the theory of comparative advantage clarifies why it can be advantageous for two countries to trade, even though one of them may be able to produce every kind of item more cheaply than the other. What matters is not the absolute cost of production, but instead, the ratio between how easily the two countries can produce different kinds of goods. The basic idea of the principle of comparative advantage is that as long as the relative opportunity costs of producing goods differ among countries, then there are potential gains from trade.

If each country specializes in areas where its advantages are greatest or disadvantages are least, the gains from trade will make each country better off than it would be if it remained self-sufficient. [3]

Dave gives “The Theory of Comparative Advantage” a different name and calls it “The Roundabout Way to Wealth”.(p.10) He says that this theory deals with the idea that even a nation which is relatively poor at doing everything, still do some things relatively well. “And a nation that is really good at many things should still specialize in producing some items and import the rest”.(p.10) Time is the ultimate scarce resource. Investing time in doing something means having less time in doing

Comparative advantage is the concept that production can be conducted with lower opportunity cost than a competitor. The lower cost of

Due to the differences between the countries in its profitable fundamentals; the International Trade occurs. The contracts between the countries consider as the primary driver of the global exchange. These contracts concluded on the basis of the countries beneficial elements and advantages. Each international trade between the countries depends on numerous focal points of this exchange process. The economics and producers effectiveness measured by absolute advantage for these economics/producers. For example; if the producer needs lesser amount of contributions/inputs to provide specific product, then this producer has an absolute advantage in producing

However, it was apparent to economists that nations with similar resource endowments exchanged similar products with each other. Economists felt that trade explained solely by comparative advantage was an incomplete analysis of international trade. Furthermore, since the classical trade theory was unable to explain intraindustry trade, economists decided to expand on the classical trade theory by creating a new theory of trade (Carbaugh, 2011). The new theory states that economies of scale provide incentive for a country to specialize in a particular product (Carbaugh, 2011). Furthermore, based on economies of scale, nations with similar factor endowments will trade with each other as sometimes it is beneficial (Carbaugh, 2011). Arguments stemming from this new trade theory puts the economic case for free trade in doubt.

Which is cost difference determines the patterns of international trade. Absolute advantage is trade benefits when each country is at least cost producer of one of the goods being traded. In the 1800s, David Ricardo developed the theory of comparative advantage to measure gains from trades. This theory is based on comparative advantage and it states each nation should specialize in production of those goods for which its relatively more efficient with a lower opportunity cost.

The country can maximize their wealth by putting the resources in the most competitive industries. Government created comparative advantage rather than free trade because now easier moves the production processes and the machines into countries that can produce more goods (Yeager & Tuereck, 1984). However, many countries now move to new trade theory suggests the ability firms to limit the number of competitors associated with economic scale (reduction of costs with a large scale of output) (Krugman, 1992). The comparative advantage occurs when two-way trade in identical products, it will useful where economic scale is important, but it will create problem with this model. As a result, government must intervene in international trade for protection to domestic firms (Krugman, 1990)

Countries are enabled by free international trade to specialise or to focus in the production of the goods in which they have a comparative advantage. Specialisation countries can take the benefit of efficiencies generated from increased output and economies of trade. The size of the firm’s market are increased by the international trade which results in lower average costs and increasing in productivity, as it ultimately leads to increase in production.

Trade freedom is a highly important factor in determining economic freedom and wealth. No one single country has the resources required to sustain the current standards of living in developed or developing nations. Trade requires specialization according to a country’s comparative advantage. Specialization allows the most efficient and effective use of a country’s scarce resources, whether that be natural resources or labor resources. The Index shows the economic benefits of specialization and trade.

Comparative advantage is affected by the interplay between the resources available to a country (the relative abundance of factors of production) and the production technology (which affects the intensity through which the factors of production are used in the production process). What we understand from the Heckscher-Ohlin model is that international trade is by and large directed by the differences in resources or in other words, the existence of differences in economies’ resources is the cornerstone of trade.

Comparative advantage is when an individual or company is made to produce services or goods at a lower opportunity cost than other individuals or companies. Opportunity cost is what you give up when you make a certain choice. When you make a decision you are valuing one decision over another and that decision that you did not choose is your opportunity cost.

RICARDO proved in 1817 that when every countries specialized in the element where they have the comparative advantage, and then trades those element, all countries are better off. This theory called the law of comparative advantage became the primary reason for international trade. Now a days MNC are the primary actors of international trade, and the bargaining model that they use with countries government can appear as a practical implementation of the law of comparative advantage. In fact Dunning, J. H. (2000) estimate that competitive advantage which is a type of comparative advantage is at the heart of company motivation and ability to operate internationally as an MNC. Besides Ramamurti, R. (2001) suggest that the traditional bargaining model is based on comparative advantage that the MNC and state have respectively. The bargaining process would then be the decision process through which each party express which comparative advantage would be traded. The MNC can for example trade its technology for the accesses to natural resource that the countries government possess. Ramamurti (2001) also emphasize the point that it became obvious that the previous process is only a part of the actual bargain and that another part of the bargain is operated at a countries level (between host and home country), this step actually allow and favors international trade between those countries, but at the hour of the liberalization the actual trade would be conducted by MNC. As an example

Considering that absolute advantage is determined by the comparison between the productivities of labor, it is therefore possible that one party can be disadvantaged to have no absolute advantage in anything. In such a case, it is normally realized that no trade can occur between such a party and other parties. Absolute advantage is normally contrasted with the theory of comparative advantage which means that one party has the ability to produce a particular good or service cheaply or at a lower opportunity cost. In any case, the two theories rely on the basic concept of economic advantage which refers to the ability of one group or party to realize the same output with more economy than another party.

The principle of comparative advantage provides a simplified theory explaining why free trade is possible, even when one country has an economic disadvantage. Both the Ricardian and Heckscher-Ohlin theories rely on fixed economic assumptions of constant return and perfect competition. However, intuitively the basic principle of business is to increase returns through innovation, improving processes and technology or increasing economies of scale. Organizations understand they control pricing and are price setters, rather than price takers as suggested by perfect competition (Krugman & Obstfeld, 2003). The idea of increasing returns and imperfect competition challenge the foundations of comparative advantage.