What are Comparative Advantage and Absolute Advantage?
The theory of absolute advantage was given by Adam Smith in the year 1776.
The theory of comparative advantage was given by David Ricardo in the year 1817.
The first question that arises why is it even needs to learn the concept of comparative advantage and absolute advantage? The reason is that all the countries trade with each other. They trade because of the price differences. As because there are some major key differences between the prices of the goods and services sold in different countries, trade takes place. It is usually the factor that the price of some commodities is in some country is low whereas the prices of the same commodities are higher in the other countries. Therefore, individuals residing in a particular country will compare the relative price of both the commodities and will decide to trade or not to trade.
What is The Absolute Advantage?
Absolute advantage refers to the number of commodities and goods produced per input. For example, if 200 units of any good are produced with the help of 10 units of labor then it would mean that each labor produces 20 units of that good. A country or a state has an absolute advantage in producing something if they can produce more amount of a commodity than the other country or the country that they trade with can produce with the same amount of input that they have.
There are certain assumptions on which the absolute advantage theory is based:
- Adam Smith assumed that the cost of the commodities was evaluated or calculated by the amount of labor or the number of labour required in the production process of the respective commodities or goods.
- It was assumed that labour can freely move from state to state within a country but labor is immobile or cannot move between different countries. In other words, it can be said that labor was mobile in intra-country and immobile in inter-country.
- The absolute advantage theory only considered a two-by-two model. This means that Adam Smith only considered there are two countries in the economy and both the country only produces 2 commodities or goods in its respective areas.
- This theory also assumes that two countries can only trade if each of the two countries is having an absolute low cost in the production of only one commodity.
When can an Absolute Advantage be Achieved?
It is said that an absolute advantage can only be achieved through a lower cost of production or in other words, it can be said that an individual or a company or even a country that can produce at lower marginal cost only that country or business or the individual can achieve an absolute advantage. Now there are varying criteria which are required to achieve this:
- There should be fewer materials that can be used to produce a good or a commodity or a product.
- The raw materials or inputs needed to be used in such a way that would result in a lower cost of production.
- The labour should take less time or fewer hours to produce a good or a commodity or a product.
- And lastly, there should be the availability of cheap labor which would ultimately result in a lower cost of production that can be used to produce a product.
What is Comparative Advantage?
On the other hand, comparative advantage refers to the opportunity cost. A country is said to have a competitive advantage in producing some goods or commodities if, what they need to give up to produce that commodity is much less than what their trading partners or any country with whom they trade must give up.
Similarly, there are a few assumptions given by David Ricardo in the comparative advantage theory as well:
- There are only two countries in the economy.
- Both the country produces the same kinds of goods or commodities or products.
- Labor is only used in the production process.
- The supply of labor is unchanged or kept constant.
- All the units of labor are the same or it can be said that they are homogeneous.
- Taste and preference of both countries are homogeneous.
- The cost of labor determines the pace of the two commodities.
- Whatever goods and services or products are produced in the two countries follows the law of constant returns.
- Both countries are having the same technical knowledge and they do not change over time.
- The factors of production are assumed to be mobile within the state of the country whereas they are employed between countries.
- There are no trade barriers or trade restrictions in the movement of the commodities.
- Both the country uses all the factors of production available for the production process efficiently and utilize them to its full potential.
- The ratio at which both the countries exchange the two commodities are assumed to be the same.
|Good X||Good Y|
The above table represents that with a given number of inputs or with a given amount of resources country A can produce 10 units of good X or 20 units of good Y. Similarly, it can be said that country B with the given amount of resources can produce 10 units of good X or 4 units of good Y. An important thing to remember is that these units of goods are considered as output per fixed inputs.
In terms of Absolute Advantage
Country B is having an absolute advantage in producing good X. This is because with the given amount of resources country A can produce 10 units of good X whereas country B can produce more than that which is 20 units of good X. But in the case of good Y, it is seen that country A is having an absolute advantage. This is because with a given number of resources or inputs country A can produce a greater number of good Y which is 20 units of good Y than country B which only produces 8 units of good Y with a given number of inputs.
In the diagram above, it is assumed that there are two countries, namely Utopia and Happyland producing two goods, hardware and software. It shows that Utopia has an absolute cost advantage in producing hardware and Happyland has an absolute cost advantage in software. They specialize the production in the respective sectors and both countries trade with each other and gain from the trade.
In terms of Comparative Advantage
In this particular example, country A is having a comparative advantage in good Y because they have to give up 1/2 of good X since 1 unit of good X can make 2 units of good Y. To get an extra good Y they have to give up one unit of good X. Therefore, it can be said that the opportunity cost of good Y in country A is half of a unit of good X. In country B it is quite different; it is of 8 to 20 which is a little more than a double. So, to get one unit of good Y in country B they need to give up a little more than two units of good X.
Country A is having a comparative advantage in good Y because its opportunity cost is lower. Country B has a comparative advantage in good X.
Therefore, the way these two countries would trade is quite obvious. Here it is country A and country B. But firstly, this scenario will be seen from the point of view of country A, this country wants to export to country B and country A imports from country B. So, the way they would trade is based on the table that country A would export good Y and country B will export good X.
In the above diagram, two countries, England, and Portugal produce two goods, say cloth and wine. England has a comparative cost advantage in producing cloth and Portugal has the comparative cost advantage in producing wine as both countries have lower opportunity costs in the respective products.
Major Differences between Comparative Advantage and Absolute Advantage
Absolute advantage is an economy's ability to produce a greater quantity of the same good or commodity with the same amount of resources than another economy. Whereas comparative advantage is the ability of an economy to produce that certain type of good or commodity at a lower opportunity cost than the neighbouring country or the countries with which that country trades.
Lastly, it can be said that absolute advantage and comparative advantage is all about international trade where specialization plays a major role. Also, it takes into consideration that how other countries have absolute and comparative advantage and how international trade can take place.
Context and Applications
This topic is significant in the professional exams for both undergraduate and graduate courses, especially for
- B.A in economics
- M.A in economics
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