Absolute and Comparative Advantage

An absolute advantage exists when a nation or other economic region is able to produce a good or service more efficiently than a second nation or region. Adam Smith, who penned An Inquiry into the Nature and Causes of the Wealth of Nations (1776), used the principle of absolute advantage to defend regional specialization and free trade in global markets. There are two main ways to measure a region's absolute advantage. First, a region has an absolute advantage if it can produce the same quantity of a product as another region while using fewer resources in the process. Second, a region has an absolute advantage if it can produce a greater quantity of a product than another region using the same amount of resources.

Nations or other regions achieve an absolute advantage in the production of a good in different ways. In some cases, absolute advantage stems from conscious policies or business practices that develop and use resources efficiently. For example, heavy investments in education create a skilled labor force. Similarly, investments in capital goods, research and development (R&D), and an economic infrastructure contribute to more efficient and productive business enterprises. A nation's absolute advantage might also be derived from its supply of natural resources, such as large tracts of arable land, plentiful rainfall and sunlight, expansive forests, or generous mineral deposits. For example, Saudi Arabia, Kuwait, and the United Arab Emirates have large reserves of crude oil. Not surprisingly, these oilproducing nations have an absolute advantage in the production of oil over countries such as Japan, France, and Germany, which have scant oil reserves.

A comparative advantage exists when a nation or economic region is able to produce a product at a lower opportunity cost compared to another nation or region. Key to understanding comparative advantage is that mutually beneficial trade between two nations can take place even if one country enjoys an absolute advantage in the production of both traded products. The theory of comparative advantage has been used to justify free trade policies since the early 1800s. Robert Torrens introduced the theory of comparative advantage in his Essay on the External Corn Trade (1815). But it was David Ricardo who popularized the theory in his book The Principles of Political Economy and Taxation (1817).

Sophisticated capital resources, such as a robotized assembly plant, influence a country's absolute and comparative advantage

Sophisticated capital resources, such as a robotized assembly plant, influence a country's absolute and comparative advantage. (Rainer Plendl)

The theory of comparative advantage is a natural complement to the earlier theory of absolute advantage.

There are different ways to measure one country's comparative advantage over a second country. One way is to compare different rates of output generated by the two countries. Suppose the United States is able to produce 100 flashlights (compared to just 50 flashlights in Mexico), or 100 disposable cameras (compared to just 20 in Mexico). In this situation the United States has an advantage in both products, but it is still mutually beneficial for each nation to specialize in the production of the product that it produces most efficiently. That is, each country should produce the product in which it has the greatest advantage, or at least the lesser disadvantage. Note that the United States is able to produce twice as many flashlights as Mexico, a two to one advantage, and five times as many disposable cameras as Mexico, a five to one advantage. Hence, from an economic perspective the United States should specialize in the production of disposable cameras because it enjoys the greatest advantage. Mexico should specialize in the production of flashlights because it has the lesser disadvantage.

Another way to illustrate the theory of comparative advantage is to compare the relative input costs, often measured in labor hours, needed to produce two goods from different countries. This second measurement is concerned with the amount of inputs (labor hours) needed to produce a good, rather than with the quantity of output generated by each nation. Suppose Ghana can produce one unit of cocoa or one unit of soybeans using just two hours of labor, as shown in Table 11.3. Sierra Leone, on the other hand, needs four

Table 11.3 Comparative Advantage: Labor Inputs in the Production of Cocoa and Soybeans

1 Unit of Cocoa

1 Unit of Soybeans

Ghana

2 hours of labor

2 hours of labor

Sierra Leone

4 hours of labor

10 hours of labor

hours of labor to produce one unit of cocoa and or 10 hours of labor to produce one unit of soybeans. In this situation Ghana can produce each product more efficiently than Sierra Leone, but Ghana's comparative advantage is in the production of soybeans, where it is five times as productive as Sierra Leone. Sierra Leone's comparative advantage is in the production of cocoa because this is where it has the lesser disadvantage.

The theory of comparative advantage supports national or regional specialization and efficiency. Yet there are practical concerns with the application comparative advantage in today's global trading system. First, comparative advantage assumes that resources within nations are easily transferable from a less efficient industry to a more efficient industry— which may or may not be the case. Second, the added costs of transporting traded items may reduce or eliminate the cost advantage gained through specialization. Third, trade barriers such as tariffs or import quotas might upset cross-border exchanges. Finally, specialization discourages diversification in an economy. If specialization is taken to an extreme the result is a one-crop economy. A one-crop economy revolves around a single product or service such as a certain agricultural output, mineral, or other resource. One-crop economies place a nation at the mercy of sudden global shifts in demand or catastrophic losses in supply through drought, infestation, or other circumstance.

 
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