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Thursday, 15 September 2011

Absolute and Comparative Advantage

Absolute Advantage

A country specialises in what it does best. It is technically and productively efficient at producing the good (after taking into account administrative and transport costs). This can be determined by natural factors such as land or climate. It is important to remember that when a country has absolute advantage, they must make sure that there is demand for the good/service they are providing, thus enabling trade to occur.

Comparative Advantage (CA)

A country has the lowest opportunity cost when producing the good. If a country wishes to increase production in one particular commodity, it must give up the least of the another commodity to have the CA. The CA is the case for free trade because it enables countries to trade.

A country that has an absolute advantage may not necessarily have the competitive advantage.

If countries specialise in activities which they possess a comparative advantage, they can trade their surpluses and the result will be gains in output and welfare.

Assumptions upon which the CA relies upon (and therefore assumptions which the case for free trade relies upon)

·     The country’s factors of production are fixed and factors can only be switched between industries (which means the country can change what they specialise in).

·     Finished goods are mobile between countries.

·     There are constant returns to scale. If this assumption were to be dropped, the country can experience decreasing returns to scale whereby increasing the scale of the factors of production leads to a less proportionate rise in output. This causes inefficiencies therefore the country cannot have the CA. If there are increasing returns to scale, the country is allocating more scarce resources to produce more output which compromises the production of other goods, leading to a greater opportunity cost. Also, in the long run, production can become unsustainable, for example, producing one single agricultural product (monoculture), can lead to soil erosion, vulnerability to pests and falling yields.

·     There are stable demand and cost conditions. If demand conditions were unstable or new technologies caused costs to change, the country would loose its comparative advantage because, again, inefficiencies will result.

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