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.

Open Economy/Closed Economy

The table below shows the cases for an open economy.



Case Study: Iceland

·     Deregulation of the financial system in 2000 led to a large growth in Iceland’s banks.

·     Iceland’s economy is small and so the banks expanded overseas and began to export financial services which enabled them to accumulate a lot of wealth (assets).

·     Because of this, Iceland began to import many luxury goods to maintain high standards of living for the rich population (Iceland’s HDI was the highest in the world in 2008).

·     In the economic crisis, Iceland’s banks also owned toxic assets thus the country’s financial system crashed and the economy shrunk.

·     The exchange rate fell.

·     Unemployment rose.

·     This case study is an argument against free trade and therefore for import controls because deregulation led to overexposure to free trade and capital. It argues the case against an open economy.



Word of the Day

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Word of the Day: Competitive Advantage

Similar to absolute advantage, except you must remember not to confuse them! Competitive advantage is where a country/firm produces the good at lower costs, better prices and higher quality than it's rivals. A viruous circle is created:

See notes on absolute and comparative advantage for more details.

Word of the Day

Absolute Poverty

Is when a household's income level is below a certain amount. This is in contrast to relative poverty which mustn't get confused! When all incomes grow, absolute poverty falls. If low incomes grow faster than average incomes, relative poverty will fall.

In the UK, relative poverty is mainly the concern. Absolute poverty occurs less because welfare benefits are given out to people as a minimum income and safety net.

Word of the Day

IMF

The International Monetary Fund is an IGO (Inter-Governmental Organisation) that loans money out to countries in financial instability. It loans money out with 'strings' attached where countries must agree to implement certain policies or meet the terms and conditions in order to receive the loan. Recent interference by the IMF include negotiating bail out packages for the Greece and Ireland. The IMF have also in the past given loans to developing countries such as Uganda, in order to help them develop. There are 187 member nations in the IMF, the most powerful member being the USA - with the highest voting power.

Word of the Day

OFT

The Office for Fair Trading uses market structure, conduct and performance indicators to scan the UK economy for evidence of monopoly abuse. This is used to analyse and evaluate costs/benefits of monopoly. The OFT, along with the Competition Commission, creates incentives for firms to resist temptation to exploit possible monopoly power. Firms will not want to risk getting caught by these regulatory bodies therefore uses these incentives.

Word of the Day

Trade Union

A collective association of workers whose aim is to improve the pay of workers and improve the conditions of work for its members. Some of the things they work to improve include:

• Real incomes
• Pensions
• Security
• Unfair dismissal
• Counter monopsony power that firms hold over workers (see Word of the Day)
• Protect against discrimination

Unions influence pay by:

• Collective bargaining: negotiate pay levels above the current levels that exist. This is only effective if the union has control over the entire labour supply available in the industry.

• Closed shop agreements: Employers and unions agree that all workers be part of the union. This is now illegal in the UK because it encourages labour restrictive practices. Two types, pre-entry and post-entry. Pre-entry is when workers must join the union before starting employment. Post-entry is when workers not part of a union start employment, but have to join a trade union to keep the job.
• This is to prevent free-riders benefiting from the mark-up wages bought about by trade unions.