A-Level Economics Notes on Absolute and Comparative Advantage

Definitions

1. Absolute Advantage: The ability of an individual, company, or country to produce a good or service at a lower resource cost than others.
2. Comparative Advantage: The ability of an individual, company, or country to produce a good or service at a lower opportunity cost than others.
3. Opportunity Cost: The cost of an alternative that must be forgone in order to pursue a certain action. In other words, the benefits you could have received by taking an alternative action.
4. Specialization: The process by which individuals, businesses, or countries focus on producing a limited scope of products or services to gain greater degrees of productive efficiency within an overall system.
5. Economies of Scale: The cost advantages that enterprises obtain due to their scale of operation, with cost per unit of output generally decreasing with increasing scale as fixed costs are spread out over more units of output.
6. Productivity: The effectiveness of productive effort, especially in industry, as measured in terms of the rate of output per unit of input.
7. Trade: The action of buying and selling goods and services.
8. Production Possibility Frontier (PPF): A curve depicting all maximum output possibilities for two goods, given a set of inputs consisting of resources and other factors.
9. Efficiency: The state or quality of being able to accomplish something with the least waste of time and effort; competency in performance.
10. Division of Labor: The assignment of different parts of a manufacturing process or task to different people in order to improve efficiency.
11. Export: A function of international trade whereby goods produced in one country are shipped to another country for future sale or trade.
12. Import: The bringing in of goods or services into a country from abroad for sale.
13. Trade Barriers: Government-imposed regulations such as tariffs, quotas, and embargoes that restrict international trade.
14. Tariff: A tax or duty to be paid on a particular class of imports or exports.
15. Quota: A limited quantity of a particular product that under official controls can be produced, exported, or imported.
16. Embargo: An official ban on trade or other commercial activity with a particular country.
17. International Trade: The exchange of goods and services between countries.
18. Trade Surplus: Occurs when the value of a country’s exports exceeds the value of its imports.
19. Trade Deficit: Occurs when the value of a country’s imports exceeds the value of its exports.
20. Factor Endowments: The quantity and quality of labor, land, and natural resources of a country.
21. Trade Protectionism: The economic policy of restraining trade between states through methods such as tariffs on imported goods, restrictive quotas, and a variety of other government regulations designed to allow (according to proponents) fair competition between imports and goods and service produced domestically.

Absolute Advantage

Definition:

• Absolute advantage occurs when an economy can produce a greater output of goods or services than other economies using the same amount of resources.

Key Points:

• It was first described by Adam Smith in his book “The Wealth of Nations” as a key driver of trade.
• Absolute advantage can be the result of a variety of factors, including technology, skilled labor force, natural resources, or infrastructure.
• It allows for specialization in production of goods where an economy is most efficient, leading to economies of scale.

Examples:

• Country A can produce 10 cars or 5 trucks using 10 tons of steel, whereas Country B can only produce 8 cars or 4 trucks with the same resources. Country A has an absolute advantage in producing both cars and trucks.

Implications for Trade:

• Countries will export products in which they have an absolute advantage and import products in which they have an absolute disadvantage.
• Trade based on absolute advantage increases total output and consumption for all countries involved.

Comparative Advantage

Definition:

• Comparative advantage occurs when an economy can produce a good or service at a lower opportunity cost than another economy.

Key Points:

• Introduced by David Ricardo in his book “Principles of Political Economy and Taxation” as a fundamental concept in the theory of trade.
• Opportunity cost is what is foregone to produce something else; in comparative advantage, this is the key to understanding trade benefits.
• Unlike absolute advantage, comparative advantage does not require one party to be more efficient across all fields.

Examples:

• If Country A has to give up 3 cars to produce an additional truck, and Country B has to give up 2 cars, Country B has a comparative advantage in truck production.

Calculating Comparative Advantage:

• To determine comparative advantage, compare the opportunity costs of producing goods in each country.
• The country with the lower opportunity cost of producing a good should specialize in that good.

Implications for Trade:

• Trade can benefit all parties as long as they specialize based on their comparative advantages.
• It allows for a greater variety of goods for consumption.
• It can lead to trade between countries even when one country has an absolute advantage in all goods.

Limitations and Considerations:

• The theory assumes that production costs are constant and do not change as output scales up.
• It assumes that there are no transportation costs involved in trade.
• It does not take into account the effects of trade on income distribution within countries.

Application of Comparative Advantage in Policy and Strategy

Trade Policy:

• Governments may use the concept to formulate trade policies, promoting industries where they have a comparative advantage.

Economic Strategy:

• Economies may invest in education, infrastructure, and technology to develop a comparative advantage in certain industries.

Dynamic Comparative Advantage:

• Comparative advantage can change over time as economies evolve and develop new capabilities or as resource availability changes.

Globalization:

• The interplay between absolute and comparative advantage underpins the economic rationale for globalization, where production chains are spread across multiple countries to leverage these advantages.