IE - Comparative Advantage and Trade Lesson
Why Countries Trade
Every nation in the world trades. No nation makes every good or provides every service consumed in its domestic markets. All countries export and import. Over the long run, international trade has led to higher standards of living across the globe. New jobs are created and prices are lowered due to international competition. Consumers can purchase goods that they would not be able to acquire in their home countries. Food is produced on one continent and consumed in another. Producers find global markets for their goods and services. Increased trade, travel, and Internet communication technology lead to globalization. Teenagers in the United States, Mongolia, France, and Kenya may all be wearing blue jeans, eating pizza for dinner, and listening to the same music. How do countries decide what, how, and for whom to produce? Countries, like individuals, specialize, and specialization makes everyone better off.
Absolute and Comparative Advantage
Most trade takes place because of comparative advantage. The law of comparative advantage states that nations are better off when they produce goods and services for which they have a comparative advantage. So how does a nation find its comparative advantage?
If a nation has an absolute advantage, that means it can produce the most of a good with its given resources. The U.S. has an absolute advantage in the production of lots of goods and services.
Example of Absolute Advantage: You can mow 5 lawns in a day, while your best friend can only mow 2 lawns in a day. You have the absolute advantage in mowing lawns because you can mow more lawns in a day.
However, the U.S. cannot have the comparative advantage in producing every good or service. Comparative advantage refers to which producer has the lowest opportunity cost when producing a good or service.
Example of Comparative Advantage: You and your friend can wash cars or mow lawns. It will cost you 1 washed car to mow 1 lawn. It will cost your friend 5 washed cars to mow 1 lawn. Which of you has comparative advantage at mowing lawns? You do because it would only cost you 1 washed car to mow 1 lawn. Your friend has to give up 5 cars so they should specialize in washing cars while you mow lawns.
If each party has absolute advantage in a different good/service...
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You can mow 5 lawns or wash 5 cars on a sunny Saturday.
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Your friend can mow 2 lawns or wash 10 cars.
|
Number per day |
||
|---|---|---|
|
Lawns |
Cars |
|
|
You |
5 |
5 |
|
Your BFF |
2 |
10 |
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Since you have an ABSOLUTE ADVANTAGE in mowing lawns and your friend has an ABSOLUTE ADVANTAGE in washing cars, we know you also have COMPARATIVE ADVANTAGE in mowing lawns and your friend has COMPARATIVE ADVANTAGE in washing cars.
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Since you are better at mowing lawns and your friend is better at washing cars, you should mow lawns and your friend should wash cars.
If one party has absolute advantage in 1 good...
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Ronald McDonald can produce 20 pizzas or 200 burgers
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Papa John can produce 100 pizzas or 200 burgers
|
Number made per hour |
||
|---|---|---|
|
Pizza |
Burgers |
|
|
Ronald McDonald |
20 |
200 |
|
Papa John |
100 |
200 |
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Since we know Papa John has an ABSOLUTE ADVANTAGE in the production of pizza and no one has an ABSOLUTE ADVANTAGE in the production of burgers, we know Papa John should make pizzas.
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Ronald must have a COMPARATIVE ADVANTAGE in the production of burgers and should produce them.
If one party has absolute advantage in producing both goods and services, you need to know the opportunity costs of each so you can compare them. Remember where it cost you 1 car wash to mow 1 lawn when it cost your friend 5 car washes to mow 1 lawn. Those are the opportunity costs you want to compare. Whichever party has the lower opportunity cost when producing that good should specialize in that good.
Absolute and Comparative Advantage Practice
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