Comparative advantage

Page 1

Definitions

A country holds an absolute advantage when it can produce a

good or service at a lower cost than another.

Comparative advantage occurs when one country can produce a good or service at

a lower opportunity cost than another.

One country may have an absolute advantage in many goods but it is not

advisable to try and produce everything. It is better to focus on on goods

where you have a relative advantage.

The terms of trade is a measure of the value of a country's exports compared with the value of its imports

Example 1

Before trade

Radios Cars

UK 300 100

USA 400 200

700 300

After trade

Radios Cars

UK 450 50

USA 200 300

750 350

UK: 1R = 1/3C 1C = 3R

USA: 1R = 1/2C 1C = 2R

Limitations

Assumes that factors of production are perfectly mobile - resources can be easily transferred from one industry to another.

Assumes that there is a constant returns to scale - doubling inputs will double output. Increased specialisation may lead to diseconomies of scale.

Transport costs and tariffs may outweigh any comparative advantage, eliminating potential gains.

Example 2

Before trade

Textiles Books

UK 100 400

India 200 300

300 700

After trade

Textiles Books

UK 0 800

India 400 0

400 800

UK: 1T = 4B 1B = 1/4T

India: 1T = 3/2B 1B = 2/3T

Causes

The quantity and quality of factors of production available e.g. Germany has a larger and more skilled workforce than most other economies, exports manufactured goods

Investment in R&D - leads to cost advantages, firms can patent this

Movements in the exchange rate e.g. weak sterling in recent years has made UK exports more competitive

Long term rates of inflation - high inflation erodes competitiveness

Import controls - tariffs raise the price of imports

Non-price competitiveness - product design, quality and reliability e.g. Japanese cars

Defintions

Examples

Limitations

Causes