DefinitionsA 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 1Before trade Radios CarsUK 300 100USA 400 200 700 300After trade Radios CarsUK 450 50USA 200 300 750 350UK: 1R = 1/3C 1C = 3RUSA: 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 2Before trade Textiles BooksUK 100 400India 200 300 300 700After trade Textiles BooksUK 0 800India 400 0 400 800UK: 1T = 4B 1B = 1/4TIndia: 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