Comparative advantage
The theory of comparative advantage states that a country should specialise in the production of good or service in which it has lower opportunity cost and it should import commodities which have a higher opportunity cost of production.
Example
Suppose for example we have two countries of equal size, Northland and Southland. Both produce and consume two goods, Food and Clothes. The productive capacities and efficiencies of the countries are such that if both countries devoted all their resources to Food production, output would be as follows:
- Northland: 100 tonnes
- Southland: 200 tonnes
If all the resources of the countries were allocated to the production of clothes, output would be:
- Northland: 100 tonnes
- Southland: 100 tonnes
Assuming each has constant opportunity costs of production between the two products and both economies have full employment at all times. All factors of production are mobile within the countries between clothing and food industries, but are immobile between the countries. The price mechanism must be working to provide perfect competition.
Southland has an absolute advantage over Northland in the production of Food. Both countries are equally efficient in the production of clothes. There seems to be no mutual benefit in trade between the economies. The opportunity costs shows otherwise. Northland's opportunity cost of producing one tonne of Food is one tonne of Clothes and vice versa. Southland's opportunity cost of one tonne of Food is 0.5 tonne of Clothes. The opportunity cost of one tonne of Clothes is 2 tonnes of Food. Southland has a comparative advantage in food production, because of its lower opportunity cost of production with respect to Northland. Northland has a comparative advantage over Southland in the production of clothes, the opportunity cost of which is higher in Southland with respect to Food than in Northland.
To show these different opportunity costs lead to mutual benefit if the countries specialize production and trade, consider the countries produce and consume only domestically. The volumes are:
|
|
Food |
Clothes |
|
Northland |
50 |
50 |
|
Southland |
100 |
50 |
|
World total |
150 |
100 |
Production and consumption before trade
This example includes no formulation of the preferences of consumers in the two economies which would allow the determination of the international exchange rate of Clothes and Food. Given the production capabilities of each country, in order for trade to be worthwhile Northland requires a price of at least one tonne of Food in exchange for one tonne of Clothes; and Southland requires at least one tonne of Clothes for two tonnes of Food. The exchange price will be somewhere between the two. The remainder of the example works with an international trading price of one tonne of Food for 2/3 tonne of Clothes.
If both specialize in the goods in which they have comparative advantage, their outputs will be:
|
|
Food |
Clothes |
|
Northland |
0 |
100 |
|
Southland |
200 |
0 |
|
World total |
200 |
100 |
Production after trade
World production of food increased. Clothing production remained the same. Using the exchange rate of one tonne of Food for 2/3 tonne of Clothes, Northland and Southland are able to trade to yield the following level of consumption:
|
|
Food |
Clothes |
|
Northland |
75 |
50 |
|
Southland |
125 |
50 |
|
World total |
200 |
100 |
Consumption after trade
Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now consume at points outside their production possibility frontiers.
Assumptions in Example 2
- Two countries, two goods - the theory is no different for larger numbers of countries and goods, but the principles are clearer and the argument easier to follow in this simpler case.
- Equal size economies - again, this is a simplification to produce a clearer example.
- Full employment - if one or other of the economies has less than full employment of factors of production, then this excess capacity must usually be used up before the comparative advantage reasoning can be applied.
- Constant opportunity costs - a more realistic treatment of opportunity costs the reasoning is broadly the same, but specialization of production can only be taken to the point at which the opportunity costs in the two countries become equal. This does not invalidate the principles of comparative advantage, but it does limit the magnitude of the benefit.
- Perfect mobility of factors of production within countries - this is necessary to allow production to be switched without cost. In real economies this cost will be incurred: capital will be tied up in plant (sewing machines are not sowing machines) and labour will need to be retrained and relocated. This is why it is sometimes argued that 'nascent industries' should be protected from fully liberalised international trade during the period in which a high cost of entry into the market (capital equipment, training) is being paid for.
- Immobility of factors of production between countries - why are there different rates of productivity? The modern version of comparative advantage (developed in the early twentieth century by the Swedish economists Eli Heckscher and Bertil Ohlin) attributes these differences to differences in nations' factor endowments. A nation will have comparative advantage in producing the good that uses intensively the factor it produces abundantly. For example: suppose the US has a relative abundance of capital and India has a relative abundance of labor. Suppose further that cars are capital intensive to produce, while cloth is labor intensive. Then the US will have a comparative advantage in making cars, and India will have a comparative advantage in making cloth. If there is international factor mobility this can change nations' relative factor abundance. The principle of comparative advantage still applies, but who has the advantage in what can change.
- Negligible Transport Cost - Cost is not a cause of concern when countries decided to trade. It is ignored and not factored in.
- Assume that half the resources are used to produce each good in each country. This takes place before specialization
- Perfect competition - this is a standard assumption that allows perfectly efficient allocation of productive resources in an idealized free market.
Example adopted from Wikipedia
Limitations of Theory of Absolute Advantage
The theory is based on unrealistic assumptions:
- Factors of production are immobile and fixed
- Technology is fixed
- There is perfect competition
- Resources are fully employed
- Imports and exports balance each other
- There is free trade
Cost of Transportation has been ignored
The theory does not allow structural changes in an economy
May result in too much specialisation: For example agricultural goods are subject to strong price fluctuation which might lead to unstable export revenue for an economy
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