Absolute Advantage
When
countries cannot produce desirable goods at all, the advantages of trade are
obvious. For example, Britain is too cold to produce coffee, but posesses
reserves of oil in the North Sea. Jamaica, on the other hand, can easily grow
coffee, and has no domestic petroleum. The mutual advantage of trade between
Jamaica and Britain is obvious.
In other
cases, the advantages might be less obvious but are still present. For example,
Germany and France are similar-sized economies, with similar social and
climatic conditions and natural resources. Both nations manufacture
automobiles. However, Germany posesses factories and specialized labor for the
production of expensive, high-performance luxury and sports cars like Porches.
France, on the other hand, posesses factories and specialized labor for the
production of inexpensive, everyday cars like Citroens. Producing an additional
Porshce in Germany is much cheaper than establishing a whole new production
line in France. Germany has an absolute cost advantage in the production of
Porshces. Similarly, France has an absolute advantage in the production of
Citroens. It is to Germany and France’s mutual benefit to trade Porches for
Citroens for the same reason that Jamaica and Britain would trade coffee and
petroleum.
But what if
France has unemployed resources? Wouldn’t it be better to put the unemployed
resources to work building high-performance cars within France? The answer is
no: In the two-country example, ceasing imports of Porsches will also cause
exports of Citroens to fall.
Absolute
advantage also explains the movement of resources across national boundaries.
Where an absolute advantage exists in a given industry, and where resource
movement is possible, resources will tend to move to where they can find the
most productive employment.
Comparative Advantage
It is also
possible for two nations to trade to mututal benefit where one nation has no
absolute advantage over the other in the production of any good, so long as a
comparative advantage exists. David Ricardo showed that a poor country without
any absolute industrial advantage can still trade to mutual benefit with a rich
country.
Given the
following assumptions:
(a)
Both
the United States and India produce only two goods, wheat (food) and burlap
(clothing).
(b)
Labor
is the only variable factor of production, but its productivity differs in each
country.
(c)
In
each country, the productivity of labor is constant respective to the scale of
production.
(d)
Labor
in each country is fully employed.
(e)
There
is no migration of labor between the two nations.
(f)
Although
output per man-hour is greater in the United States than in India for both
products, the productivity gap in wheat is not proportional to the productivity
gap in burlap.
Also suppose the following schedule:
|
Product
|
Hours of labor in United States
|
Hours of labor in India
|
|
1 Bushel of Wheat
|
1
|
10
|
|
1 Meter of Burlap
|
2
|
10
|
The United
States is absolutely more efficient in both products. However, it takes 10
times as much effort to produce wheat in India than in the U.S., but only 5
times as much effort to produce burlap. India has a comparative advantage in
burlap and the U.S. has a comparative advantage in wheat.
If I live in
the U.S. and I want a meter of burlap, I can pay the value of 2 hours of labor
and buy one locally. Alternately, I can pay the value of 1½ hours of labor for
1½ bushels of wheat, which I trade to India for a meter of burlap. This is to
India’s benefit since wheat and burlap cost the same on Indian market. I now
have my meter of burlap for less than it would have cost to produce locally, so
I have benefited.
If two
countries engage in mutual trade where a comparative advantage exists, the actions
of independent traders will tend to establish a market price for different
goods. In the example above, we start out with a bushel of wheat worth 1 meter
of burlap in India, and 2 meters in the U.S. As trading occurs, the U.S. will
specialize in wheat and India will specialize in burlap, and eventually the
relative prices will be equal in both markets. Without knowing more about the
preferences of consumers, all that can be said is that the price ratio will be
somewhere between 1 and 2. As long as the ratio is different in the two
countries, there will be an incentive for trading and specialization to occur
that will tend to move the ratio closer to equal.
Each country
has a production possibility frontier that shows the efficient combinations of
wheat and burlap that can be produced in that country. It is also possible to
draw a production possibility frontier that shows the efficient production
possibilities across both countries. This frontier will show that
specialization allows greater total production between the two countries than
they would have been able to achieve acting independently.