Thursday, December 02, 2004

Absolute vs Comparative Advantage

In discussing international trade, economists use the terms absolute and comparative advantage to describe how to determine trading relationships that are most beneficial to each partner.

Absolute advantage means that one nation has an undisputed advantage, in terms costs, over the other in the production of a good. If, because of its climate, Israel can grow oranges at a lower cost (i.e., use fewer resources) than Iceland and Iceland can harvest cod fish at a lower cost than Israel, then Israel should export oranges to Iceland and Iceland export cod fish to Israel. This is an easy concept to grasp and students usually do not have a problem understanding it.

The problem comes in when you have a country that has an absolute advantage in both products. The U.S., due to its geography, can produce both oranges and cod fish at a lower cost than Canada. This does not mean that the U.S. Should produce and export both. Rather, Canada should produce and export the product in which it has the lowest opportunity cost and the U.S. should specialize in producing the other one. In this way there will be more of both products for each country.

A very simple example of this is the case of a husband and wife who have eight hours available on Saturday to relax and enjoy themselves at their weekend get away cottage on the lake. They would like to spend as much of the day as possible cruising on the lake in their boat. However, it has been a few weeks since thay had time to visit the cottage and both the inside and the yard need cleaning. Based upon past experience, they know that the wife can do either job in two hours. But it takes the husband four hours to clean the cottage and three hours to do the yard work.

If the wife, who has an absolute advantage in both tasks, does both jobs it will take her a total of four hours (two to clean the house and two to do the yard work) to complete the tasks. This will leave the couple with four hours to cruise on the lake. However, if the husband does the yard work which has a lower opportunity cost than the housework for him (three hours for yard work vs four hours for housework) both jobs will be done in three hours leaving the couple with five hours to spend in their boat.

This is the concept of comparative advantage.

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