Absolute and Comparative AdvantageA2 Economics

Aims and Objectives

Aim: • Understand the theory of absolute

and comparative advantage.Objectives: • Define the theory of absolute and comparative advantage.• Analyse the effects of specialisation• Evaluate the case for free trade

Starter

• What is the UK current account?

• Do we have a deficit on the CA? Have we always had a deficit on the CA?

• Is the UK trade deficit important?

Absolute Advantage

China & Russia

Absolute Advantage• Two countries• Produce just two commodities – guns and oil.• Each country has 10 units of resources• Using all resources they can produce the output

shown: China Russia

Oil 400 320

or or

Guns 400 160

Absolute Advantage• Trading (Production) possibility diagram:

0 100 200 300 400

100

200

300

400

• China has an absolute advantage in the production of both guns and oil.

• Absolute Advantage: where a country using a given resource input is able to produce more than other countries with the same input.

China

Russia

Self Sufficiency

• If each country was self-sufficient and did not trade (closed economy) the output would be shown as follows:

China Russia Total Output

Oil 200 160 360

Guns 200 80 280

Comparative Advantage

China & Russia

Comparative Advantage

• While Russia has an absolute disadvantage compared to China, it still benefits countries to specialise in the production of a good or service.

• Theoretical basis for free trade is comparative advantage.

• Comparative Advantage: where a country can produce a good with a lower input cost than other countries. Therefore global resources can be allocated more efficiently.

Comparative Advantage

• Opportunity costs in each country:

1 Oil Barrel = 1 Gun

1 Gun = 1 Oil Barrel

1 Oil Barrel = 0.5 Gun

1 Gun = 2 Oil Barrel

These op.cost ratios show Russia has a comparative adv. in oil, as to produce an extra unit of oil it only has to give up half a gun compared

to 1 gun for China.

Comparative Advantage

• Opportunity costs in each country:

1 Oil Barrel = 1 Gun

1 Gun = 1 Oil Barrel

1 Oil Barrel = 0.5 Gun

1 Gun = 2 Oil Barrels

However, China has a comparative advantage in guns as to produce an extra gun it only has to give up 1 unit of oil, compared to 2 units for

Russia.

Comparative Advantage

Differences in comparative adv. and op. cost give rise to international trade, where countries specialise in the area where they have the greatest comparative adv.

China Russia Total Output

Oil 0 320 320

Guns 400 0 400

SPECIALISATION

However, the output of oil has fallen from 360 to 320. Partial specialisation can be used to

rectify this…..

China Russia Total Output

Oil 0 320 320

Guns 400 0 400

China Russia Total Output

Oil 200 160 360

Guns 200 80 280

Comparative Advantage

Original Economies Output

Partially Specialised Economies Output

China Russia Total Output

Oil 60 320 380

Guns 340 0 340

China Russia Total Output

Oil 200 160 360

Guns 200 80 280

Therefore, total output of oil has increased from 360 to 380 whilst the production of guns has also

increased from 280 to 340. International trade has led to an increase in total supply of both products

and economic welfare will increase in both countries.

China Russia Total Output

Oil 200 160 360

Guns 200 80 280

China Russia Total Output

Oil 60 320 380

Guns 340 0 340

Plenary

Define and give examples of comparative and absolute advantage.

Should specific countries specialise in the sole production of just a few goods, for which they possess a comparative advantage?