Assumptions underlying the concept of comparative advantage

Perfect occupational mobility of factors of production - resources used in one industry can be switched into another without any loss of efficiency

Constant returns to scale (i.e. doubling the inputs in each country leads to a doubling of total output)

No externalities arising from production and/or consumption Transportation costs are ignored

If businesses exploit increasing returns to scale (i.e. economies of scale) when they specialise, the potential gains from trade are much greater. The idea

that specialisation should lead to increasing returns is associated with economists such as Paul Romer and Paul Ormerod

What determines comparative advantage? Comparative advantage is a dynamic concept. It can and does change over time. Some businesses find they have enjoyed a comparative advantage in one product for several years only to face increasing competition as rival producers from other countries enter their markets. For a country, the following factors are important in determining the relative costs of production:

The quantity and quality of factors of production available (e.g. the size and efficiency of the available labour force and the productivity of the existing stock of capital inputs). If an economy can improve the quality of its labour force and increase the stock of capital available it can expand the productive potential in industries in which it has an advantage.

Investment in research & development (important in industries where patents give some firms significant market advantage) - for more information on this have a look at this page

Movements in the exchange rate. An appreciation of the exchange rate can cause exports from a country to increase in price. This makes them less competitive in international markets.

Long-term rates of inflation compared to other countries. For example if average inflation in Country X is 4% whilst in Country B it is 8% over a number of years, the goods and services produced by Country X will become relatively more expensive over time. This worsens their competitiveness and causes a switch in comparative advantage.

Import controls such as tariffs and quotas that can be used to create an artificial comparative advantage for a country's domestic producers- although most countries agree to abide by international trade agreements.

Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales support)

Absolute Advantage The Scottish economist Adam Smith developed the trade theory of absolute advantage in 1776. A country that has an absolute advantage produces greater output of a good or service than other countries using the same amount of resources. Smith stated that tariffs and quotas should not restrict international trade; it should be allowed to flow according to market forces. Contrary to mercantilism Smith argued that a country should concentrate on production of goods in which it holds an absolute advantage. No country would then need to produce all the goods it consumed. The theory of absolute advantage destroys the mercantilistic idea that international trade is a zero-sum game. According to the absolute advantage theory, international trade is a positive-sum game, because there are gains for both countries to an exchange. Unlike mercantilism this theory measures the nation's wealth by the living standards of its people and not by gold and silver. There is a potential problem with absolute advantage. If there is one country that does not have an absolute advantage in the production of any product, will there still be benefit to trade, and will trade even occur? The answer may be found in the extension of absolute advantage, the theory of comparative advantage. Comparative Advantage The most basic concept in the whole of international trade theory is the principle of comparative advantage, first introduced by David Ricardo in 1817. It remains a major influence on much international trade policy and is therefore important in understanding the

modern global economy. The principle of comparative advantage states that a country should specialise in producing and exporting those products in which is has a comparative, or relative cost, advantage compared with other countries and should import those goods in which it has a comparative disadvantage. Out of such specialisation, it is argued, will accrue greater benefit for all. In this theory there are several assumptions that limit the real-world application. The assumption that countries are driven only by the maximisation of production and consumption, and not by issues out of concern for workers or consumers is a mistake. Heckscher-Ohlin Theory In the early 1900s an international trade theory called factor proportions theory emerged by two Swedish economists, Eli Heckscher and Bertil Ohlin. This theory is also called the Heckscher-Ohlin theory. The Heckscher-Ohlin theory stresses that countries should produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply. This theory differs from the theories of comparative advantage and absolute advantage since these theory focuses on the productivity of the production process for a particular good. On the contrary, the Heckscher-Ohlin theory states that a country should specialise production and export using the factors that are most abundant, and thus the cheapest. Not produce, as earlier theories stated, the goods it produces most efficiently. The Heckscher-Ohlin theory is preferred to the Ricardo theory by many economists, because it makes fewer simplifying assumptions. In 1953, Wassily Leontief published a study, where he tested the validity of the Heckscher-Ohlin theory. The study showed that the U.S was more abundant in capital compared to other countries, therefore the U.S would export capital- intensive goods and import labour-intensive goods. Leontief found out that the U.S's export was less capital intensive than import.

Absolute vs Comparative Advantage Absolute advantage and comparative advantage are two terms that are widely used in international trade. Both terms deal with production, goods and services. Absolute advantage is a condition in which a country can produce particular goods at a lower cost in comparison to another country. On the other hand, comparative advantage is a condition in which a country produces particular goods at a lower opportunity cost in comparison to other countries. While absolute advantage is a condition where the trade is not mutually beneficial, comparative advantage is a condition in which the trade is mutually beneficial. Comparative advantage can be described as the ability of a particular country to produce a certain product better than another country. Comparative advantage generally compares the output of production of the same type of goods or services between two countries A country will have an absolute advantage over another country when it produces the highest number of goods after the same resources are supplied to both of them. Absolute advantage also means more goods and services in an efficient way. Unlike absolute advantage, comparative advantage also looks into the overall production of the services or goods within a time frame. When compared to comparative advantage, absolute advantage is concerned with multiple goods. While cost is a factor involved in absolute advantage, opportunity cost is the factor that is involved in comparative advantage. Unlike absolute advantage, comparative advantage is always reciprocal and mutual. It was Adam Smith who first described absolute advantage in the context of International trade. Robert Torrens described comparative advantage for the first time in 1815 in an essay about Corn Laws. But the concept of absolute advantage is attributed to David Ricardo, who explained the concept in his book On the Principles of Political Economy and Taxation.

Summary: 1. Comparative advantage can be described as the ability of a particular country to produce a certain product better than another country. A country will have an absolute advantage over another country when it produces the highest number of goods after the same resources are supplied to both of them. 2. While absolute advantage is a condition where the trade is not mutually beneficial, comparative advantage is a condition in which the trade is mutually beneficial. 3. While cost is a factor involved in absolute advantage, opportunity cost is the factor that is involved in comparative advantage. 4. Unlike absolute advantage, comparative advantage is always reciprocal and mutual. Read more: Difference Between Absolute and Comparative Advantage | Difference Between | Absolute vs Comparative Advantage http://www.differencebetween.net/business/differencebetween-absolute-and-comparative-advantage/#ixzz2DRJNjxJP

Sunday, January 20, 2008 What are the similarities and differences between Absolute and Comparative Advantage? In economics, the principle of comparative advantage explains how trade is beneficial for all parties involved (countries, regions, individuals and so on), as long as they produce goods with different relative costs. Usually attributed to the classical economist David Ricardo, comparative advantage is a key economic concept in the study of trade. Adam Smith had used the principle of absolute advantage to show how a country can benefit from trade if the country has the lowest absolute cost of production in a good (i.e. it can produce more output per unit of input than any other country). The principle of comparative advantage shows that what matters is not the absolute cost, but the opportunity cost of production. The opportunity cost of production of a good can be measured as how much production of another good needs to be reduced to increase production by one more unit. The principle of comparative advantage shows that even if a country has no absolute advantage in any product (i.e. it is not the most efficient producer for any good), the disadvantaged country can still benefit from specializing in and exporting the product(s) for which it has the lowest

opportunity

cost

of

production.

(Wikipedia

the

Free

Encyclopedia.

http://en.wikipedia.org/wiki/Comparative_advantage as visited on 01/20/2008) A country has an absolute advantage over another in producing a good, if it can produce that good using fewer resources than another country. For example if one unit of labour in Scotland can produce 80 units of wool or 20 units of wine; while in Spain one unit of labour makes 50 units of wool or 75 units of wine, then Scotland has an absolute advantage in producing wool and Spain has an absolute advantage in producing wine. Scotland can get more wine with its labour by specializing in wool and trading the wool for Spanish wine, while Spain can benefit by trading wine for wool. (Adam Smith, Wealth of Nations, Book IV, Ch.2.) The benefits to nations from trading are the same as to individuals: trade permits specialization, which allows resources to be used more productively. The principle of comparative advantage, generally attributed to David Ricardo in his 1817 Principles of Political Economy and Taxation, extends the range of possible mutually beneficial exchanges. It is not necessary to have an absolute advantage to gain from trade, only a comparative advantage. This means that one need only to be able to make something at a lower cost, in terms of other goods sacrificed, to oneself to gain from trade. The economist Paul Craig Roberts notes that the comparative advantage principles developed by David Ricardo do not hold where the factors of production are internationally mobile. Limitations to the theory may exist if there is single kind of utility. The very fact that people want food and shelter already indicates that multiple utilities are present in human desire. The moment the model expands from one good to multiple goods, the absolute may turn to a comparative advantage. However, pure labour arbitrage, where one country exploits the cheap labour of another, would be a case of absolute advantage that is not mutually beneficial. The two concepts have applications outside international trade, though this is where they are most commonly used. Suppose that two castaways on a desert island gather both fruit and grain, which they then share equally between them. Suppose that Castaway A can gather more fruit per hour than Castaway B, and therefore has an absolute advantage in this good. Nonetheless, it may well make sense for A to leave some fruit-gathering to B. This is because it is possible that B gathers fruit slightly slower than A, but gathers grain extremely slowly. One needs to look at comparative advantage rather than absolute advantage, to discover how A and B can each best allocate their effort. If A's initial advantage over B in grain-gathering is greater than his or her advantage in fruit-gathering, then fruit-effort should be transferred from A to B, to the point where A's comparative advantages in the two goods are equal. Thus it may be rational for

fruit to flow from B to A, despite A's absolute advantage. (Wikipedia The Free Encyclopedia).