Trade and Aid

Absolute and Comparative Advantage

If we are going to trade with other countries, then it makes sense for us to try and maximise the benefits of international trade. If that is to happen, then we need to develop some theories about the way in which this can be done. We will look at two theories here.

Absolute Advantage

This is very simple to understand. A country is said to have an absolute advantage in the production of a good or service if they are able to make it at a lower cost than another country. For example, if it costs $20 to make a chair in Australia, but only $12 to make the same chair in China, then we would say that the Chinese economy has an absolute advantage in the production of that chair. Therefore we should allow people in China to make these chairs, as the finished product will be cheaper for consumers.

If all international trade followed this theory, then production would increasingly be isolated in countries with low wages. Only highly specialised items would be able to be produced in countries with high wages. This would result in lower overall world production, which is clearly an undesirable outcome. As such, a different theory is needed.

Comparative Advantage

To understand the theory of comparative advantage, you first need to review the concept of opportunity cost. In Unit 1, we said that opportunity cost is the value of the next best alternative – the one that you didn’t get. At the time we measured that cost in dollars, but we can also think of it in terms of products.

Consider the example of two countries. Each country has the same number of resources. In Country A, dedicating all of their resources to the production of barley would result in 4,000 tonnes of the crop. On the other hand, if they dedicated all of their resources to the production of cars, they would be able to make 500 of them. Country B is in a different situation; they must choose between the production of 1,000 tonnes of barley, or 400 cars. We can represent this information on two production possibility frontiers.

It is clear from this example that Country A has an absolute advantage in the production of both barley and cars. So why should they trade with Country B? The answer is that by allowing each country to specialise at the thing they do best, we will all end up with more.

Imagine that you are able to express the cost of a car in terms of the barley that each country would have to give up to make one. Country A must give up eight tonnes of barley to make one car. If they give up all 4,000 tonnes, then they will get 500 cars. On the other hand, Country B gains a car for each two and a half tonnes of barley that they give up. The opportunity cost of producing cars in Country B is lower; if we allow them to specialise in the production of cars, we will end up with higher overall levels of production.

We can prove this with a mathematical example. In the first instance, what if each country allocated 50% of their resources to the production of each item?

	Country A	Country B	Total
Barley	2,000	500	2,500 tonnes
Cars	250	200	450 cars

How would this change if we allowed Country B to specialise in the production of cars? In making this decision, Country A is recognising that Country B is more efficient in terms of relative production, even though Country A is actually the more efficient producer. This would then free up some resources in Country A, and they could focus more on the production of barley. The end result might look something like this:

	Country A	Country B	Total
Barley	3,000	125	3,125 tonnes
Cars	125	350	475 cars

Although this is a theoretical example, you can see that we have ended up with more barley and more cars. As the two countries will now trade, it will result in a higher standard of living for the people in both countries – there are more products to share amongst the population.

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