Absolute Advantage

Question 1

What is absolute and comparative advantage?

Answer 1

Absolute - The possibility that, due to differences in supply conditions, one country can produce a product at a lower price than another country.
Comparative - when a country’s relative price ratio of one good in terms of another is lower than that of other countries.
Comparative advantage has replaced absolute advantage as a means of explaining trade patterns.

Question 2

How does efficiency cause trade patterns?

Answer 2

Countries should import goods from other countries who can produce the goods more efficiently and these countries should allocate resources towards producing the goods they can more efficiently.

Question 3

Explain the concept of absolute advantage using the example of rice production in Vietnam and japan.

Answer 3

Assuming the only factor of production is rice and that Vietnam and Japan are the only two rice producing economies:
The amount of labour used to produce a unit of rice in Vietnam is aR1 and in Japan is aR2.
If aR1<aR2, so that the amount of labour to produce the same amount of rice is less in Vietnam than in japan, Vietnam has an absolute advantage in rice production and should export rice to japan because Vietnam can produce more efficiently.

Question 4

Describe the absolute advantage supply and demand model

Answer 4

• assume 2 economies, Vietnam and japan, who both produce rice
• assume demand is the same in terms of preferences, income and elasticity in both countries (same demand curves)
• assume perfect competition so prices converge to marginal costs and firms are price takers
• price on y axis and quantity on x
• vietnams supply curve is more rightward than japan’s
• Vietnam produces rice at a lower autarky (before trade) price and higher quantity
• Vietnam has an absolute advantage in rice production

Question 5

Explain how trade is incorporated in their absolute advantage supply and demand model

Answer 5

• If both countries abandon autarky and trade, the world price of rice will settle between the two autarky prices
• Vietnam experiences an increase in the price of rice. Quantity supplied increases while quantity demanded decreases.
• The amount by which supply exceeds demand in Vietnam constitutes Vietnam’s exports of rice
• Japan experiences a decrease in the price of rice. Quantity supplied falls while quantity demanded increases.
• The amount by which demand exceeds supply constitutes Japan’s imports of rice.
• thus, the country with an absolute advantage, Vietnam, expands its production and exports the good, while its trading partner, japan, contracts its production and imports the good

Question 6

In the absolute advantage supply and demand model, how does trade impact Vietnam?

Answer 6

• In moving from autarky to trade, rice producers in Vietnam experiences an increase in price and quantity supplied
• There is an increase in producer surplus of area A+B
• Consumers experience an increase in price and decrease in quantity demanded.
• there is a decrease in consumer surplus of area A
• A+B>A so the surplus gain to producers exceeds the surplus lost for consumers
• there is a net welfare increase of area B to the Vietnamese economy and Vietnam gains from trade overall

Question 7

In the absolute advantage supply and demand model, how does trade impact Japan?

Answer 7

• In moving from autarky to importing rice, producers experience a decrease in price and quantity supplied
• there is a loss of producer surplus of area C
• consumers experience a decrease in price and increase in quantity demanded
• there is an increase in consumer surplus by area C+D
• C+D>C so the gain to consumers exceeds the loss to producers
• there is a net welfare increase of area D and japan gains from trade

Question 8

What are limitations to the law of absolute advantage?

Answer 8

• it suggests if a country does not have an absolute advantage in anything, it has nothing to export. This is untrue due to comparative advantage
• although overall an economy can benefit from trade, not everyone in an economy benefits, ie consumers in Vietnam and producers in japan lose out
• assumes factor mobility, ie labour can move to exporting sector
• doesn’t apply to all forms of trade, ie illicit trading of illegal goods doesn’t contribute to human welfare