Principles of Absolute and Comparative Advantage

Question 1

Absolute Advantage

Answer 1

the situation where one country can produce a product using fewer resources (or more products with the same number of resources) than another country.

Question 2

Absolute Advantage Assumptions

Answer 2

1) Two countries, two products.
2) Traded products are homogeneous (identical).
3) Labour is homogeneous (identical) and perfectly mobile (straight line PPC) within the same country and heterogeneous (different) and perfectly immobile between countries.
4) No transport costs.
5) Full employment occurs (i.e. operate on PPC).

Question 3

Benefits of Absolute Advantage

Answer 3

• Absolute advantage occurs due to a country’s resource (FOP) endowment.
• The country with absolute advantage therefore has a cost advantage.
• This causes the country to be more efficient than another country.

Question 4

Comparative advantage

Answer 4

the situation where one country can produce a product at a lower opportunity cost than another country.

Question 5

Comparative advantage assumptions

Answer 5

1) Two countries, two products.
2) Traded products are homogeneous (identical).
3) Production costs are constant (i.e. no economies of scale).
4) Factors of production are perfectly mobile.
5) No transport costs.
6) There are no tariffs or other trade barriers.
7) Consumers and producers have perfect knowledge.

Question 6

Criticisms of Comparative advantages

Answer 6

1) Assumes two countries and two products - in reality there are many countries and many products.
2) Assumes no transport costs - but transport costs could eradicate any comparative advantage.
3) Assumes constant returns to scale (perfect FOP mobility / straight line PPC) - PPC is usually curved as FOPs are not perfectly mobile and will be better at producing one product compared to another product.
4) Assumes exchange rates are fixed - many exchange rates are floating and depreciation / appreciation can help / hinder trade.

Question 7

Outcome of Comparative advantages between countries

Answer 7

Countries should specialize in the product with comparative advantage and trade it with another product from another country with a comparative advantage.

• Both countries will mutually benefit from an improvement in allocation of resources.
• Increase in output, increase in consumption, allowing the economy to consume outside their original PPC

Question 8

Absolute Advantage vs Comparative Advantages

Answer 8

• Absolute advantage is concerned with producing at a lower cost.
• Comparative advantage is concerned with producing at a lower opportunity cost (ie. relatively better at producing).