Key Terms

• Absolute Advantage: the ability to produce more of a good or service with a given amount of resources than someone else, enabling lower production costs and faster output.

• Comparative Advantage: the ability to produce a good at the lowest opportunity cost.

• Terms of Trade: the rate at which one good can be exchanged for another.

Introduction

• The concepts of absolute and comparative advantage illustrate how individual countries or entities interact and trade with each other.

• These concepts highlight specialization in production, where entities focus on producing goods they are most efficient at and trade for goods they are less efficient in producing.

• Countries strive to gain a competitive edge in the global economy to increase their influence and power. 

Types of Problems

• Output Problems:

  • Focus on data related to what each party can produce with a given set of resources.

  • Determine who should specialize in each good based on productivity.

• Input Problems:

  • Focus on the amount of resources needed to produce one unit of a particular good or service.

Output Problems

• To determine the absolute advantage you are simply looking for which country can produce a higher amount of the good or service.

• To determine comparative advantage you have to calculate per unit opportunity cost using the formula give up/gain (the amount of good you are giving up divided by the amount of good you are gaining). Once you have calculated per unit opportunity cost, the country with the lowest one has a comparative advantage.

• If the two countries can both make the same amount of the good, then we say neither country has an absolute advantage.

• Countries export what they have a comparative advantage in and import what they don't have a comparative advantage in.

Determining Absolute Advantage

• Using the table above, we would determine that Japan has an absolute advantage in steel (1200 > 1000) and Canada has an absolute advantage in coal (500 > 300).

Determining Comparative Advantage

• The per unit opportunity cost for steel in Canada is 1/2 a unit of coal (500/1000).

• The per unit opportunity cost for steel in Japan is 1/4 a unit of coal (300/1200). 

• Since 1/4 is less than 1/2, Japan has a comparative advantage in steel.

• The per unit opportunity cost for coal in Canada is 2 units of steel (1000/500).

• The per unit of opportunity cost for coal in Japan is 4 units of steel (1200/300).

• Since 2 is less than 4, Canada has a comparative advantage in coal.

• Japan will export steel to Canada and import coal from Canada.

Terms of Trade

• Terms of trade are determined by looking at the two opportunity costs and choosing a number that falls between the opportunity costs in order for it to be beneficial to both countries.

• Acceptable terms of trade for this situation would be:

  • 1 coal = 3 units of steel

  • 1 steel = 1/3 units of coal

Input Problems

• To determine absolute advantage, you are looking for the country that uses the least amount of resources (i.e. the lower number).

• To determine comparative advantage, you have to calculate the per unit opportunity cost using the formula gain/give up. Once you have calculated the per unit opportunity cost the country with the lowest one has a comparative advantage.

• If the two countries can both make one unit of the good with the same amount of resources, then we say neither country has an absolute advantage.

• Countries export what they have a comparative advantage in and import what they don't have a comparative advantage in.

Terms of Trade

• It consists of the ration of a country's export prices to income prices and determines the relative price between that nation's exports and imports. 

• Terms of trade are determined by looking at the two opportunity costs and choosing a number that falls between the opportunity costs in order for it to be beneficial to both countries.

• Acceptable terms of trade for the situation described above would be:

  • 1 truck for 1.5 cars—this number is between 1, the comparative advantage for a truck in Brazil, and 2, the comparative advantage for a truck in the United States

  • 1 car for 3/4 of a truck—this number is between 1/2, the comparative advantage for a car in the United States, and 1, the comparative advantage for a car in Brazil ToT (Terms of Trade) can be influenced by several factors, such as: exchange rates, changes in prices of raw materials, and shifts in the global demand. 

• A favorable terms of trade for a country means that it can purchase more imports for the same amount of exports, which can consequently boost its economy. 

  • A country with unfavorable terms of trade has to export more to purchase the same amount of imports, which is damaging to its economy.