Trade Policy and the Economic Principles of Absolute & Comparative Advantage.

Hello readers, welcome back.

In my last post I described 4 key reasons or traps as to why some countries are poorer than others. I discussed many of the thoughts and ideas from leading economists such as Tim Harford and Sir Paul Collier and I hope that by reading it you now have a clearer understanding as to why such disparities exist between countries.

In today’s post, I will be looking at the idea of international trade and will consider ideas such as why we need to trade, the impacts of trade and I will explain the concept of an absolute and comparative advantage- 2 important economic concepts relating to trade. I will also keep this post short and to the point. If you have any unanswered questions or are unsure about the content discussed in this post feel free to comment below.

To start with here are a few simple reasons as to why countries want/need to trade with each other:

  • access to larger markets
  • greater variety of goods
  • increased standards of living
  • can help poorer nations escape issues such as subsistence farming
  • more competition which in turn drives lower prices
  • diplomacy
  • increased economic growth as exports can generate large revenues.

 

A few reasons as to why countries may decide not to trade with each other:

  • strategic industries
  • trade barriers
  • diplomatic issues e.g. Qatar
  • protecting workers e.g. Trump in the US
  • culturally important industries

 

There are a number of key words/economic jargon associated with trade which you may have come across in the news or whilst reading an article. I will briefly explain a few of these:

Balance of Payments- A summary of an economy’s transactions with the rest of the world in a given period of time (normally a quarter or a year).

Trade deficit- If a country imports more than it exports. Also known as the current account deficit.

Trade surplus- If a country exports more than it imports. Also known as the current account surplus.

Issues with a trade deficit:

  • Unemployment
  • Dependency & reliance on other countries

Issue with a trade surplus

  • Countries may rely on the income from exports; however this may not be guaranteed.
  • Exporting commodities such as oil-price fluctuations, which make the market very volatile and unpredictable.

 

Absolute and comparative advantage are two important concepts in international trade that largely influence how and why nations devote limited resources to the production of particular goods.

Absolute Advantage

Absolute advantage means that an economy can produce a good for lower costs than another. It means that less resources are needed to produce the same amount of goods. The idea of absolute advantage was pioneered by Adam Smith in the late 18th century as part of his division of labor doctrine. Absolute advantage doesn’t necessarily mean an economy should produce that good. This requires a country to have a comparative advantage (described below).

It is easiest to understand if we work through an example.

Let’s suppose that china can produce 30 cars and 15 planes whilst the UK can produce 24 cars and 20 planes. In this situation, China has an absolute advantage at making cars whereas the UK has one in making planes. Since each has advantages in producing certain products and services, they can both benefit from trade. If both China and the UK specialize in the products they have an absolute advantage in and buy the products they don’t have an absolute advantage in from the other entity, they will both be better off.

However lets consider a different scenario, still linked to cars and plane with China and the UK.

Suppose China can now make 30 cars and 15 planes, whereas the UK could only make 24 cars and 8 planes. This would mean that China has an absolute advantage for both. Does it still make sense for them to trade. This is where the concept of Comparative Advantage comes in.

Comparative Advantage

Whereas absolute advantage refers to the superior production capabilities of one nation versus another, comparative advantage is based on the concept of opportunity cost (the value of the next best alternative foregone). If the opportunity cost of choosing to produce a particular good is lower for one nation than for others, then that nation is said to have a comparative advantage. Even if one country has an absolute advantage in producing all goods, different countries could still have different comparative advantages. If one country has a comparative advantage over another, both parties can benefit from trading because each party will receive a good at a price that is lower than its own opportunity cost of producing that good. Comparative advantage drives countries to specialize in the production of the goods for which they have the lowest opportunity cost, which leads to increased productivity.

The law of comparative advantage is popularly attributed to English political economist David Ricardo and his book “Principles of Political Economy and Taxation” in 1817, although it is likely that Ricardo’s mentor James Mill originated the analysis. David Ricardo famously demonstrated how England and Portugal both benefit by specializing and trading according to their comparative advantages, Portugal with wine and England with cloth.

Now lets revisit our original example, which should hopefully make everything click. If we look at the opportunity cost in terms of producing one car and one plane, it should be easy to see why there is an incentive to trade.

To produce one car, China would have to forego 1/2 a plane whereas the UK would only have to forego 1/3 plane. Since the opportunity cost is lower for the UK, it makes sense for the UK to focus on producing planes. To produce one plane, China would have to forego 2 cars whereas the UK wold have to forego 3 cars, thus it makes sense for China to focus and specialise on producing cars.

Therefore we can say that although absolute advantage is important, comparative advantage is what determines what a country will specialize in.

Sources Used:

http://www.investopedia.com/terms/a/absoluteadvantage.asp

http://www.investopedia.com/ask/answers/033115/what-difference-between-comparative-advantage-and-absolute-advantage.asp

https://www.boundless.com/economics/textbooks/boundless-economics-textbook/international-trade-31/introduction-to-international-trade-124/absolute-advantage-versus-comparative-advantage-493-12589/

http://www.economicshelp.org/blog/glossary/absolute-advantage/

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