Market Behavior - Comparative and Absolute Advantage

Market Behavior

Case Assignment (Module 01)

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date

TUI University

Abstract

This paper describes the concepts of Comparative and Absolute Advantage. I will demonstrate the basic concepts of module to a classic model in economics by showing the USA and Canada in trade. This will be done by assuming there are only two goods in the economy; wheat and corn. I will also include how trade affects the production possibilities frontier and how other factors can expand the production possibilities frontier.

1. Explain the concepts of Comparative and Absolute Advantage.

If there were only 2 goods in the economy: wheat and corn.

Wheat Corn

USA 4 2

Canada 5 8

Opportunity cost represents the lost value, which is suffered as a result of choosing to produce one amount of a good over a given amount of the other. In this case, we assume that each party's ability is limited to the production of the listed quantities only. Every time the US will produce 4 units of wheat and 2 units of corn while Canada will produce 5 units of wheat and 8 units of corn. For every 1 unit of wheat the US produces, there is 0.5 unit of corn produced as well by the US. However, for every 1 unit of corn the US produces, there are 2 units of wheat produced as well. For every 1 unit of wheat Canada produces, there are 1.6 units of corn produced by Canada. And for every 1 unit of corn produced by Canada, there is 0.6 unit of wheat produced. According to these figures, the US is more efficient in the production of wheat while Canada is more efficient in the production of corn.

Absolute advantage is an economic theory initially developed by Adam Smith in his "Wealth of Nations" book. He established that a party (person, country, company) has an absolute advantage over its competitor(s) if/ when the said party can produce greater outputs by using the same/ equal resources or inputs as its competitor(s). Looking at the given example, Canada produces 5 units of Wheat when the US is producing only 4 units and Canada produces 8 units of Corn when the US is only producing 2, using the same inputs. In this case, Canada has an absolute advantage over the United States in the production of both goods.

Comparative advantage is an extension of Adam Smith's theory according to British economist David Ricardo. It was developed by David Ricardo in response to contentions that in case the same party has absolute advantage in everything, trade was not anymore advantageous to that said party. To illustrate his argument, I would rely on an example given in one of our suggested background writings: An attorney may be a better typist and lawyer in the sense of arguing cases than his secretary. However, does it mean that the said attorney should get rid of his secretary? David Ricardo's response would be a positive NO. The fact is that the attorney would rather focus on arguing cases, an area in which he would be more efficient and leaving the typing to his secretary. This is also true about companies and countries. In the previous example, Canada has an absolute advantage in the production of both corn and wheat. However, if each country had to specialize on one product alone, the opportunity cost of production of wheat would be higher for Canada (has to give up 1.6 unit of corn to produce 1 unit of wheat) and much lower for the US (has to give up 0.5 unit of corn to produce 1 unit of wheat). On the contrary, the opportunity cost of production of corn would be much lower for Canada (has to give up 0.6 unit of wheat to produce 1 unit of corn) than for the US (has to give up 2 units of wheat to produce 1 unit of corn). In sum, based on the opportunity cost, the US would be considered to have a comparative advantage in the production of Wheat, while Canada will be considered to have a comparative advantage in the production of corn. Therefore, trade will still be advantageous to both parties if each focused on the area in which they had a comparable advantage. The idea of having a comparative advantage results from the ability to produce the same product as the competitor with relatively lower costs of production.

2. How does trade affect the possibility frontier?

The production possibility frontier refers to that point at which an economy is most efficiently producing its good and services, as a result of allocating its resources in the best way possible. Economics is a science based on the assumption that supply is limited while demand is limitless. So there is a need to efficiently manage production to meet the increasing demand. Our previous example, when talking about comparative advantage shows that a party may be producing goods and services inefficiently. For instance, if the attorney were to focus on both typing and