Forex Trading

Absolute advantage International Trade, Comparative Advantage & Trade Theory

Company A claims it has a comparative advantage in producing cars over company B. One can note that the US has an absolute advantage in producing Wine or cloth compared with the United Kingdom. With one labor hour, it’s either 30 units of cloth or 30 units of wine.

A perfectly competitive final producer combines the composite output of each industry in the domestic economy with a Cobb-Douglas production function. In each industry there is a producer of a composite good that operates under perfect competition and that sells the good to the final producer and to intermediate producers from all industries in that country. The growth rate of that measure represents the speed of convergence of country and industry . Those countries that have a higher potential to adopt technologies (i.e., are farther away from the technology frontier) close the gap faster.

Suppose its neighbor has no oil but lots of farmland and fresh water. It can get more food from its neighbor by trading it for oil than it could produce on its own. As already noted, British classical economists simply accepted the fact that productivity differences exist between countries; they made no concerted attempt to explain which commodities a country would export or import. During the 20th century, international economists offered a number of theories in an effort to explain why countries have differences in productivity, the factor that determines comparative advantage and the pattern of international trade. Section 2 presents the methodology used to estimate relative productivity from trade data and then reports the quantitative results.

In this analysis, we narrow down our sample of countries to those that have available R&D data at the industry level. With respect to the previous section, we lose 13 countries (12 countries and the rest of the world) that do not report data on R&D at the industry level for the sample of analysis. These countries include Bulgaria, Brazil, Cyprus, Greece, Croatia, Indonesia, India, Lithuania, Luxembourg, Latvia, Malta, and Russia.

  1. In each industry there is a producer of a composite good that operates under perfect competition and that sells the good to the final producer and to intermediate producers from all industries in that country.
  2. It states that there is a point in production where the increased output is no longer worth the additional input in raw materials.
  3. Countries like China and South Korea have made major productivity gains by specializing their economies in certain export-focused industries, where they had a comparative advantage.
  4. The theory of comparative advantage is attributed to political economist David Ricardo, who wrote the book Principles of Political Economy and Taxation (1817).

For example, the Boeing Company has been able to produce airplanes more efficiently and cheaply because it is able to sell large numbers of aircraft to other countries. The importing countries also gain because they can buy aircraft abroad at prices far lower than they would pay for domestically produced equivalents. Despite its plausibility the Heckscher-Ohlin theory is frequently at variance with the actual patterns of international trade. As an explanation of what countries actually export and import, it is much less accurate than the more obvious and straightforward natural resource theory. The way you price your products or services can set you apart from your competitors. When doing so, it’s vital to understand your customers’ willingness to pay.

Understanding Comparative Advantage

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Our results confirm that both R&D and technology transfer are key determinants of productivity growth and convergence to the frontier. To find comparative advantage for a specific good or service, compare the opportunity cost of producing that same good or service between two businesses or countries. In the past, comparative advantages occurred more in goods and rarely in services. But telecommunication technologies like the internet are making services easier to export.

Advantages and Disadvantages of Comparative Advantage

The theory of comparative advantage became the rationale for free trade agreements. For example, at the time, England was able to manufacture cheap cloth. As a result, Ricardo predicted that England would stop making wine and that Portugal would stop making cloth. Instead, he suggested, they would trade with each other for the product that they were less efficient at producing. If you are better than everyone else in the neighborhood at both plumbing and babysitting, you have absolute advantage in both fields.

“Price discrimination is one of the most common and powerful price strategies for companies,” says Harvard Business School Professor Bharat Anand in the online course Economics for Managers. Harvard Business School Online’s Business Insights Blog provides the career insights you need to achieve your goals and gain confidence in your business skills.

Definition and Examples of Comparative Advantage

Factory B should focus its resources on making and trading tables, leaving Factory A to produce chairs. England made more money by trading its cloth for Portugal’s wine, sources of comparative advantage and vice versa. It would have cost England a lot to make all the wine it needed because it lacked the correct climate to grow grapes efficiently.

In the United States, the country specializes in cloth and produces 2,000 pieces. Recall that the opportunity cost of 1 piece of cloth in France is 2 barrels of wine. Therefore, France would be open to accepting a trade of 1 cloth for up to 2 barrels of wine.

If your customers are willing to pay the same amount for your and your competitors’ products, consider what can be shifted to increase their willingness to pay for yours. You are required to determine how each country should optimize the use of labor, that is, by producing the good in which they have a comparative advantage. 4 We take the average of 2005 GDP per capita data (USD) of our 30 sample countries, define those with higher-than-average GDP per capita as higher-income countries, and define the rest as lower-income countries. Developing nations tend to have much lower labor costs than industrialized nations, so that gives them a comparative advantage in many labor-intensive industries, such as construction and manufacturing. This is because you’ll make more money as a plumber because an hour of babysitting services costs far less than you would make doing an hour of plumbing. Every hour you spend babysitting is an hour’s worth of lost revenue you could have gotten on a plumbing job.

Oil-producing nations, for example, have a comparative advantage in chemicals. Their locally-produced oil provides a cheap source of material for the chemicals when compared to countries without it. A lot of the raw ingredients are produced in the oil distillery process. As a result, Saudi Arabia, Kuwait, and Mexico became competitive with U.S. chemical production firms in the early 1980s.

The secretary can produce $0 in legal services and $20 in secretarial duties in an hour. Over time, Smith’s view came to be known as the absolute advantage theory of trade and was the dominant trade theory until David Ricardo, a 19th-century English economist, developed the theory of comparative advantage. Comparative advantage can be said a theory that is based on the concept of relativity. If a company or country is relatively better at producing or making a particular product, it should make that product and should ignore anything else. This is the first book to present a clear empirical picture of the international exchange of goods and of the resources that account for the exchanges that occur.

Comparative advantage is one of the most important concepts in economics. In classical economics, this idea explains why people, countries, and businesses can experience greater collective benefits through trade and exchange than they can produce alone. However, contemporary economists have also pointed out that these gains can be one-sided, or result in exploitation of the weaker parties.

A main reason for this situation lies in what is called the economies of large-scale production (see economy of scale). With an understanding of your customers’ willingness to pay, you may find that different types of customers are willing to pay different amounts for your products. In such cases, it can be useful to employ price discrimination, which can be a valuable tool for expanding your company’s reach when competing with others. In the context of competition, it’s important to view willingness to pay as a strategic tool.

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