Understanding Absolute and Comparative Advantage: A Guide to Economic Production and Trade, Summaries of Business Fundamentals

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Created by Jacob Finnell

Absolute and Comparative

Advantage

Actor: Firm, individual, nation, or other participant in the economy.

Opportunity Cost: The benefit that would have been received by taking the next best action instead of the action taken.

Absolute Advantage: The ability of an actor to produce more of a good or service than a competitor.

Comparative Advantage: The ability of an actor to produce a good or service for a lower opportunity cost than a competitor.

Autarky: A state of affairs in which countries do not trade, and only acquire goods or services from within.

The Terms

Imagine you have two countries, California, and Mexico that make two goods, tequila, and wine. How much of each good a country can produce is listed off to the right.

You can see California can make more of everything and therefore has an absolute advantage in producing both goods.

Under Autarky, California might produce 50 bottles of wine and 25 bottles of tequila.

California:

100 bottles of Wine OR 50 bottles of Tequila

Mexico: 20 bottles of Wine OR 40 bottles of Tequila

Absolute Advantage within Nations

About Simplification

Quick Side Note : In the real world, stores sell more than two

products, and countries produce more than two goods. We simplify

these scenarios to two products to illustrate the concept. The

concepts stay true as more goods are added.

Bookend Books

Giftcard Amount: $

Price of StarWars Book: $

Price of House M.D. DVD: $

MockBuster

Giftcard Amount: $

Price of StarWars Book: $

Price of House M.D. DVD: $

Solution on the following slides

Question: What is the most amount of DVDs and Books you can get if you have $500 at each store?

If you split your money down the middle and allocated half of each gift card to buying one product you get the following outcome.

Bookend Books:

Books = 250/25 = 10

DVDs = 250/20 = 12.

MockBuster:

Books = 250/10 = 25

DVDs = 250/15 = 16.

Books = 10 + 25 = 35 DVDs = 12.5 + 16.67 = 29.

This is similar to a country without trade. We can, however, get more books and DVDs by following a different purchasing strategy.

Answer to Corporate trade question Part 1

It’s all about opportunity cost.

At Bookend Books, the cost for DvDs is $20, and the cost for books is $25. This makes the opportunity cost of a book 1.25 DvDs and the opportunity cost of a DvD 0.8 books.

At Mockbuster, the price of a DvD is $15 and the price of a book is $10. This makes the opportunity cost of a book. DvDs and the opportunity cost of a DvD 1. books.

The opportunity cost for books is higher at Bookend books, so books should be bought at mockbuster. Meanwhile, opportunity cost for DvDs is higher at mockbuster, so DvDs should be bought at bookend books.

But Why does that work? AKA Comparative Advantage

Obviously, California has an absolute advantage in both goods, but trade between them is still beneficial. To see how, let’s calculate the comparative advantage between both countries.

California:

100 bottles of Wine OR 50 bottles of Tequila

Mexico: 20 bottles of Wine OR 40 bottles of Tequila

California: Wine Costs .5 Tequila in opportunity cost Tequila costs 2 Wine in opportunity cost Mexico: Wine costs 2 Tequila in opportunity cost Tequila costs .5 Wine in opportunity cost

Question: What is the way to get the most wine and tequila from California and Mexico?

If you are still confused, here are more video resources.

Specialization and

Trade: Crash Course

Economics #

YouTube Video

International Relations 101 (#27): Absolute Advantage and Trade YouTube Video

International Relations 101 (#28): Comparative Advantage and Trade YouTube Video

Further references