Overview
This lecture explains the concepts of absolute and comparative advantage, how they determine trade patterns between countries, and why specializing in goods with lower opportunity costs benefits all trading partners.
Absolute and Comparative Advantage
- Absolute advantage means a country can produce more of a good with fewer resources than another country.
- Comparative advantage refers to producing a good at a lower opportunity cost than another country.
- The U.S. has an absolute advantage in both shoes and refrigerators compared to Mexico.
- The U.S. has a comparative advantage in refrigerators; Mexico has a comparative advantage in shoes.
Production Possibility Frontiers (PPF) and Trade
- The PPF shows the maximum feasible production combinations of two goods with given resources.
- Specialization according to comparative advantage increases total combined output for both countries.
- After each country specializes, both can consume more of both goods through trade than without it.
Opportunity Cost and Benefits from Trade
- Opportunity cost is what must be given up to produce one unit of another good.
- The mutually beneficial range of trade is determined by each country's opportunity cost.
- Both countries are better off if they trade at a rate that falls between their opportunity costs.
Calculating Absolute and Comparative Advantage (Example: Canada and Venezuela)
- Canada has absolute and comparative advantage in lumber; Venezuela in oil.
- Opportunity cost (Canada): 1 oil = 2 lumber, 1 lumber = 0.5 oil.
- Opportunity cost (Venezuela): 1 oil = 0.5 lumber, 1 lumber = 2 oil.
- Each country should specialize in and export the good for which it has the lower opportunity cost.
Trade and Incomes
- Absolute advantage leads to higher incomes due to greater labor productivity.
- Specializing based on comparative advantage maximizes countries' average labor productivity and income.
- Comparative advantage, not absolute advantage, is critical for determining beneficial trade patterns.
Key Terms & Definitions
- Absolute Advantage — Ability to produce more of a good with fewer resources than another producer.
- Comparative Advantage — Ability to produce a good at a lower opportunity cost than another producer.
- Production Possibility Frontier (PPF) — A graph showing the maximum combinations of goods that can be produced with available resources.
- Opportunity Cost — The value of the next best alternative given up when making a decision.
Action Items / Next Steps
- Practice calculating absolute and comparative advantage using provided numerical examples.
- Watch the recommended video for additional practice and review of these concepts.