Lesson 1 Absolute and Comparative Advantage ESSENTIAL QUESTION How does trade benefit all participating parties? Reading HELPDESK Academic Vocabulary volume amount; quantity enables made possible Content Vocabulary exports the goods and services that a nation produces and then sells to other nations imports the goods and services that a nation buys from other nations absolute advantage country s ability to produce more of a given product than can another country production possibilities curve diagram representing maximum combinations of goods and/or services an economy can produce when all productive resources are fully employed comparative advantage country s ability to produce a given product relatively more efficiently than another country; production at a lower opportunity cost opportunity cost cost of the next best alternative use of money, time, or resources when one choice is made rather than another Key Ideas and Details Complete the graphic organizer below by defining each term and providing an example. Absolute advantage Definition Comparative advantage Definition Example Example 1 ECON16_TX_TC_C17L01_wsresg.indd 1
Why Nations Trade Guiding Question How does trade allow for specialization? Nations trade for the same reasons that people do. They believe that the products they receive are worth more than the products they give up. International trade is partially responsible for the amazing variety of goods we use every day. For example, we may purchase clothing made in China, oil from the Middle East, bananas from Honduras, and coffee beans from Colombia and Brazil. We can take advantage of a service when we visit the Caribbean or Europe. Shoppers in other countries are doing the same thing. For example, in Russia consumers may enjoy goods produced in France, Sweden, and Japan. Some trade takes place because countries lack goods at home. Figure 17.1 shows some essential raw materials used in the United States that come from other countries. Specialization An important reason for trade among people, states, or countries is specialization. When people specialize, they produce the things they do best. Then they exchange those products for the things that other people do best. States can specialize. For example, New York is a center for trading stocks and bonds. Automobiles are a major industry in Michigan. Texas is known for oil and cattle. Florida and California are famous for growing citrus fruit. Countries specialize in different goods and services in the same way. If you want to find out what a country specializes in, look at its exports. These are the goods and services that the country produces and sells to other nations. If you want to see what a country wants but does not produce well itself, look at its imports. These are the goods and services that the country buys from other countries. Extent of Trade International trade is important to all nations. Even a country as large as the United States needs to trade. Most of the products that countries trade are goods. However, trade in services such as banking and insurance is increasing. Figure 17.2 shows the patterns of U.S. trade in goods with the rest of the world. The import of goods alone amounts to $1.968 billion or about $5,400 per person. The numbers would be even larger if we included services. In the end, international trade is much more than a way to obtain exotic products. The sheer volume of trade between nations with such different geography, politics, and religions is proof that trade is beneficial. Explaining Why is specialization a good idea in trade? 2 ECON16_TX_TC_C17L01_wsresg.indd 2
The Basis for Trade Guiding Question How does trade result in greater overall output? In 1776, Adam Smith, in his book The Wealth of Nations, was the first to write that a country should import products if they can be made more cheaply abroad than at home. This was an important departure from the main economic thought at the time. Smith was also the first writer to discuss the idea of absolute advantage. This concept was later refined to a doctrine called comparative advantage. Absolute Advantage A country has an absolute advantage when it can produce more of a product than another country. For example, take the case of two imaginary countries Alpha and Beta. They are the same size and have the same population and capital stock. Only their climate and soil richness differ. In each country, only two crops can be grown coffee and cashew nuts. In Figure 17.3 you see production possibilities curves for Alpha and Beta. Note that if both countries give all their efforts to producing coffee, Alpha could produce 40 pounds and Beta 6 pounds. This gives Alpha an absolute advantage in coffee production. If both countries concentrate on producing cashew nuts, Alpha could produce 8 pounds and Beta 6 pounds. Therefore, Alpha also has an absolute advantage in the production of cashew nuts. For years, people thought that absolute advantage was the basis for trade. This is because it enables a country to produce enough of a good to consume domestically while leaving some for export. However, absolute advantage did not explain how two countries could benefit from trade in which a country with a large output, like Alpha, traded with a country with a smaller output, like Beta. Comparative Advantage Even when one country has an absolute advantage in all goods, as Alpha does, trade is beneficial. This happens whenever a country has a comparative advantage. This means that the country has the ability to produce a good more efficiently, or at a lower opportunity cost. For example, because Alpha can produce either 40 pounds of coffee or 8 pounds of cashews, the opportunity cost of producing 1 pound of cashews is 5 pounds of coffee (40 pounds of coffee divided by 8). Meanwhile, Beta s opportunity cost of producing 1 pound of cashews is 1 pound of coffee (6 pounds of coffee divided by 6). Beta is the lower-cost producer of cashews. This is because its opportunity cost of producing 1 pound of nuts is 1 pound of coffee. On the other hand, Alpha would have to give up 5 pounds of coffee to produce the same amount of cashews. If Beta has a comparative advantage with cashews, then Alpha must have a comparative advantage with coffee. Alpha s opportunity cost of producing 1 pound of coffee is 1/5 of a pound of cashews (8 pounds of cashews divided by 40). Using the same formula, Beta s opportunity cost is 1 pound of cashews (6 pounds of cashews divided by 6). Alpha, then, has a comparative advantage in coffee production. This is because its opportunity cost of production is lower than Beta s. 3 ECON16_TX_TC_C17L01_wsresg.indd 3
Summarizing What is the difference between comparative advantage and absolute advantage? Exploring the Essential Question Imagine that you and a partner are starting a lawn-service business. You will each contribute an equal amount of money to buy a mower, a trimmer, gas, and other materials for the business. Now you have to get organized. Make a list of the different tasks associated with your business. Keep in mind that these tasks will not all be related to lawn work. Explain how you could use what you have learned about comparative advantage to divide up these jobs between you and your partner. The Gains from Trade The concept of comparative advantage is based on the assumption that everyone will be better off by specializing. This applies to people, companies, states, and regions, as well as to nations. Greater World Output Look at the final result of trade between Alpha and Beta in Panel A of Figure 17.3. We can see that specialization and trade increased the total world output. Without trade, both countries together produced 25 pounds of coffee and 5 pounds of cashews. After trade, total world output grew to 40 pounds of coffee and 6 pounds of cashews. This explains why countries such as the United States and Colombia trade. The United States has the resources to produce farm equipment, while Colombia has the resources to produce coffee. Each country has a comparative advantage in a product that the other country wants. In this way, trade will be beneficial to both and will lead to economic growth. Increased Political Stability The benefits of trade are not limited to the increased world output. There are non-production benefits, too. One of the most important benefits is greater political stability between nations that have strong trade relations. 4 ECON16_TX_TC_C17L01_wsresg.indd 4
Lesson 1 Absolute and Comparative Advantage For example, the United States and Britain were bitter enemies of Japan and Germany during World War II. Since then, these countries have become strong allies. Their partnerships started with increased trade and ended up with more political cooperation. In the case of Britain and Germany, tighter economic and political coordination took place because of the Common Market. Economists argue that cooperation in economic affairs precedes, or comes before, political cooperation. For example, countries that are at war usually have the least amount of trade between them. As a result, economists often favor increased trade between nations. They believe such policies tend to decrease potential conflicts between nations. Faster Economic Growth The gains from trade also help an economy grow. The growth comes from two sources. The first is a bigger market for a country s goods and services. Second is the ability to get needed inputs for production. Without access to the vital raw materials shown in Figure 17.1, for example, many large-scale manufacturing companies would shut down. A bigger market for a country s goods and services allows greater specialization at home. Specialization is good for an economy because it lets people and firms produce even more output, which can then be traded for other items that a country wants. All these things increase economic growth. In turn, growth means more jobs and more income. Summarizing Why is it beneficial for a country to trade with another when it has comparative advantage? 5 ECON16_TX_TC_C17L01_wsresg.indd 5