Absolute Advantage, Comparative Advantage, and Opportunity Costs
People succeed in life by specializing at what they do best. If they do something where they do not have an advantage over others, then they will not be nearly as successful because of the competition. Likewise, for countries. A country can maximize its own wealth and the wealth of the world by specializing in what it does best, where it has the greatest advantages or the least opportunity costs. These are the products and services it should export. So, for instance, since Saudi Arabia has an abundance of oil, it exports oil, and since the United States has an abundance of fertile land, it exports agricultural products. On the other hand, Saudi Arabia is mostly desert, so it cannot grow enough food to feed its population, and the United States consumes more oil than what can be economically provided from its own resources. Both countries would be better off if Saudi Arabia traded oil for agricultural products and if the United States traded its agricultural products for oil.
A country has an absolute advantage in producing a good if it can either produce a product with fewer resources or with a lower cost of resources. The opportunity cost of a product or service is the difference in value between the value of what is actually produced with a given set of resources minus the maximum value that can be produced with those resources. A country has a comparative advantage in producing a good if it has a lower opportunity cost of producing that good compared to whatever else it could produce with its resources.
The differences between absolute and comparative advantage can easily be seen in a simple example. Take a model who makes $10,000 a day modeling but who is also very efficient at mowing her large yard around her mansion. If she cuts her grass herself, she can do it in one day. Or she can hire a lawn service that takes 2 days to mow the lawn and charges $400. Thus, the model has an absolute advantage in both working as a model and mowing her own lawn, but, she would, nonetheless, still hire the lawn service, because if she mowed her own lawn, she would have to give up a day of modeling, resulting in $10,000 less in earnings. By hiring the lawn service, she earns $10,000 a day as a model and pays the lawn service $400, for a net gain of $9,600. Hence, the $9,600 is her opportunity cost for mowing her own lawn. If the lawn service does not mow the model's lawn, then it will not get the $400 that it charges the model, but it will have time to mow other people's lawns for the same amount of money. Therefore, the lawn service's maximum opportunity cost of not mowing the model's lawn is only $400, which gives it a comparative advantage over the model.
Because countries differ in their absolute or comparative advantage in producing specific products or services, the world benefits by allowing free trade. However, trade is often restricted on the specious grounds of preserving jobs or because politically powerful people who will benefit from restricted trade want to increase their wealth at the expense of the public.
In the early 19th century, Corn Laws, which consisted of tariffs, subsidies, and restrictions on the trading of corn and other grains, were enacted by British Parliament so that the landowners in the House of Lords could increase their own wealth at the expense of the public, by discouraging imports and encouraging exports of grain, particularly corn.
In 1817, David Ricardo published Principles of Political Economy and Taxation in which he advanced the idea of absolute and comparative advantage by comparing the production of wine and cloth in England and Portugal. If, in England, it took the labor of 100 men working for 1 year to produce a given amount of cloth and 120 man-years to produce an equal value of wine, while, in Portugal, it took only 80 man-years to produce wine and 90 man-years to produce cloth of equivalent value, then Portugal has an absolute advantage in producing both wine and cloth because it can produce them with less labor than England. However, Portugal only has a comparative advantage in producing wine because the opportunity cost of producing cloth in England is less than the opportunity cost of producing cloth in Portugal. This is because England would have to sacrifice an extra 20 man-years to make wine while Portugal would only have to sacrifice 10 more man-years to make cloth. If England exported cloth for the wine, then it needs only the 100 man-years to create the cloth to exchange for the equivalent value of wine; if it produced its own wine, it would need 120 man-years. Likewise, for Portugal to make its own cloth, it would have to sacrifice 90 man-years, but by exchanging wine for cloth, it can receive the equivalent value of cloth for only 80 man-years. Hence, both England and Portugal benefit by trading wine for cloth.
Without trade, each country produces the goods that it consumes.
- Cloth: 100 man-years
- Wine: 120 man-years
- Total: 220 man-years
- Cloth: 90 man-years
- Wine: 80 man-years
- Total 170 man-years
With trade, instead of producing both cloth and wine, England produces double the amount of cloth, exporting half of it for the equivalent amount of wine from Portugal. Portugal produces double the amount of wine, then exports half of it for the equivalent amount of cloth from England.
- England, double the cloth: 200 man-years, saving 20 man-years over producing both products itself.
- Portugal, double the wine: 160 man-years, saving 10 man-years over producing both products itself.
- So the total savings of this international trade is 30 man-years. Each country is richer by engaging in international trade than it would be without trade.
(Here, it would seem that Portugal has the lower opportunity cost since it only has to sacrifice 10 man-years instead of 20. However, it only makes sense to compare opportunity costs using the same resources, meaning that an individual or a country can only compare what it can do with its own resources, since that individual or country is one of the resources. Hence, a country will only produce at its own lowest opportunity cost, and whether it will import or export will depend on those opportunity costs. So if Portugal, in the above example, can produce both wine and cloth at the cost of 80 man-years, then it will export both and import neither.)
Several years after the publication of his book, Ricardo became a member of Parliament where he presented his ideas as to why the Corn Laws should be repealed, arguing that specialization and free trade will benefit all trading partners, even those who are less efficient at producing.
Some economists make a distinction between natural and acquired comparative advantages. A natural comparative advantage exists within a country that has natural resources that are required to produce a product, while an acquired comparative advantage is the advantage gained by an individual or a country by spending a lot of time or resources producing a product. For instance, Saudi Arabia has a natural comparative advantage with its huge reserves of oil. (Saudi Arabia also has an absolute advantage in oil, since the cost of its extraction is less than elsewhere.) Since Saudi Arabia has few other resources, without trade, it would be extremely poor; because of trade, it is extremely wealthy. Japan, on the other hand, has few natural resources, but it has an acquired comparative advantage in its manufacturing and business know-how, which it has developed over the years.
Terms of Trade
The terms of trade is the ratio at which a country can exchange domestic products for imported products. If the imported costs of the products are less than the opportunity costs for the countries to produce the product themselves, then they will continue to trade the products. So, referring to the above example, Portugal would continue to import cloth from England as long as its opportunity cost of producing cloth itself is higher than the opportunity cost of producing wine that can be exported in exchange for the cloth.
To summarize, absolute advantage compares the nation's ability to produce a product or service compared to other nations, while comparative advantage compares one nation's ability to produce a product or service compared to the other products or services that it can produce and export. Most countries that have an absolute advantage in a product also have a comparative advantage in that same product. For instance, Saudi Arabia has an absolute advantage in producing oil, because it can produce oil more cheaply than any other nation, but it also has a comparative advantage in oil production, because there is no other economic activity in Saudi Arabia that is as productive and profitable as producing oil.
Hence, absolute and comparative advantages determine what products or services nations import or export.