Absolute Advantage and Comparative Advantage (with examples) | International Business
Summary
TLDRThis video from 'Business School 101' explores the concepts of absolute and comparative advantage in international trade. It explains how countries, even if wealthy like the U.S., can benefit from trading by specializing in goods where they have an absolute advantage (producing more efficiently) or a comparative advantage (lower opportunity cost). The video uses simplified examples to illustrate these economic theories, which are fundamental to understanding global trade, despite their limitations.
Takeaways
- 🌐 The United States, despite being a wealthy nation, engages in international trade to benefit from the exchange of goods with other countries.
- 🔍 Understanding international trade involves grasping the concepts of absolute and comparative advantage in international business.
- 💡 Absolute advantage means a country uses fewer resources to manufacture a product more efficiently than others, like Saudi Arabia's oil production.
- 🔄 Countries can benefit from trade by specializing in producing goods where they have an absolute advantage, exemplified by a hypothetical trade between the US and China.
- 🛠️ The US has an absolute advantage in plane production, while China has it in truck production, according to the simplified example provided.
- 🚚 By trading, the US can save resources by producing planes and trading them for trucks, and China can do the opposite, highlighting mutual benefits.
- 🔄 Comparative advantage is about producing a product at a lower opportunity cost compared to another country, even if one has an absolute advantage in all products.
- 📉 Opportunity cost is the loss of potential gain from choosing one alternative over another, a key factor in determining comparative advantage.
- 🔄 Even if the US has an absolute advantage in both planes and trucks, it still benefits from trading by focusing on comparative advantage, like producing planes over trucks.
- 🚧 The theories of absolute and comparative advantage, while foundational, have limitations, such as not accounting for product features, quality, and real-world constraints like trade wars and pandemics.
Q & A
Why do wealthy nations like the United States engage in international trade?
-Wealthy nations engage in international trade to benefit from the specialization in the production of goods where they have an absolute or comparative advantage, allowing them to obtain goods more efficiently and at a lower cost than producing them domestically.
What is the definition of absolute advantage in the context of international trade?
-A country has an absolute advantage in manufacturing a product if it uses fewer resources to produce that product compared to another country. It means it can produce the same output with less input, making it more efficient.
Can you provide an example of a country with an absolute advantage in oil production?
-Saudi Arabia is an example of a country with an absolute advantage in oil production because it requires fewer resources to extract oil compared to other countries, often just a matter of drilling a hole.
How does the concept of absolute advantage influence trade decisions between countries?
-Countries with an absolute advantage in certain goods will tend to specialize in producing those goods, and then trade with other countries to obtain goods in which they do not have an absolute advantage.
What is the significance of the simplified example involving the United States and China in the script?
-The simplified example is used to illustrate how the principle of absolute advantage works in international trade. It shows that even if one country can produce all goods more efficiently, it can still benefit from specializing in the production of goods where it has the greatest advantage.
What is the opportunity cost, and how does it relate to the concept of comparative advantage?
-Opportunity cost refers to the potential gain that is lost when one alternative is chosen over another. It is used to determine comparative advantage, which is the ability to produce a good at a lower opportunity cost compared to another country.
Why is it beneficial for the United States to trade planes for trucks with China, as per the script?
-It is beneficial for the United States to trade planes for trucks with China because it can produce planes more efficiently (lower percentage of total resources) and trade them for trucks, saving resources compared to producing trucks domestically.
How does the concept of comparative advantage differ from absolute advantage?
-Comparative advantage is based on the opportunity cost of producing goods. A country has a comparative advantage in producing a good if it can produce it at a lower opportunity cost than another country, even if it does not have an absolute advantage.
What are some limitations of the absolute and comparative advantage theories as mentioned in the script?
-Some limitations include not considering product features and quality, the assumption that resources can move freely between industries, and overlooking transportation costs. These theories also do not account for real-world complexities such as trade wars or global pandemics.
Why are the absolute and comparative advantage theories still valuable despite their limitations?
-These theories are valuable because they provide a fundamental understanding of the logic behind global trade, explaining why countries engage in trade even when one country has an absolute advantage in all goods.
How can countries benefit from trading even if one country has an absolute advantage in all products?
-Countries can still benefit from trading by focusing on the production of goods where they have a comparative advantage, which allows them to produce certain goods at a lower opportunity cost than other countries.
Outlines
🌐 Understanding International Trade Through Absolute Advantage
This paragraph introduces the concept of international trade, focusing on why wealthy nations like the United States continue to engage in trade with other countries. It explains the importance of understanding 'absolute advantage' in the context of international business. Absolute advantage is defined as a country's ability to produce a product more efficiently with fewer resources compared to another country. The example of Saudi Arabia's oil production is used to illustrate this concept. The paragraph also sets up a simplified model involving trade between the United States and China, where both countries can produce planes and trucks, but the U.S. is more efficient in plane production, and China in truck production. The discussion highlights how each country can benefit from specializing in the production of goods where they have an absolute advantage and trading for the rest.
🔄 Exploring Comparative Advantage in Global Trade
The second paragraph delves into the concept of 'comparative advantage,' which is crucial for understanding why countries trade even when one holds the absolute advantage in producing all goods. The example continues with the United States and China, but this time the U.S. has the absolute advantage in producing both planes and trucks. The paragraph explains that despite this, both countries can still benefit from trade by focusing on the production of goods where they have a lower opportunity cost. Opportunity cost is defined as the loss of potential gain from other alternatives when one alternative is chosen. The U.S. has a lower opportunity cost in producing planes, while China has a lower opportunity cost in producing trucks. The paragraph concludes by emphasizing that even with absolute advantages, countries can benefit from specializing in goods where they have a comparative advantage, thus supporting the fundamental logic of global trade.
Mindmap
Keywords
💡Absolute Advantage
💡Comparative Advantage
💡International Trade
💡Opportunity Cost
💡Specialization
💡Resources
💡Efficiency
💡Trade War
💡Global Pandemic
💡Product Features and Quality
Highlights
The United States is one of the wealthiest nations yet engages in international trade.
Understanding international trade benefits requires knowing absolute and comparative advantage.
A country has an absolute advantage if it uses fewer resources to manufacture a product.
Saudi Arabia has an absolute advantage in oil production due to lower resource requirements.
Economists suggest countries can benefit from trade by specializing in their absolute advantage goods.
A simplified example is used with the U.S. and China trading planes and trucks.
The U.S. has an absolute advantage in plane production, while China has it in truck production.
The U.S. can save resources by trading planes for trucks rather than producing trucks domestically.
China can also save resources by trading trucks for planes instead of producing planes domestically.
Even if one country has the absolute advantage in all products, trade can still be beneficial.
Comparative advantage is defined as the ability to manufacture at lower opportunity costs.
Opportunity cost is the loss of potential gain from choosing one alternative over another.
In a scenario where the U.S. has absolute advantage in both products, opportunity costs determine comparative advantage.
China has a comparative advantage in truck production, and the U.S. in plane production.
Both countries can save resources by specializing in their comparative advantage goods and trading.
Absolute and comparative advantage theories help understand global trade but have limitations.
Theories do not account for product features, quality, or the cost of resources.
Resource movement within a country is not always free, especially during unusual periods like trade wars or pandemics.
Transportation costs between countries are not considered in these theories.
Despite limitations, the theories illustrate the fundamental logic of global trade.
Transcripts
hello everyone welcome to business
school 101
the united states is one of the
wealthiest nations in the world
yet we continue to trade with other
countries have you ever considered why
this is the case
if the u.s is so powerful then how does
it benefit from international
trade to answer this question we need to
understand two important terms in the
international business field
the absolute advantage and the
comparative advantage
by definition a country has an absolute
advantage in manufacturing a product
over another country
if it uses fewer resources to
manufacture that product
in other words a country has an absolute
advantage when it manufactures a product
more efficiently than any other country
for example extracting oil in saudi
arabia is basically just a matter of
drilling a hole
in contrast literally striking oil in
other countries could involve
considerable exploration
and costly technologies for drilling and
extraction
therefore saudi arabia requires less
resources than other countries to
produce the same amount of oil
as a result we can say that saudi arabia
maintains the absolute advantage in oil
production
economists suggest that two countries
can benefit from engaging in trade
by specializing in the production of
goods in which each country has an
absolute advantage
to better understand this logic let's
use a simplified example and assume that
there are only two countries
the united states and china they are
engaging in trade that both countries
can only produce two types of goods
planes and trucks before we go any
further please keep in mind the
international trade doesn't actually
look like this in real life
there are obviously more than two
countries in the world and they produce
much more than just two types of goods
however for the sake of learning we are
going to simplify the underlying logic
of international trade
which can be extended to the real
business world
okay let's say that the united states
can produce either 100 planes
or 2500 trucks and china can produce
either 20 planes
or 8 000 trucks in this imaginary
international market
one plane can be traded for 200 trucks
for the united states the production of
one plane
will cost one percent of its total
resources while the production of one
truck
will cost point zero four percent of its
total resources
similarly for china the production of
one plane will cost
five percent of its total resources and
the production of one truck will cost
point zero one two five percent of its
total resources
since the u.s uses less of its resources
in china
to produce planes we can say that the
u.s holds the absolute advantage in
plane production
similarly because china uses less of its
resources in the u.s
to produce trucks china holds the
absolute advantage in truck production
therefore if the us wants to have one
thousand trucks then it has two options
option one the us chooses to produce
trucks itself
this way the us would need to spend 40
percent of its total resources
option two the us chooses to spend five
percent of its total resources
to produce five planes and then trades
those planes with china for one thousand
trucks
when we compare these two options it is
not difficult to conclude that option
two
is better for the us because it can save
a lot of the country's resources
while still obtaining the same number of
trucks therefore
the us benefits from trading with china
now how can china also benefit from this
trade
if china wants to have five planes then
it also has two options
option one china decides to produce the
plants itself
which will cost 25 percent of its total
resources
option two china spends 12.5 percent
of its total resources to produce 1 000
trucks
and then trades those trucks with the us
for five planes
so china also benefits from the trade by
saving half of its resources
by studying these examples we now can
understand that both countries can
benefit from trading by specializing in
the production of goods
in which each country has an absolute
advantage
however this is not always the case in
the real world
what if one country holds the absolute
advantage in both products
will that country still be able to
benefit from trading with other
countries
to answer these questions we need to
understand another important term
the comparative advantage
by definition if a country can
manufacture a product at a lower
opportunity costs in another country
then it has a comparative advantage for
manufacturing that product
opportunity cost refers to the loss of
potential gain from other alternatives
when one alternative is chosen i know
this sounds a little confusing
so let's use an example to explain this
time let's assume that there are only
two countries
the united states and china engaging in
trade and that both countries only
produce two goods
planes and trucks china can still
produce either 20 planes or 8 000 trucks
however this time the united states can
either produce 100 planes
or 10 000 trucks in this imaginary
international market
one plane can still be traded for 200
trucks
for the united states the production of
one plane will cost one percent of its
total resources
while the production of one truck will
cost point zero one percent of its total
resources
similarly for china the production of
one plane will cost five percent of its
total resources
and the production of one truck will
cost point zero one two five percent of
its total resources
in this scenario the us spends less
resources on both plane and truck
production than china
in other words the us holds the absolute
advantage on the productions of both
planes and trucks
so how can the u.s still benefit from
trading with china
to answer this question we need to
calculate the opportunity cost for each
country
as i mentioned earlier the opportunity
cost refers to the loss of potential
gain
from other alternatives when one
alternative is chosen
because the u.s can spend its resources
to produce either 100 planes
or 10 000 trucks in this example the
opportunity cost for the us to produce
one plane
is 100 trucks and the opportunity cost
for the us
to produce one truck is .01 planes
similarly because china can produce
either 20 planes or 8
000 trucks the opportunity cost for
china to produce one plane
is 400 trucks and the opportunity cost
for china to produce one truck
is .0025 planes
compared with the u.s china has less
opportunity costs to produce one truck
so we can say that china holds that
comparative advantage for truck
production
in contrast the u.s has less opportunity
costs to produce one plane
so we can say that the us holds
comparative advantage for plane
production
now let's still assume that the us needs
1 000 trucks
and that it still has two options option
one
the u.s spends 10 percent of its total
resources to produce those trucks itself
option two the u.s spends five percent
of its total resources to produce five
planes
and then trades those planes with china
for one thousand trucks
as you can see option two is still
better for the us
because it can save half of the
country's resources while still
obtaining the same number of trucks
we can conclude from this example that
even though one country holds the
absolute advantage for both products
it can still benefit from trading by
specializing in the production of goods
in which it has a comparative advantage
in general the absolute and comparative
advantage theories
help us immensely in understanding why
countries should get involved in global
trade
however these theories also suffer many
limitations
first we have not taken the product
feature and quality as well as the cost
of resources into consideration
for example one percent of american
resources
might cost a different amount than one
percent of china's resources
also trucks made in the us might have
different product features and quality
than trucks made in china
second we have assumed that resources
can move freely from the manufacturing
of one product
to another within a country in reality
this is not always the case
especially during an unusual period such
as the trade war or a global pandemic
third we have failed to acknowledge
transportation costs between countries
although the absolute advantage and
comparative advantage theories may have
drawbacks
they are still valuable because they
illustrate the fundamental logic of
global trade
so what do you think about the absolute
and comparative advantage
do they make sense to you please leave
your thoughts in a comment below
thanks for watching and i will see you
next time
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