Absolute Advantage and Comparative Advantage (with examples) | International Business

Summary

This 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

00:00

🌐 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.

05:02

🔄 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.

Keywords

💡Absolute Advantage

Absolute advantage refers to a country's ability to produce a good or service using fewer resources than another country. In the script, Saudi Arabia is given as an example where it has an absolute advantage in oil production because it requires fewer resources to extract oil compared to other countries. This concept is central to the video's theme of explaining why countries engage in trade, as it sets the stage for understanding the benefits of specialization and trade.

💡Comparative Advantage

Comparative advantage is the economic principle that a country should produce goods for which it has the lowest opportunity cost, rather than goods for which it has an absolute advantage. The script explains this by comparing the opportunity costs of producing planes and trucks for the United States and China, showing that even if the U.S. has an absolute advantage in both, it has a comparative advantage in planes, while China has a comparative advantage in trucks. This concept is crucial for understanding how trade can be beneficial even when one country is more efficient at producing all goods.

💡International Trade

International trade involves the exchange of goods and services across international borders. The video script uses the context of international trade to explore the concepts of absolute and comparative advantage, illustrating how countries like the U.S. and China can benefit from specializing in the production of certain goods and trading with each other. The script's discussion of trade helps to highlight the economic interdependence and cooperation among nations.

💡Opportunity Cost

Opportunity cost is the value of the next best alternative that is foregone when making a decision. In the script, opportunity cost is used to explain comparative advantage, as it is the loss of potential gain from choosing one option over another. For example, the U.S. has an opportunity cost of 100 trucks for every plane it produces, while China has an opportunity cost of 400 trucks for each plane, indicating that China has a comparative advantage in truck production.

💡Specialization

Specialization is the process by which countries or individuals focus on producing specific goods or services in which they have a comparative advantage. The video script emphasizes the importance of specialization in international trade, suggesting that countries should focus on producing goods where they have the lowest opportunity cost, allowing for more efficient use of resources and potentially greater overall production.

💡Resources

Resources in the context of the script refer to the inputs required to produce goods, such as labor, capital, and raw materials. The efficiency with which a country uses its resources to produce goods is a key factor in determining its absolute and comparative advantages. The script uses the concept of resources to illustrate how countries can benefit from trade by specializing in the production of goods where they use resources most efficiently.

💡Efficiency

Efficiency in the script is related to how well a country uses its resources to produce goods. A country is more efficient if it can produce more output with the same amount of input or the same output with less input. The concept of efficiency is central to understanding absolute advantage, as countries with absolute advantage are more efficient producers of certain goods.

💡Trade War

A trade war refers to a situation where countries impose tariffs or other trade barriers on each other's goods, leading to reduced trade and economic harm. The script briefly mentions trade wars as an example of a situation where resources might not move freely between industries, which could affect the principles of absolute and comparative advantage.

💡Global Pandemic

A global pandemic, like the one mentioned in the script, is a worldwide public health emergency caused by a disease. The script uses the example of a global pandemic to illustrate how such an event can disrupt the free movement of resources and the principles of international trade, affecting the ability of countries to specialize and benefit from trade as they normally would.

💡Product Features and Quality

Product features and quality refer to the characteristics and standards of the goods being produced. The script notes that these factors were not considered in the simplified examples of trade, but they are important in the real world. Different countries may produce goods with different features and quality levels, which can influence trade decisions and the benefits derived from trade.

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