Absolute and comparative advantages (HL)
Absolute advantage: when a country can produce more of a good and service than another country with the same amount of resources. This is a result of productivity a country may be more efficient at producing certain goods than others.
As shown in the diagram, country green has the absolute advantage in the production of good Y because the PPC cuts the axis higher than country grey. Whereas, country grey has the absolute advantage in the production of good X.
According to the theory of absolute advantage, if a country is absolutely more efficient in the production of both goods, then there is no reason for it to specialise and engage in trade. This would be illustrated if the PPCs did not intersect.
Comparative advantage: when a country can produce a given amount of output at a lower opportunity cost than another country. Therefore, it gives up less resources than other countries in producing the concerned good or service.
As shown in the diagram, country green has the absolute advantage in the production of both goods. However, according to the theory of comparative advantage, trade is still worthwhile because there is a difference in opportunity cost. Country grey has the comparative advantage in the production of good X, whereas country green has the comparative advantage in the production of good Y.
Opportunity cost of producing the good on the horizontal = ΔY/ΔX
Comparative advantage is a result of a difference in factor endowments and technology. For instance, countries differ in the quality and quantity of factor of production, including stock of human, natural and physical capital. Technology is embodied in physical capital and therefore also has an effect on the productivity of country and its comparative advantage.
The exchange rate can also have an effect on the comparative advantage because an exchange rate that is appreciating will make exports less competitive, whereas a depreciating exchange rate will have the opposite effect.
Assumptions of comparative advantage:
Constant costs of production as the PPCs are linear – economies of scale and increasing returns to scale mean that costs tend to depend on output
Perfect mobility of factors of production within a country – in reality workers are often geographically and occupationally immobile
No transaction costs
Perfect competition in markets
Free trade without barriers