Comparative and Absolute Advantage

• Who developed the idea of comparative advantage?

  David Ricardo
• What is comparative advantage?

  It exists when a country's relative opportunity cost of production for a good is lower than in another country.
• What are the two conditions for comparative advantage?

  1. Lower relative opportunity cost 2. More productive efficiency
• What is the basic rule of comparative advantage?

  Specialize in the goods and services that you are relatively best at.
• What are the potential gains from specialization and trade?

  • More efficient allocation of scarce resources
  • Increased total output
  • Better economic welfare
• What is absolute advantage?

  It occurs when a country can produce a product using fewer resources than another nation.
• How does a country demonstrate absolute advantage?

  If it can produce more of a product using the same factors of production.
• What is the focus of comparative advantage?

  It focuses on having lower relative opportunity costs when specializing in a product.
• What is the Factor Endowment model?

  • Developed by Heckscher and Ohlin
  • Countries with relative factor abundance can specialize and trade
  • Exports embody the abundant factor; imports embody the scarce factor
• What happens when a country has an abundance of skilled labor?

  It can specialize and export goods produced by countries with unskilled labor abundance.
• What does the comparative advantage lead to in terms of economic welfare?

  Increased total output and better allocative efficiency.
• What is a key assumption of the comparative advantage theory regarding factors of production?

  That factors of production are fixed and immobile between countries.
• What does the comparative advantage theory assume about cost conditions?

  That cost conditions are stable and do not allow for sudden changes.
• What is one flaw in the comparative advantage theory regarding economies of scale?

  It does not allow for the theory of economies of scale or the law of diminishing returns.
• What are the key assumptions behind the theory of comparative advantage?

  1. Constant returns to scale
  2. Factor mobility between industries
  3. No import controls
  4. Low transportation costs
  5. Ignores externalities of production/consumption
  6. Terms of trade may not benefit both countries equally
• What is intra-industry trade?

  Trade between countries that export and import similar products.
• What are the key factors determining comparative advantage?

  1. Quantity and quality of natural resources
  2. Demographics
  3. Rates of capital investment
  4. Investment in research & development
  5. Fluctuations in exchange rates
  6. Import controls
  7. Non-price competitiveness
  8. Institutions
• What is the formula for terms of trade?

  Index of average export prices x 100 / Index of average import prices
• What does the terms of trade determine?

  The gains from trade.
• What are the short-run and long-run aspects of terms of trade?

  • Short-run: Volatility of supply
  • Long-run: Deterioration