Absolute and Comparative Advantage

• absolute advantage principle background: in 1776, Scottish political economist Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations, attacking the mercantilist view by suggesting that nations have much to benefit from free trade. By minimizing imports and maximizing exports, a country wastes much of its national resources by having to produce products it is not suited to produce efficiently, reducing the wealth of the nation as a whole.
• absolute advantage principle: nations differ in their ability to produce a product efficiently
• absolute advantage principle states that a country benefits by producing primarily products in which it has an absolute advantage - those that it can produce using fewer resources than any other country
• comparative advantage background: in his 1817 book The Principles of Political Economy and Taxation, British political economist David Ricardo explained why it's beneficial for two countries to trade even though one may have an absolute advantage in production of all products
• the comparative advantage principle states that it'll be beneficial for two countries to trade with each other as long as one is relatively more efficient at producing goods or services needed by other
• the principle of comparative advantage is the foundational logic for free trade among nations today
• comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners
• the comparative advantage view is optimistic because it implies that a nation need not be the first, second, or even third best producer of a particular product to benefit from international trade
• the comparative advantage view implies that it's generally advantageous for all countries to participate in international trade
• Initially for national efficiency differences, scholars focused on the importance of resource advantages such as fertile land, abundant minerals, and favorable climate. Because South Africa has extensive mineral deposits, it produces and exports diamonds. Because Brazil has abundant fertile land and a suitable climate, it produces and exports wheat and beef.
• In addition to natural advantages, countries can also create or acquire comparative advantages. A few decades ago, Japan intentionally acquired many advantages that benefited its consumer electronics industry. Companies such as Hitachi, Panasonic, and Sony invested massive resources to acquire the knowledge and skills needed to become world leaders in consumer electronics.
• limitations of absolute and comparative advantage theories:

  1. government restrictions such as tariffs, import barriers, and regulations
  2. government investments in certain industries to build competitive advantage
  3. economies of scale
  4. entrepreneurial and innovative firms
  5. international shipping and insurance
  6. today, traded goods are relatively complex
  7. many services can't be exported