So, why would countries trade with each other? Well, part of the answer is because countries have different advantages and disadvantages in terms of:
EXAMPLEFor example, some countries will have an advantage in labor-intensive raw materials, while others have the advantage in capital-intensive goods.
The United States has the potential to produce many goods and services because we have many natural resources, sophisticated technologies, and a trained, highly skilled, and educated workforce.
Does that mean, though, that we should not trade with others who might be slightly less efficient?
EXAMPLEWhenever the United States decides to devote resources, like land, labor, and capital, to producing textiles, we give up the opportunity to use those resources to produce something else, like cars, because our land, labor, and capital are scarce. There is a limited amount of them. Therefore, what is given up is our opportunity cost.
Absolute advantage is the advantage conferred between two countries where one country clearly has a lead in the production of a given good relative to the amount of needed inputs.
Let's explore the concept of absolute advantage by walking through an example in context.
In this case, the United States enjoys an absolute advantage in both activities, because they are absolutely more productive.
Absolute advantage is defined as advantage conferred between two countries, where one country clearly has a lead in the production of the given good relative to the amount of needed inputs.
An easy way to remember the concept of absolute advantage is, "Who is better at it?"
So, how should these countries divide the tasks? Well, we must figure out who has the lower cost for each activity, and this utilizes the theory of comparative advantage.
Comparative advantage is advantage conferred with a country to one good's production relative to another.
So, if the United States and Mexico divide the tasks most efficiently by specializing in the task for which they have the lower opportunity cost, then both countries will benefit.
Therefore, we need to determine who gives up less in terms of textiles when they produce cars, and who gives up less in terms of cars when they produce textiles. Let's outline the relevant information in chart form.
|Output in a Production Period|
Now, as mentioned, you can see that the United States has an absolute advantage in both cars and textiles because they can produce more.
So, who should produce each good? What we have to look at now is opportunity cost.
This chart outlines the opportunity cost per country of producing one car.
|Opportunity Cost of Production|
|United States||1/3 Textile||3 Cars|
|Mexico||1/2 Textile||2 Cars|
Every time the United States produces one car, the cost is what they give up in terms of textiles. In this case, they give up one-third of a textile for one car, determined by dividing textiles by cars.
When they decide to produce one textile, they give up three cars.
We calculate the same thing for Mexico, and as you can see, the United States has the lower opportunity cost in producing cars, and Mexico has the lower opportunity cost in producing textiles.
If they specialize in trade according to this, they will both end up with more cars and textiles, known as gains from trade, which we will cover in the next section.
This concept can be a bit tricky, so let's continue with our current example to understand it fully.
Let's say the United States is now going to devote all resources to producing cars. If you recall, in a production period, they are able to produce 21 cars.
|Output in a Production Period|
For simplicity's sake, we will assume an even, one-to-one trade, so if they want, for instance, five textiles, they will have to trade away five cars, leaving them with 16 cars and five textiles.
Now, if we assume that they devote half of their resources into cars and half into textiles--producing both items--they are left with 10.5 cars and 3.5 textiles.
|U.S.: Before and After Specialization|
Their gains from trade are 5.5 cars and 1.5 textiles.
Even though the United States enjoys an absolute advantage in the production of both items, they are still better off when they specialize in trade with Mexico. In the same way that two people can get more accomplished by specializing, so can we.
Now, a production possibility frontier, or PPF, shows us the maximum combination of two goods that can be produced when an economy's resources are being utilized.
It is somewhat similar to the long-run aggregate supply curve, except this is a different graph completely, because here, we are not graphing the price and quantity of something.
Instead, we are graphing all the textiles that can be produced (y-axis) versus cars (x-axis). Notice that we have plotted the numbers from our previous example, that show the number of each item that each country can produce in a production period.
The x-intercept means how many cars can be produced when all resources are devoted to car production (specialization).
The y-intercept represents how many textiles can be produced with specialization in textiles.
You can easily see an absolute advantage. On the x-intercept, who can produce more? The U.S. On the y-intercept, who can produce more? Again, it is the U.S.
Comparative advantage, though, can be seen by looking at the slope. The slope represents the trade-off, or how many of one item has to be sacrificed in order to produce one more unit of the other.
If you think about it, the country with the flatter slope is going to have a comparative advantage in the item on the x-axis.
EXAMPLEThe United States is giving up fewer textiles every time they produce one more car.
The country with the steeper slope is going to have the comparative advantage in the y-axis item because they will be giving up fewer of the item on the x-axis-- in this case, fewer cars when they are producing one more textile.
Now, it may seem complicated, but it does make sense if you recognize that the PFF represents a trade-off for every time we produce one more, versus how many we give up in terms of the other good.
As we calculated earlier, when the United States and Mexico trade according to comparative advantage--using the United States PPF here--you can see that the United States gains 5.5 cars and 1.5 textiles.
This gain is outside of our initial possibility, which is how we can show economic growth.
Source: Adapted from Sophia instructor Kate Eskra.