Question

Decipher numerical examples of absolute and comparative advantage by analyzing gains from trade and differentiating among concepts of absolute advantage, comparative advantage, and competitiveness.

Answer 1

the classic example of absolute and comparative advantage is given by mr. paul krugmen in his book. since it was very helpful, i am going to cite the same example.

now there are two countries home and foreign. and there are two goods cheese and wine.

unit labour requirements are define as the no. of labour required the produce 1 unit of each good. now the theory of comparative advantage ha one main assumption that there is only 1 resource used in the production of both goods ad that is labour. and the countries have to allocate their labour between the two sectors.

if alc and alw re the unit req. of labour in home for cheese and wine and alc* and alw* are the same i foreign. let alc=1 and alw=2 and alc*=6 alw*=3

now with this ex, 1 units of labour are used to produce 1 unit of cheese n home and 6 units of labour are required to do the same in foreign, so since more labour are required to produce the same 1 unit of cheese in foreign, home has absolute advantage of production of cheese.

coming on to wine , alw= 2 and alw*= 3 again less labour are required in home to produce 1 unit of wine here than in foreign, we say home has absolute advantage in the production of wine also.

however when we talk about trade we don't just take into account the absolute advantage but we take comparative advantage. it is basically reflected by the opportunity cost of producing 1 unit of cheese here and in foreign. is the opp. cost of producing cheese here is less, home specialises by producing cheese.

here 1 unit of cheese production require 1 labour, by these 2 labour 2 units of wine would have been produced. so opportunity cost is 1/2.

in foreign, 1 unit of cheese req. 6 labour and by this 6 labour 3 wine would have been produced. thus to produce 1 unit of cheese 2 units of wine are sacrificed.

thus home has a comparative advantage in producing cheese.

if we talk about wine, to produce 1 unit of wine 2 labour are req, 2 cheese would have to be sacrificed for that o opp. cost is 2

in foreign 3 labour are req to produce 1 unit of wine and that would lead to sacrifice of 1/2 units of cheese.

thus producing 1 unit of wine has a lower sacrifice of cheese in foreign than in home so foreign has comparative advantage in producing wine.

in this way 1 country specialises in production of cheese and 1 in wine and then they export and import the commodities ad so gains from trade are that by trading each country is in a position to consume more than what it produces.