Question

What is the basis for trade (absolute or comparative advantage)? How can an individual or a country gain from specialization and trade (please use an example).

Answer 1

Absolute Advantage:

Absolute advantage is the ability of a country to produce a good or service at a lower per unit cost as compared to any other country that produces same good or service.

Comparative Advantage

Comparative cost advantage theory was formulated by Ricardo. This model of international trade is also referred as 2X2X1 model. It means that there are 2 countries producing 2 goods by using only one factor of production i.e. labor.

According to this theory, A country has a comparative advantage in producing that good if the opportunity cost of producing that good is lower in that country as compared to another country. This approach in which international trade arises due to difference in productivity of labor is known as Ricardian Model of International Trade.

Let us assume that there are two countries, UK and India who produces rice and tea.

UK requires 4 and 5 units labor to produce 1 unit of tea and rice respectively. On the other hand, India requires 5 and 4 units of tea and rice respectively.

So, Opportunity cost in UK:

4 units of tea = 5 units of rice

implies, 1 unit of tea = 5/4 or 1.25 unit of rice or 1 unit of rice = 4/5 or 0.8 units of tea

Opportunity cost in India:

5 units of tea = 4 units of rice

implies, 1 unit of tea = 0.4 unit of rice or 1 unit of rice = 1.25 units of tea

Since, opportunity cost of producing tea is less in India, so India has comparative advantage in the production of tea. Opportunity cost of producing rice is less in UK so UK has comparative advantage in the production of tea.

When India produces only tea while UK produces only rice then both countries gains from trade because they are able to consume more goods that without specialization.