Question

1. What is comparative advantage, and why is it important in international trade? Contrast with the term "absolute advantage" and illustrate with an example (20%). 2. Briefly explain how short-term movements in the business cycle affect the trade balance (20%).

2. Briefly explain how short-term movements in the business cycle affect the trade balance (20%).

Answer 1

Comparative advantage- Comparative advantage when a firm is able to produce a good a particular good at lower opportunity cost than its other trading partners.

The advantage is that firm cam sell their goods and services at lower price than its competitors.

[Opportunity cost- When someone is losing his/her opportunity to consume something because of its cost and looking for another something (similar). Actually Opportunity cost is the value of next best alternatives.]

Why comparative advantage important for international; trade

1. Both parties are benefitted from trading as the opportunity cost is low

2. Domestic firms will be encouraged to produce more good, export will increase imbalance in trade will decrease.

3. A competition will be seen and indicate a healthy economy

Absolute advantage can be achieved when a firm can produce a good with fewer resources or with same resources but at less time.

For example let firm A can produce 60 computers in 30 days and another firm B can produce 30 computers in 30 days

That means firm A takes 1 day to produce 2 computers and on the other hand Firm B making 1 computer per day.

Or, both the firms are making 60 computers, firm A takes 1 month but firm B takes 2 months for it.

Comparative advantage- when a firm is able to sell a product at lower opportunity cost

Assume that two firms A and B are renowned for producing TV and radio. Firm A can produce either 10 TVs or 5 radios

Opportunity cost of manufacturing one TV is 5/10 or 0.5 radios. On the other hand for Radio it will be 10/5 or 2 TVs

To get the comparative advantage firm B need to make a TV at opportunity cost should be less than 0.5, or in case of radio it should be less than 2.