If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked. We're going to talk more about markets in the future. Which is a situation that was unattainable left to their own production possibilities. • Everyone can benefit when people trade with one another. Now this is interesting, we can now compare their relative opportunity costs. If we go to the situation for Patty, let's swap these 2 around, the opportunity cost for 10 cups is 30 plates. If she wanted to produce 30 plates then she would have to give up 10 cups. Explain. As such, specialization and comparative advantage are related because a company that has a comparative advantage in the production of a certain item may choose to specialize in the production of that item. a. African countries b. European countries c. Middle Eastern countries d. Central American countries But obviously where they end up is dependent on how much the other one is willing to trade. This is not why she has a comparative advantage. She would have to give up 3 plates. This is called an absolute advantage, and we'll talk about that more. Understanding Production Possibilities. In this sense, the company in country A could decide to specialize in the production of orange juice since it has the comparative advantage due to easy access to raw materials. Specialization and Trade • Gains from trade are based on comparative advantage, not absolute advantage • Specialization and trade increase productivity within a nation and increase a nation’s output and standard of living. So let's see how they can actually do it. And let's think about her opportunity cost for producing a plate. So relative to Charlie, we say, because her opportunity cost is lower in producing plates, 1/3 relative to 3, we say that Patty has the comparative advantage in plates, relative to Charlie. By specializing they could get these gains of trade. So for Patty, especially when you measure it in terms of cups, it is cheaper for her to produce a plate. So what we can see is, for example, they can get an outcome where they are each able to get 15 cups and 15 plates, which would have been impossible left to their own devices. So, this makes sense for him because the market price is lower than his opportunity cost. Specialization And Trade When A Country Has A Comparative Advantage In The Production Of A Good, It Means That It Can Produce This Good At A Lower Opportunity Cost Than Its Trading Partner. It‘s cheaper this way. Based on the definition of specialization and comparative advantage, what area in the world could be said to have a comparative advantage in oil production? Comparative advantage is a term associated with 19th Century English economist David Ricardo.. Ricardo considered what goods and services countries should produce, … Specialization and Trade In general, a person (or country) will specialize in the activity in which she has a comparative advantage. Our mission is to provide a free, world-class education to anyone, anywhere. But let's say that they both want to get to that 15-15 scenario so they can both trade 15 cups to the other person. Well, if we divide both sides of this right over here by 3, well let's swap both sides, so the opportunity costs for Charlie of producing 3 cups, is equal to 1 plate. A country has a comparative advantage when a good can be produced at a lower cost in terms of other goods. This practice of producing only that which you have a comparative advantage in making is called specialization and allows for surpluses to be … Absolute Advantage is the country’s inherent ability that allows that country to produce specific goods efficiently and effectively at a relatively lower marginal cost.A country has an absolute advantage in producing a good if it can produce that good at lower marginal cost, lesser workforce, lesser time and lesser cost … And I'm going to fix the price here. The theory of comparative advantage provides a strong argument in favour of free trade and specialization among countries. Countries that specialize based on comparative advantage gain from trade. Here’s the next video in the Freedom Partner series, which looks at why trade (whether inside a nation or across borders) makes our lives better. Specialization and trade When a country has a comparative advantage in the production of a good, it means that it can produce this good at a lower opportunity cost than its trading partner. Comparative advantage drives specialization in the production of a good in a country as they have a lower opportunity cost and thus leads to higher production and better efficiency. Then The Country Will Specialize In The Production Of This Good And Trade It For Other Goods. It doesn't even have to be the case that she can produce more plates in a given day. And the same thing for Patty. Comparative Advantage. And they would both be able to get right over there. AP® is a registered trademark of the College Board, which has not reviewed this resource. And because this is a linear PPF his opportunity cost does not change. So he's going to specialize in cups, and Patty, for the same reason, is going to specialize in plates. Or if you divide both sides by 30, the opportunity cost of her producing 1 plate, in terms of cups, is 10 divided by 30, is 1/3, 1/3 of a cup. That's fair enough. And this makes sense for either of them because this trading price, or this market price, is lower than their opportunity cost. Khan Academy is a 501(c)(3) nonprofit organization. The basic difference between absolute and comparative advantage is that Absolute advantage is one when a country produces a commodity with the best quality and at a faster rate than another. And obviously, and we've talked about this before, the opportunity cost of 1 incremental unit is the same thing as the marginal cost of a cup. But now in the market, she would only have to give up 1 plate. The Comparative Advantage and Specialization chapter of this course is designed to help you plan and teach lessons on the concepts of comparative advantage and … If you divide both sides by 10, the opportunity cost of 1 cup is equal to 3 plates. The concept of comparative advantage was first formulated by economist David Ricardo as an explanation of the benefits of international trade for countries. So his opportunity cost of producing 10 plates, is equal to 30 cups. These factors also cause greater specialization based on comparative advantage. What Is a Sustainable Competitive Advantage. For instance, if ACB company and XYZ company both produce body lotion and body powder, the company that has the comparative advantage over the other can be found through an analysis of the opportunity cost for producing the two items. Comparative advantage and the gains from trade. If Patty focused all of her time on cups she could produce 10 cups in a day and if she focused all of her time on plates, she could produce 30 plates in a day. November 30, 2018 by Dan Mitchell. Self-sufficiency is one possibility, but it turns out you can do better and make others better off in the process. By using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country.Mexico started out, before specialization and trade, So, this is what his PPF is going to look like. Well to produce 10 plates, he's going to have to give up those 30 cups. Specialisation means a country will increase the output of one particular good. Also, while the principle of comparative advantage is typically introduced to explain international trade, this principle is the root reason for all specialization and trade. On the other hand, comparative advantage is when a country has the potential to produce a particular product better than any other country. Or if you want the opportunity cost for one plate, you just divide both sides by 10, and so you get the opportunity cost of 1 plate, is equal to 3 cups. That’s how we find comparative advantage: to sum up the main lessons, we benefit from specialization, the division of labor, and trade and when we specialize according to comparative advantage and trade, there’s more for everybody. Donate or volunteer today! They specialize in their comparative advantage. And we're going to assume he has a linear Production Possibilities Frontier. So this is a good deal, this is lower than her opportunity cost. Economics > Comparative Advantage. If XYZ produces the body lotion at $10 and the powder at $5, then its opportunity cost for producing the body lotion is $5, or one jar of powder. A country has an absolute advantage in those products in which it has a productivity edge over other countries; it takes fewer resources to produce a product. Peter Hann Date: January 29, 2021 Businessman giving a thumbs-up . Well, let's see, Charlie can produce a cup, or Charlie's opportunity cost for producing an extra cup is 1/3 of a plate, and Patty's is 3 plates. Just select one of the options below to start upgrading. Comparative Advantage vs. Absolute Advantage Absolute advantage is anything a country does more efficiently than other countries. David Ricardo and Comparative Advantage. Comparative advantage, specialization, and gains from trade, Comparative advantage and absolute advantage, Opportunity cost and comparative advantage using an output table, Input approach to determining comparative advantage, Lesson summary: Comparative advantage and gains from trade, Practice: Comparative advantage and the gains from trade. The orange juice example seems more like absolute advantage. What Are the Benefits of Comparative Advantage? So this is where Charlie has the comparative advantage. And let's say we have a producer, Charlie, and if he were to focus all of his time on cups, he could produce - let me put these [labels]10, 20, 30. This example shows that both parties can benefit from specializing in their comparative advantages and trading. So if he were to focus all of his time on cups, he could produce 30 cups, and if he were to focus all of his time on plates, he could produce 10 plates. So cup specialties. If ABC produces body lotion at $12 per jar, and produces body powder for $3 per jar, then the opportunity cost for producing body lotion is $9 or three jars of powder. comparative advantage in both activities (or goods). This will allow each country to trade and reduce its opportunity cost of the good it imports. Three weeks ago, I shared a video about the economics of trade balances. It's not that bow-shaped curve that we saw for the hunter gatherer. The lotion example is comparative advantage. Now imagine, I'm going to make an assumption here, but imagine that they both do that but they don't each only want to have what they're producing they want to have some combination of them, so they decide to trade. Wikibuy Review: A Free Tool That Saves You Time and Money, 15 Creative Ways to Save Money That Actually Work. She's going to produce 30 plates every day. Under a linear PPF, comparative advantage is constant so each country will specialize completely. And Patty could actually do the same thing: she could trade the cups for plates and end up someplace over there. So that is.. and she also has a linear production possibilities frontier, so that right over there is the PPF for Patty. She has all of these plates, but if she wants a cup, left by herself, she would have to spend 3 plates to do it. Nations that are blessed with an abundance of farmland, fresh water, and oil reserves have an absolute advantage in … Nonetheless there is a large amount of empiricalwork testing the predictions of comparative advantage. potential for both of the to benefit if they specialize in what they each have comparative advantage The reason why the company in country A has the comparative advantage is because it can produce the oranges at a cheaper cost than can the company is located in country B. If each country now specializes in one producing good then assuming constant returns to scale, the output will double. If you're seeing this message, it means we're having trouble loading external resources on our website. So Charlie specializing in cups means he's going to focus only on cups. So let's make him specialize in cups. What we're going to see is if both of these parties specialize in their comparative advantage and then trade, they can get outcomes that are beyond each of their individual production possibility frontiers. What Is the Difference between Comparative and Competitive Advantage? Nothing about the presence or absence of a geopolitical border separating two trading parties is essential. So that right over there is the PPF for Charlie. So, it's only 1/3 plate relative to 3 plates. So he would definitely rather get a plate in the market than have to do it by producing it himself. A follow up to my earlier post. The production possibility frontier shows the combinations … Comparative advantage takes a more holistic view, with the perspective that a country or business has the resources to produce a variety of goods. To use Khan Academy you need to upgrade to another web browser. Now let's think about his opportunity cost. Another way of identifying a comparative advantage is by analyzing the opportunity cost for the production of a commodity. So the opportunity cost, if she's sitting right over here, and she was focused all on cups, and if she wanted to produce 30 plates, and I'm intentionally using the end points to make the math more obvious. So she'll want to transact. Specialization and comparative advantage are separate but related concepts. Comparative advantage. Countries should specialize in the production of the good they have comparative advantage over other countries. But I assume that they agree to trade at 1 cup for 1 plate. Difference Between Absolute Advantage vs Comparative Advantage. However, for some industries increasing output may lead to diminishing returns. (Let me do this in a different color: magenta). Comparative advantage is a theory about the benefits that specialization and trade would bring, rather than a strict prediction about actual behavior. Advantages of Specialization The biggest advantage of specialization is that it reduces the risk of error as the person who is a specialist is less likely to commit a mistake in doing a particular task than a non-specialist person doing the same task. And Patty specializing in plates means that she's going to produce 30 plates every day. The slope of this line is not changing. So Charlie has the lower opportunity cost for producing a cup. So it's going to be a fixed opportunity cost for one product relative to the other, at any point along this production possibilities frontier. Yes. If you do everything better than anyone else, should you be self-sufficient and do everything yourself? The opportunity cost for Charlie to produce a plate is 3 cups, the opportunity cost for Patty to produce a plate is 1/3 of a cup. She has a comparative advantage because her opportunity cost is lower. 4. So her opportunity costs to produce 30 plates is equal to 10 cups. Therefore, if one has the comparative advantage in painting, the other will have the comparative advantage in wallpapering. Clearly, ABC should have comparative advantage in the production of powder and should specialize in this production, while XYZ should specialize in the production of body lotion. The empirical works usually involve te… Who has a comparative advantage in cups? To log in and use all the features of Khan Academy, please enable JavaScript in your browser. Should specialization and trade be based on absolute advantage or comparative advantage? Her opportunity cost for producing a plate is lower than it is for Charlie. to produce some particular good or service at a lower opportunity cost than other economic actors can. Let's now move away from the world of the hunter-gatherer and into the dinnerware market. What Is the Difference between Absolute Advantage and Comparative Advantage? So here's Charlie, he's got all of these cups, left to his own devices, if he wanted an extra plate he would have to spend 3 cups but now in the market, with this price over here, he only has to spend 1 cup for an extra plate. The concept of comparative advantage suggests that as long as two countries (or individuals) have different opportunity costs for producing similar goods, they can profit from specialization and trade. We draw a little bit, actually connect the 2 dots, so that's.. So we've said that Charlie has a comparative advantage in cups. This article seems to mix up comparative advantage with absolute advantage. So he's going to produce 30 cups every day. So hopefully you found that interesting. Specialization refers to a situation in which an entity chooses to focus on the production of an item due to several perceived benefits and advantages. Now let's think about the same scenario or let's think about another producer, in this market for dinner ware. The relationship between specialization and comparative advantage is mainly due to the fact that specialization could be the natural consequence of an identified comparative advantage. (In practice, governments restrict international trade for a variety of reasons; under Ulysses S. Grant, the US postponed opening up to free trade until its industries were up to strength, following the example set earlier by Britain. ) Specialization refers to a situation in which an entity chooses to focus on the production of an item due to several perceived benefits and advantages. First introduced by David Ricardo (pictured) in 1817, comparative advantage exists when a country has a 'margin of superiority' in the supply of a product i.e. So Charlie could trade 15 cups for 15 plates and obviously Patty would be trading 15 plates for 15 cups. So let's say we're sitting over here, this will just make things simple to just think about the end points, and he's producing 30 cups, what is his opportunity cost of producing 10 plates? An illustration of specialization and comparative advantage can be seen in a case where two companies located in different countries produce similar items. Assuming the item is orange juice and country A produces vast quantities of oranges while country B has to augment its weaker production with imported oranges, then, the company in country A has the comparative advantage. So let's say we're going to talk about two products -- two types of dinnerware. The Economics of Trade, Specialization, and Comparative Advantage. But anyway, who has the lower opportunity cost for producing cups? His theory concluded that a country could increase its income by specializing in certain products and services and selling these on the international market. Then the country will specialize in the production of this good and trade it for other goods. I want to make it more looking like a line, so that's about as good as I can do. Now let's think about it the other way around. And so they can do, each of them, so for example, Charlie could keep trading cups for plates and he could end up anywhere on this line over there. Let's call her Patty. It's only 1/3 of a plate relative to 3 plates. This cuts down on expenditure and logistics related to importing oranges. By instead concentrating on the things you do the “most best” and exchanging or trading any excess of those things with someone else for the things that person does the “most best,” you can both be better off. And it's not just because she can produce - We'll see situations in maybe the next video where we'll actually show this. Comparative advantage. The ability of one economic actor (an individual, a household, a firm, a country, etc.) We'll have cups on this axis, and we will have plates on this axis. His opportunity cost of producing a cup is lower than it is for Patty. Or if you divide both sides by 3, opportunity cost of 1 cup is 1/3 of a plate. It can be argued that world output would increase when the principle of comparative advantage is applied by countries to determine what goods and services they should specialise in producing. She has a lower opportunity cost than Charlie does in producing plates. Comparative advantage refers to a situation in which two entities may produce similar products, yet one entity might have an advantage over the other due to lower production costs or other identified factors. For plates and obviously Patty would be trading 15 plates for 15 plates obviously. Little bit, actually connect the 2 dots, so that 's as. 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