Microeconomics – Comparative & Absolute Advantage
This article follows on from the previous gains from trade article. People consume goods produced domestically and overseas. Interdependence and trade mean more goods and services are available in increased variety. Differences in costs determines the value of trade.
Production costs -> absolute advantage. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.
Opportunity costs -> comparative advantage. The producer that requires a smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.
The gains from trade are based on comparative advantage, not absolute advantage. As people specialise in those activities in which they have a comparative advantage. David Ricardo in his 1817 book Principles of Political Economy and Taxation, developed the Principle of Comparative Advantage as we know it today. Comparative advantage and differences in opportunity costs are the basis for specialised production and trade. Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade. Trade can benefit everyone in a society because it allows people to specialise in activities in which they have a comparative advantage.