Comparative advantage

Econ HL
Mr. Sasaki
10/6/09
Past Paper Question: Using the principle of comparative advantage, explain why economic theory suggests that countries should specialize and trade with each other.

First I will like to define what comparative advantage is. Comparative advantage is a principle of economics which states that trade between two countries will be mutually beneficial as long as their domestic opportunity costs of production differ. Countries should specialize and trade with each other because it allows each country to allocate their resources more efficiently saves time. Thus, if one country is able to a produce a good more cheaply because they have better natural resources and are specialized to it, which is juxtaposed to an other good produced domestically, then another country, trade become essential. The only time a country shouldn’t trade is when the country has established absolute advantage, which means they are able to produce goods more cheaply than absolute terms and another country. Moreover, this means the country has already maximized their resources efficiently and received no benefit in trade.
Furthermore, there are limitations in the comparative advantage theory, which should be taken in account for. First of all there are transport cost and tariffs, the government can levied tax on import goods on either Valorem tax or a specific tax based on quantity which protects countries revenue against foreign countries.

Example.

Hardware  (units)    Software (units)
Japan    100    500
China    50    750
Total consumption    150    1250

Hardware (units) Japan
1 units of hardware = 5 software      ← lower opportunity cost
(100/100 = 500/100)
Hardware (units) China
1 units of hardware = 15 software
(50/50 = 750/50)

Software (units) Japan
1 units of software = 0.2 hardware
(500/500 = 100/500)
Software (units) China
1 units of software = 0.06    ← lower opportunity cost

Since trade benefits both countries, Japan should specialize in hardware since for them the opportunity cost is much lower then China. Conversely, China should specialize in software since for them the opportunity cost is much then Japan.

~ by scioneconblog on October 6, 2009.