Discuss the meaning and role of absolute advantage and comparative advantage.
Absolute advantage and comparative advantage are two important concepts when transactions between two parties are involved, for example trade between two countries, two states or even two manufacturers in the same city.
As an illustration assume that manufacturers in China are able to produce all products at a lower cost than manufacturers in the US. This is due to the fact that labor and raw materials are cheaper in China than they are in the US. In such a case it does not make sense for the Chinese to buy anything from the US and by buying all its products from China, the US utilizes its financial resources in a more efficient manner. There would then be only a one way movement of goods according to the concept of absolute advantage.
But in spite of one of two parties having an absolute advantage in everything there can be an exchange of different products between the two due to a concept called comparative advantage.
To illustrate this, assume farmers in China can grow rice as well as maize and on every square unit of land they can grow either 5 tonnes of rice or 4 tonnes of maize. Farmers in the US can grow 3 tonnes of rice and 3 tonnes of maize on every square unit of land in their nation. Here, it is obvious that the Chinese have an absolute advantage over the Americans in both maize as well as rice, but still trade can take place between the two. Here comes in the concept of comparative advantage. If only rice and maize are considered, for every 4 tonnes of maize grown, the Chinese farmer misses out on growing 5 tonnes of rice while the American farmer only loses out on growing 3 tonnes of rice for every 3 tonnes of maize grown. The American farmer is said to have a comparative advantage over the Chinese in growing maize. The Chinese can utilize all their land to grow rice and the Americans can grow only maize in their farms and the two can trade these with each other.
This example shows how trade between two parties is possible in spite of one of them having an absolute advantage in everything due to comparative advantage that each has in some goods that can be traded.