Absolute Advantage

INTERNATIONAL TRADE AND INVESTMENT THEORY

COLLEGE OF AGRIBUSINESS MANAGEMENT PANTNAGAR

ABSOLUTE ADVANTAGE  Export those goods and services for which a country is

more productive than other countries



Import those goods and services for which other

countries are more productive than it is

Australia has more agricultural land but less labor, and capital, and mines 3 than Great Britain; consequently, Australia is better adapted to the production of goods that require great quantities of agricultural land, whereas Great Britain has an advantage in the production of goods requiring considerable quantities of other factors.

Australia vs Great Britain

MUTUAL ABSOLUTE ADVANTAGE YIELD PER ACRE OF WHEAT AND COTTON Wheat Cotton

INDIA

BANGLADESH

6 MT 2 MT

2 MT 6 MT

•In this example, India can produce three times the wheat that Bangladesh can on one acre of land, and Bangladesh can produce three times the cotton. We say that the two countries have mutual absolute advantage.

MUTUAL ABSOLUTE ADVANTAGE •Suppose that each country divides its land to obtain equal units of cotton and wheat production.

TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE, MUTUAL AND 100 INDIAABSOLUTE ADVANTAGE, BANGLADESH 25 acres x 6 MT/acre 75 acres x 2 MT/acre AVAILABLE ACRES Wheat

Cotton

150 MT 75 acres x 2 MT/acre 150 MT

150 MT 25 acres x 6 MT/acre 150 MT

GAINS FROM SPECIALIZATION  An agreement to trade 300 MT of wheat for 300 MT

of cotton would double both wheat and cotton consumption in both countries. PRODUCTION AND CONSUMPTION OF WHEAT AFTER SPECIALIZATION PRODUCTION CONSUMPTION India

Wheat Cotton

Bangladesh

100 acres x 6 MT/acre 0 acres 600 MT 0 0 acres 100 acres x 6 MT/acre 0 600 MT

India

Bangladesh

300 MT

300 MT

300 MT

300 MT

PRODUCTION POSSIBILITY FRONTIERS FOR BANGLADESH AND INDIA BEFORE TRADE

Bangladesh

India

 Because both countries have an absolute advantage in

the production of one product, specialization and trade will benefit both.

GAINS FROM SPECIALIZATION Bangladesh

India

COMPARATIVE ADVANTAGE  Produce and export those goods and services for

which it is relatively more productive than other countries

 Import those goods and services for which other

countries are relatively more productive than it is

COMPARATIVE ADVANTAGE WITH MONEY One is better off specializing in what one

does relatively best  Produce and export those goods and services

one is relatively best able to produce  Buy other goods and services from people

who are better at producing them

GAINS FROM COMPARATIVE ADVANTAGE

MT INDIA

BANGLADESH

INDIA

MT

MT INDIA

BANGLADESH

BANGLADES H

MT

GAINS FROM COMPARATIVE ADVANTAGE  To illustrate the gains from comparative advantage,

assume (again) that in each country people want to consume equal amounts of cotton and wheat. Now, each country is constrained by its domestic production possibilities curve, as follows: YIELD PER ACRE OF WHEAT AND COTTON Wheat Cotton

India

Bangladesh

6 MT 6 MT

1 MT 3 MT

GAINS FROM COMPARATIVE ADVANTAGE TOTAL PRODUCTION OF WHEAT AND COTTON ASSUMING NO TRADE AND India 100 AVAILABLE ACRES Bangladesh

Wheat Cotton

50 acres x 6 MT/acre 300 MT 50 acres x 6 MT/acre 300 MT

75 acres x 1 MT/acre 75 MT 25 acres x 3 MT/acre 75 MT

 The gains from trade in this example can be

demonstrated in three stages.

GAINS FROM COMPARATIVE ADVANTAGE  Stage 1: Bangladesh transfers all its land into cotton

production. India cannot completely specialize in wheat because it needs 300 MT of cotton and will not be able to get enough cotton from Bangladesh (if countries are to consume equal amounts of cotton and wheat).

REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE STAGE ABSOLUTE ADVANTAGE 1 India Bangladesh

Wheat Cotton

50 acres x 6 MT/acre 300 MT 50 acres x 6 MT/acre 300 MT

0 acres 0 100 acres x 3 MT/acre 300 MT

GAINS FROM COMPARATIVE ADVANTAGE  Stage 2: India transfers 25 acres out of cotton and

into wheat. REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE STAGE ABSOLUTE ADVANTAGE 2 India Bangladesh

Wheat Cotton

75 acres x 6 MT/acre 450 MT 25 acres x 6 MT/acre 150 MT

0 acres 0 100 acres x 3 MT/acre 300 MT

GAINS FROM COMPARATIVE ADVANTAGE Stage 3: Countries trade REALIZING A GAIN FROM TRADE WHEN ONE COUNTRY HAS A DOUBLE STAGE ABSOLUTE ADVANTAGE 3 India Bangladesh

Wheat Cotton

100 MT (trade) 350 MT

100 MT

(after trade) 200 MT (trade) 350 MT (after trade)

100 MT

DIFFERENCES BETWEEN COMPARATIVE AND ABSOLUTE ADVANTAGE 

A country enjoys an absolute advantage over

another country in the production of a product if it uses fewer resources to produce that product than the other country does.



A country enjoys a comparative advantage in the

production of a good if that good can be produced at a lower cost in terms of other goods.

  

ABSOLUTE ADVANTAGE VERSUS COMPARATIVE ADVANTAGE  Absolute versus relative productivity differences  Comparative advantage incorporates the concept of

opportunity cost



GAINS FROM COMPARATIVE ADVANTAGE Even if a country had a considerable absolute

advantage in the production of both goods, then specialization and trade are still mutually beneficial.

 When countries specialize in producing the goods in

which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently.

GAINS FROM COMPARATIVE ADVANTAGE The real cost of producing cotton is the wheat that

must be sacrificed to produce it.

 A country has a comparative advantage in cotton

production if its opportunity cost, in terms of wheat, is lower than the other country.

FACTOR ENDOWMENT THEORY Comparative advantage is explained by factor

endowments. Trade takes place because of differences in factor endowments.

 Nations export products that use inputs which are

relatively abundant (cheap) at home, and import products which need inputs which are relatively scarce (expensive) at home.



HOW DOES A COUNTRY DIFFERENTIATE FROM ANOTHER? ß There should be some kind of natural distinction between regions. ß ßThe principal criterion used to differentiate one region from another is its endowment with factors of production. ß ßHence, regions have different factor endowments, while the factors within a region are essentially similar.

ASSUMPTIONS Two countries, two goods & two factors One good labor intensive & the other capital

intensive Same technology Same taste (same indifference curves) Incomplete specialization Constant returns to scale Perfect competition in both goods & factor markets Factors mobile domestically but not internationally No transportation costs or restrictions on trade

FACTOR ENDOWMENT THEORY: IMPLICATIONS Factor price equalization  The shift within each nation towards use of cheaper factors, and away from expensive ones, leads to more equal factor prices (if factors are mobile)

 Distribution of income  Trade changes domestic distribution of income as demand for different factors changes

 Tests of factor endowment theory  Emphasize the importance of varieties of different factors (such as human capital) and accounting for changes in resource endowment; other explanations are also important

SOME COMMENTS ON FACTOR ENDOWMENT THEORY Factor endowment theory breaks away from the

classical labor value theory and tries to explain the reason of international trade in an entirely new way. Heckscher-Ohlin theory holds that comparative advantages enjoyed by different countries are the prerequisite of trade. These comparative advantages, however, do not come from the relative differences in labor inputs of production as the classical economists described. It is the differences in a country’s production factor endowment that determines the production costs of different countries and thus their respective comparative advantages in international trade.

PRODUCT LIFE CYCLES & OTHER THEORIES OF INTERNATIONAL BUSINESS  The Product Life Cycle (PLC) is based upon the biological life cycle.

For example, a seed is planted (introduction); it begins to sprout (growth); it shoots out leaves and puts down roots as it becomes an adult (maturity); after a long period as an adult the plant begins to shrink and die out (decline).

  In theory it's the same for a product. After a period of development it is

introduced or launched into the market; it gains more and more customers as it grows; eventually the market stabilizes and the product becomes mature; then after a period of time the product is overtaken by development and the introduction of superior competitors, it goes into decline and is eventually withdrawn.

The Product Life Cycle (PLC)  However, most products fail in the introduction phase.

Others have very cyclical maturity phases where declines see the product promoted to regain customers.



The Product Life Cycle (PLC)  Introduction.

The need for immediate profit is not a pressure. The product is promoted to create awareness. If the product has no or few competitors, a skimming price strategy is employed. Limited numbers of product are available in few channels of distribution.  Growth.  Competitors are attracted into the market with very similar offerings. Products become more profitable and companies form alliances, joint ventures and take each other over. Advertising spend is high and focuses upon building brand. Market share tends to stabilise. 

The Product Life Cycle (PLC) Maturity. 

Those products that survive the earlier stages tend to spend longest in this phase. Sales grow at a decreasing rate and then stabilize. Producers attempt to differentiate products and brands are key to this. Price wars and intense competition occur. At this point the market reaches saturation. Producers begin to leave the market due to poor margins. Promotion becomes more widespread and use a greater variety of media.

The Product Life Cycle (PLC) Decline. 

At this point there is a downturn in the market. For example more innovative products are introduced or consumer tastes have changed. There is intense price-cutting and many more products are withdrawn from the market. Profits can be improved by reducing marketing spend and cost cutting.

Product Life-Cycle Theory  The product life-cycle theory is an economic theory that was

developed by Raymond Vernon in response to the failure of the Heckscher-Ohlin model to explain the observed pattern of international trade. The theory suggests that early in a product's life-cycle all the parts and labor associated with that product come from the area in which it was invented. After the product becomes adopted and used in the world markets, production gradually moves away from the point of origin. In some situations, the product becomes an item that is imported by its original country of invention.

The International Product Life Cycle: Innovating Firm’s Country

The International Product Life Cycle: Other Industrialized Countries

The International Product Life Cycle: Less Developed Countries