MS 97 IGNOU MBA Solved Assignment -What is the concept of comparative cost advantage? Critically examine the concept with suitable examples.

What is the concept of comparative cost advantage? Critically examine the concept with suitable examples.

Ans : The key to understanding the concept of comparative advantage is to understand that all costs are in terms of marginal opportunity cost. But before we begin the analysis, let’s define some important terms:

Marginal opportunity cost: The number of units of one good that do not get produced when one additional unit of another good is produced.

Absolute advantage: The ability of an economic entity to produce a greater amount of some good (relative to resource use) than another entity can (i.e. is more efficient with respect to resource use).

Comparative advantage: An economic entity’s ability to produce a good at a lower marginal opportunity cost than some other entity.

Exchange costs: The costs of the resources used in making trades; includes transaction costs, transportation costs, and artificial barriers to trade (i.e. government restrictions such as tariffs and import quotas).

Terms of trade (trading ratio): The number of units of one good that exchange in the market for one unit of some other good.

In order to begin the analysis we first must make some assumptions:

ASSUME: There are only two countries and there is only one factor of production—labor. Also assume both countries make two goods: cheese and bread.

It takes 3 labor hours to produce 1 pound of bread and 1 labor hour to produce 1 pound of cheese in the U.S. It takes 6 labor hours to produce 1 pound of bread and 3 labor hours to produce 1 pound of cheese in England:

The U.S. has an absolute advantage in producing both bread and cheese because it takes less labor hours to produce them in the U.S. In order to determine which country has a comparative advantage in one or both goods, we must determine the marginal opportunity costs for both countries.

The marginal opportunity cost of producing 1 pound of bread in the U.S. is 3 pounds of cheese (since in order to produce the 1 pound of bread the U.S. must use 3 labor hours—which could have been used to make 3 pounds of cheese). The marginal opportunity cost of producing 1 pound of cheese in the U.S. is 1/3 of a pound of bread. In England, the marginal opportunity cost of producing 1 pound of bread is 2 pounds of cheese and the marginal opportunity cost of producing 1 pound of cheese is ½ of a pound of bread.

Therefore, the U.S. has a comparative advantage in the production of cheese and England has a comparative advantage in the production of bread. The U.S. should specialize in producing cheese and England should specialize in producing bread. Why?

ASSUME: There are 1200 labor hours available in each country and these hours are divided equally between producing bread and cheese. Therefore there are 600 labor hours available for producing cheese and 600 available for producing bread in both countries.

Therefore, production before specialization and trade will be as follows:

U.S. :  Bread = 200 pounds 

           Cheese = 600 pounds

                 Cheese = 200 pounds Bread = 300 pounds  Cheese = 800 pounds U.S. :  Bread = 195, Cheese = 615  England:  Bread = 106, Cheese = 188 Cheese = 800 pounds Cheese = 803 pounds

England:  Bread = 100 pounds 

Total world production: 

Because the U.S. has a comparative advantage in one good and England has a comparative advantage in the other good there is the opportunity for trade to take place that would benefit both countries.

England will be willing to give up 1 pound of bread if it can get anything more than 2 pounds of cheese in return (because 2 pounds of cheese is England’s cost of producing 1 pound of bread). The U.S. will be willing to export up to 3 pounds of cheese if it can get more than 1 pound of bread in return (because 1 pound of bread is the U.S.’s cost of producing 3 pounds of cheese).

ASSUME: A trading ratio between the two countries is 2.5 pounds of cheese to 1 pound of bread. (Which means 2.5 pounds of cheese is worth 1 pound of bread and vice versa).

Therefore:

If England exports 6 pounds of bread it uses 36 labor hours to produce these 6 pounds of bread (6 x 6 = 36). England’s cost of producing these 6 pounds of bread is 12 pounds of cheese (36 / 3 – 12). However, England will receive 15 pounds of cheese in exchange for the 6 pounds of bread: 6 pounds of bread x 2.5 = 15 pounds of cheese. WHAT A DEAL!!!

The U.S. will then import the 6 pounds of bread and must pay the 15 pounds of cheese in exchange. In order to produce the 15 pounds of cheese it must use 15 labor hours (15 x 1 = 15). The U.S.’s cost of producing these 15 pounds of cheese is 5 pounds of bread (15 / 3 = 5). However, the U.S. will receive 6 pounds of bread in exchange for the 15 pounds of cheese: 15 pounds of cheese / 2.5 = 6 pounds of bread. AGAIN, WHAT A DEAL!!!

Both countries are, therefore, better off with the exchange: England has just as much bread and more cheese. The U.S. has just as much cheese and more bread.

AND ALSO IMPORTANT: Total world production after specialization and trade has increased:

Production after trade: 

Total world production before specialization and trade:

Bread = 300 pounds 

Total world production after specialization and trade:

Bread = 301 pounds 

IT’S A MIRACLE!!!

CONCLUSION: WITH SPECIALIZATION AND TRADE TOTAL WORLD PRODUCTION WILL INCREASE AND BOTH COUNTRIES WIL BE BETTER OFF WHEN EACH COUNTRY PRODUCES MORE OF THAT GOOD IN WHICH IT HAS A COMPARATIVE ADVANTAGE.

Note: We have assumed away exchange costs. They must also be accounted for when calculating the benefits of specialization and trade.