Absolute advantage is achieved when a producer can produce a good using fewer resources than another producer.
Comparative advantage is achieved when a producer can produce a good at a lower opportunity cost than another producer.
The difference between the two therefore, is that comparative advantage takes into account opportunity cost. If, using the same resources, China can produce 10 cars and 3 houses while Switzerland can only produce 5 cars and 1 house, China has an absolute advantage. In terms of resource use, China is more efficient and production and thus according to traditional terms of trade, China should not trade with Switzerland. David Ricardo however, demonstrated that because of comparative advantage, trade between China and Switzerland would still be beneficial to both countries.
Cars
Houses
China
10
6
Switzerland
5
4
Mathematical representation: China has to give up 6/10 houses for each car produced while Switzerland gives up 4/5 houses for each car produced. China gives up 10/6 cars for every house produced whereas Switzerland gives up 5/4. Because 6/10<4/5 and 5/4<10/6, the lowest opportunity costs would be incurred if China produced cars and Switzerland produced houses.
Countries have comparative advantages due to their advantages in factors of production: for example, the US has a comparative advantage in agriculture because of the large amounts of arable land. China has a comparative advantage in manufacturing due to cheap labor and low cost of capital.
Limitations to the theory of comparative advantage:
assumption of perfect knowledge
there are transport costs
politics (subsidies, sanctions, tariffs), assumption of free trade when there is not
economies of scale can cause comparative advantages to increase
hard to analyze comparative advantages in a complex, global economy
factors of production move from country to country
Comparative advantage is achieved when a producer can produce a good at a lower opportunity cost than another producer.
The difference between the two therefore, is that comparative advantage takes into account opportunity cost. If, using the same resources, China can produce 10 cars and 3 houses while Switzerland can only produce 5 cars and 1 house, China has an absolute advantage. In terms of resource use, China is more efficient and production and thus according to traditional terms of trade, China should not trade with Switzerland. David Ricardo however, demonstrated that because of comparative advantage, trade between China and Switzerland would still be beneficial to both countries.
Mathematical representation: China has to give up 6/10 houses for each car produced while Switzerland gives up 4/5 houses for each car produced. China gives up 10/6 cars for every house produced whereas Switzerland gives up 5/4. Because 6/10<4/5 and 5/4<10/6, the lowest opportunity costs would be incurred if China produced cars and Switzerland produced houses.
Countries have comparative advantages due to their advantages in factors of production: for example, the US has a comparative advantage in agriculture because of the large amounts of arable land. China has a comparative advantage in manufacturing due to cheap labor and low cost of capital.
Limitations to the theory of comparative advantage: