{"id":599,"date":"2015-04-22T19:41:00","date_gmt":"2015-04-22T19:41:00","guid":{"rendered":"https:\/\/courses.candelalearning.com\/masterybusiness1xngcxmaster\/?post_type=chapter&p=599"},"modified":"2019-01-05T01:41:24","modified_gmt":"2019-01-05T01:41:24","slug":"reading-absolute-and-comparative-advantage","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/wmintrobusiness\/chapter\/reading-absolute-and-comparative-advantage\/","title":{"raw":"Reading: Absolute and Comparative Advantage","rendered":"Reading: Absolute and Comparative Advantage"},"content":{"raw":"\"Photo<\/a>\r\n

Introduction<\/h2>\r\nConsider the humble banana. Even if you're not a big fan of this yellow fruit, you've surely\u00a0seen them in the grocery store or in a market somewhere. If you walked through a U.S.\u00a0city with a banana and asked people to identify it, it's unlikely you\u00a0would encounter anyone\u00a0who had no idea what it was. What if you did the same thing with a picture of a banana<\/em> tree<\/em>? How many people could identify it? Maybe some, but not all.\u00a0Why is that? In the United States, bananas are grown in Hawaii, and not everyone has been to Hawaii. In fact, most of the bananas in the world are grown in Ecuador. If we Americans love bananas and don't\u00a0live in Hawaii and can't get to Ecuador regularly, without global trade, we're out of luck: no bananas for cereal in the morning or as snacks during the day and, worse, no banana splits\u00a0at the local ice cream parlor. Why do Ecuador\u00a0and Hawaii trade away their bananas instead of keeping them all to themselves? Probably because, although bananas are delicious and nutritious, it's hard to build houses out of them. Instead, the state of Hawaii and nation of Ecuador\u00a0choose to trade their bananas for things they lack, while considering the cost and profitability of exporting their product.\r\n\r\nEcuador\u00a0and Hawaii offer an\u00a0example of comparative advantage. Because bananas are not grown or readily available everywhere\u00a0in the world, Ecuador and Hawaii\u00a0can profitably export theirs to\u00a0banana-less places like Iowa and Canada. At the same time, Ecuador\u00a0may need computer systems to keep track of all of those bananas they are selling, but Ecuador\u00a0is not a technologically advanced economy like the United States. The United States has a comparative advantage in computers, so we sell our computers to Ecuador\u00a0and let them concentrate on selling us bananas.\r\n

The Concept\u00a0of\u00a0Advantage<\/h2>\r\nIn order to understand why businesses are willing to operate in a complex global environment, we must first understand two fundamental concepts that drive almost all business decisions: absolute and comparative advantage. Countries\u00a0and companies\u00a0are willing to assume the risk of engaging in global trade because they believe that they have an advantage over the competition that they can turn\u00a0into profits. Not all countries have the same natural resources, infrastructure, labor force, or technology. These differences create advantages that can be exploited in\u00a0global trade, to a country's\u00a0(or company's) benefit.\r\n

Absolute Advantage<\/h3>\r\nAn entity (country, region, company, or individual) is considered to have an absolute advantage<\/strong> if either of the following\u00a0conditions\u00a0exists:\r\n\r\n(1) It\u00a0is the only<\/em> source of a particular product, good, or service. This kind\u00a0of absolute advantage is very rare and usually depends on a particular natural resource being available\u00a0only within a certain\u00a0region or country. An example might be the coveted edible red bird's nests<\/a> found only in\u00a0the caves of Thailand (and prized in Chinese cooking as the main ingredient in bird's nest soup). Similarly, if Ecuador were\u00a0the only place in the world where bananas could\u00a0be grown, it\u00a0would have an absolute advantage. However, suppose\u00a0some sneaky banana spy goes\u00a0to Ecuador and pilfers some banana tree seedlings and takes them back to her\u00a0home country and begins growing and exporting bananas. At that point Ecuador no longer has an\u00a0absolute advantage\u00a0on the basis of\u00a0the \"only-source\" condition.\r\n\r\n(2) An entity is also considered to have an absolute advantage if it is able to produce more<\/em> of something than another entity while using the same amount\u00a0of resources (factors of production). When the sneaky banana spy started growing bananas in her\u00a0home country, she didn't actually take away Ecuador's absolute advantage, because Ecuador can produce more<\/em> bananas using\u00a0the same amount of resources (labor, land, water, equipment, etc.). Put another way, Ecuador's direct cost of producing bananas is lower than the banana spy's. Assuming that the bananas can be grown in the new country, it will take that country a very long time to match\u00a0Ecuador's skill, efficiency, and output level, and until it does, Ecuador will retain its absolute advantage.\r\n

Comparative Advantage<\/h3>\r\nAn entity (country, region, company, or individual) is considered to have a\u00a0comparative advantage<\/strong> over another in producing a particular good or service if it\u00a0can produce the good or service at a lower relative opportunity cost.\r\n\r\nYou'll recall from the economic environment module that opportunity cost is the value of the next best alternative<\/em>. (The video, below, also includes a refresher on this concept.) Since countries\u00a0and businesses have limited resources, they are forced to make choices about how they allocate those resources. As a student, you understand opportunity cost better than you think. You have a limited amount of time, and you must choose between reading this module and going out with your friends, because you can\u2019t do both. If you choose to go out with your friends, then the opportunity cost might\u00a0be failure on your next exam because you did not use the time to prepare.\r\n\r\nEcuador has a\u00a0comparative advantage\u00a0in bananas over a long list of countries, including the United States. This comparative advantage is even better understood\u00a0when you consider that their next best alternative<\/em> product is oil. The Middle Eastern countries have been pumping oil from the ground for as long as Ecuador has been growing bananas. It makes as much\u00a0sense for Kuwait to attempt to\u00a0export bananas as it does for Ecuador to export oil. It's the reality of comparative advantage that encourages\u00a0countries and businesses to do what they do best\u2014leaving the production of other goods and services\u00a0to other countries or companies\u2014and in so doing, focusing on producing goods and services where they have advantage, thus maximizing their opportunities in a global environment.\r\n\r\nThe following video provides an excellent illustration of comparative and absolute advantage and explains why they are such\u00a0important considerations in how countries decide to specialize and\u00a0trade.\r\n\r\nhttps:\/\/youtu.be\/38hvvAzgXZY\r\n
\r\n

Try It<\/h3>\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/7675\r\nhttps:\/\/assessments.lumenlearning.com\/assessments\/7676\r\n\r\n<\/div>\r\nStill unsure about how these different kinds of advantages play out in the real, complex world of global trade? Up next: Try your hand at ruling\u00a0your own island nation and choosing trade partners on the basis of comparative advantage.","rendered":"

\"Photo<\/a><\/p>\n

Introduction<\/h2>\n

Consider the humble banana. Even if you’re not a big fan of this yellow fruit, you’ve surely\u00a0seen them in the grocery store or in a market somewhere. If you walked through a U.S.\u00a0city with a banana and asked people to identify it, it’s unlikely you\u00a0would encounter anyone\u00a0who had no idea what it was. What if you did the same thing with a picture of a banana<\/em> tree<\/em>? How many people could identify it? Maybe some, but not all.\u00a0Why is that? In the United States, bananas are grown in Hawaii, and not everyone has been to Hawaii. In fact, most of the bananas in the world are grown in Ecuador. If we Americans love bananas and don’t\u00a0live in Hawaii and can’t get to Ecuador regularly, without global trade, we’re out of luck: no bananas for cereal in the morning or as snacks during the day and, worse, no banana splits\u00a0at the local ice cream parlor. Why do Ecuador\u00a0and Hawaii trade away their bananas instead of keeping them all to themselves? Probably because, although bananas are delicious and nutritious, it’s hard to build houses out of them. Instead, the state of Hawaii and nation of Ecuador\u00a0choose to trade their bananas for things they lack, while considering the cost and profitability of exporting their product.<\/p>\n

Ecuador\u00a0and Hawaii offer an\u00a0example of comparative advantage. Because bananas are not grown or readily available everywhere\u00a0in the world, Ecuador and Hawaii\u00a0can profitably export theirs to\u00a0banana-less places like Iowa and Canada. At the same time, Ecuador\u00a0may need computer systems to keep track of all of those bananas they are selling, but Ecuador\u00a0is not a technologically advanced economy like the United States. The United States has a comparative advantage in computers, so we sell our computers to Ecuador\u00a0and let them concentrate on selling us bananas.<\/p>\n

The Concept\u00a0of\u00a0Advantage<\/h2>\n

In order to understand why businesses are willing to operate in a complex global environment, we must first understand two fundamental concepts that drive almost all business decisions: absolute and comparative advantage. Countries\u00a0and companies\u00a0are willing to assume the risk of engaging in global trade because they believe that they have an advantage over the competition that they can turn\u00a0into profits. Not all countries have the same natural resources, infrastructure, labor force, or technology. These differences create advantages that can be exploited in\u00a0global trade, to a country’s\u00a0(or company’s) benefit.<\/p>\n

Absolute Advantage<\/h3>\n

An entity (country, region, company, or individual) is considered to have an absolute advantage<\/strong> if either of the following\u00a0conditions\u00a0exists:<\/p>\n

(1) It\u00a0is the only<\/em> source of a particular product, good, or service. This kind\u00a0of absolute advantage is very rare and usually depends on a particular natural resource being available\u00a0only within a certain\u00a0region or country. An example might be the coveted edible red bird’s nests<\/a> found only in\u00a0the caves of Thailand (and prized in Chinese cooking as the main ingredient in bird’s nest soup). Similarly, if Ecuador were\u00a0the only place in the world where bananas could\u00a0be grown, it\u00a0would have an absolute advantage. However, suppose\u00a0some sneaky banana spy goes\u00a0to Ecuador and pilfers some banana tree seedlings and takes them back to her\u00a0home country and begins growing and exporting bananas. At that point Ecuador no longer has an\u00a0absolute advantage\u00a0on the basis of\u00a0the “only-source” condition.<\/p>\n

(2) An entity is also considered to have an absolute advantage if it is able to produce more<\/em> of something than another entity while using the same amount\u00a0of resources (factors of production). When the sneaky banana spy started growing bananas in her\u00a0home country, she didn’t actually take away Ecuador’s absolute advantage, because Ecuador can produce more<\/em> bananas using\u00a0the same amount of resources (labor, land, water, equipment, etc.). Put another way, Ecuador’s direct cost of producing bananas is lower than the banana spy’s. Assuming that the bananas can be grown in the new country, it will take that country a very long time to match\u00a0Ecuador’s skill, efficiency, and output level, and until it does, Ecuador will retain its absolute advantage.<\/p>\n

Comparative Advantage<\/h3>\n

An entity (country, region, company, or individual) is considered to have a\u00a0comparative advantage<\/strong> over another in producing a particular good or service if it\u00a0can produce the good or service at a lower relative opportunity cost.<\/p>\n

You’ll recall from the economic environment module that opportunity cost is the value of the next best alternative<\/em>. (The video, below, also includes a refresher on this concept.) Since countries\u00a0and businesses have limited resources, they are forced to make choices about how they allocate those resources. As a student, you understand opportunity cost better than you think. You have a limited amount of time, and you must choose between reading this module and going out with your friends, because you can\u2019t do both. If you choose to go out with your friends, then the opportunity cost might\u00a0be failure on your next exam because you did not use the time to prepare.<\/p>\n

Ecuador has a\u00a0comparative advantage\u00a0in bananas over a long list of countries, including the United States. This comparative advantage is even better understood\u00a0when you consider that their next best alternative<\/em> product is oil. The Middle Eastern countries have been pumping oil from the ground for as long as Ecuador has been growing bananas. It makes as much\u00a0sense for Kuwait to attempt to\u00a0export bananas as it does for Ecuador to export oil. It’s the reality of comparative advantage that encourages\u00a0countries and businesses to do what they do best\u2014leaving the production of other goods and services\u00a0to other countries or companies\u2014and in so doing, focusing on producing goods and services where they have advantage, thus maximizing their opportunities in a global environment.<\/p>\n

The following video provides an excellent illustration of comparative and absolute advantage and explains why they are such\u00a0important considerations in how countries decide to specialize and\u00a0trade.<\/p>\n