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PERFECT COMPETITION, PROFIT MAXIMIZATION: A perfectly competitive firm is presumed to produce the quantity of output that maximizes economic profit--the difference between total revenue and total cost. This production decision can be analyzed directly with economic profit, by identifying the greatest difference between total revenue and total cost, or by the equality between marginal revenue and marginal cost.

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LAW OF COMPARATIVE ADVANTAGE:

A principle that states that every nation, worker, or production entity has a production activity that incurs a lower opportunity cost than that of another nation, worker, or production entity, which means that trade between the two can be beneficial to both if each specializes in the production of a good with lower relative opportunity cost. This law is most often studied in the confines of international trade, but it also applies to labor and other types of production.
The law of comparative advantage is the guiding principle for international trade. It provides insight into why and how nations engage in trade. In particular, it indicates why a technologically advanced nation is able to purchase goods produced by a nation with lesser technology.

The key to the law of comparative advantage is opportunity cost, the value of foregone production. If very little production is foregone when a good is produced, then the opportunity cost is relatively low. As such, an extremely productive, technologically advanced nation is bound to forego a great deal of production and incur high opportunity cost to produce a given good, while a less productive, less advanced nation can produce the same good at a lower opportunity cost.

What It Means

The law of opportunity cost is the "silver lining" in the game of international trade and resource allocation. It is the embodiment of "making lemonade out of lemons" for less advanced countries. This law means that every nation, every person, can find at least one good or service that it can produce more cheaply than another nation or person, which can then be exchanged to the benefit of both sides.

The United States, for example, has the technology and resources to produce athletic shoes. However, it imports athletic shoes from Indonesia, which are produced at lower opportunity cost. The United States foregoes highly valuable production when using resources to produce athletic shoes and thus incurs relatively high opportunity cost. Indonesia, in contrast, foregoes less valuable production when producing athletic shoes and thus incurs relatively lower opportunity cost.

Working a Few Numbers

Two Countries, Two Goods
Two Countries, Two Goods
To illustrate the law of comparative advantage, consider the exhibit to the right. This exhibit illustrates the production alternatives facing two hypothetical countries. The United Provinces of Csonda is a relatively industrialize and technologically advanced country, not unlike the United States. The quaint and courteous Republic of Northwest Queoldiola is a less advanced, less industrialized country.

Both nations are able to produce two goods -- turnips and sundials. Reflecting greater production capabilities in the United Provinces of Csonda, one worker over a one month period is able to produce 60 pounds of turnips or 20 sundials. In contrast, lesser production capabilities in the Republic of Northwest Queoldiola means that one worker over a period of one month is able to produce only 20 pounds or turnips or 10 sundials.

Csonda is clearly more productive than Northwest Queoldiola. However, the law of comparative advantage indicates that Northwest Queoldiola can produce a good more cheaply that Csonda. But which good? The answer lies with the opportunity cost of producing each good.

Opportunity cost is the alternative production foregone when resources are use to produce a good. For example, when Csondan labor is used to produce sundials it is not used to produce turnips. The cost of producing sundials in Csonda is thus turnips NOT produced.

  • If Csonda uses one worker to produce 20 sundials then that worker is not able to produce 60 pounds of turnips. As such, the Csondan cost of the 20 sundials is the 60 pounds of turnips and the cost of each sundial is 3 pounds of turnips.

  • If Northwest Queoldiola uses one worker to produce 10 sundials then that worker is not able to produce 20 pounds of turnips. As such, the Queoldiolan cost of the 10 sundials is the 20 pounds of turnips and the cost of each sundial is 2 pounds of turnips.
The law of comparative advantage is revealed by the relatively opportunity cost of producing sundials in Csonda and Northwest Queoldiola. Even though Csonda is more technologically advanced, the opportunity cost of sundial production in Northwest Queoldiola is lower -- 2 pounds of turnips versus 3 pounds of turnips. Northwest Queoldiola has a comparative advantage in sundial production, just as the law of comparative advantage suggests.

Rather than producing sundials using domestic labor, Csonda is actually better off importing sundials from Northwest Queoldiola.

In contrast, Csonda has a comparative advantage in turnip production.

  • If Csonda uses one worker to produce 60 pounds of turnips then that worker is not able to produce 20 sundials. As such, the Csondan cost of the 60 pounds of turnips is the 20 sundials and the cost of each pound of turnips is 1/3 sundial.

  • If Northwest Queoldiola uses one worker to produce 20 pounds of turnips then that worker is not able to produce 10 sundials. As such, the Queoldiolan cost of the 20 pounds of turnips is the 10 sundials and the cost of each pound of turnips is 1/2 sundial.
For turnip production, Csonda comes out ahead. The opportunity cost of turnip production in Csonda is lower -- 1/3 sundial versus 1/2 sundial. Csonda has a comparative advantage in turnip production, once again, just as the law of comparative advantage suggests.

Each nation has a good that it can produce at a lower opportunity cost than the other nation. The two nations can then trade these two goods for the betterment of both. Csonda can produce turnips, which it can then trade to Northwest Queoldiola for sundials. Csonda obtains sundials at a lower cost than it can produce domestically and Northwest Queoldiola obtains turnips at a lower cost that it can produce domestically. It is a comparative advantage win-win.

Why It Works

The law of comparative advantage might seem to be a paradox, a contradiction of the obvious. Why is it that a technologically advanced country like the United Providences of Csonda is unable to produce a good like sundials at a lower cost than the less advanced Republic of Northwest Queoldiola? Surely Csonda could used its advanced technology to devise a method of producing sundials at a lower cost that Northwest Queoldiola.

As a matter of fact, the high level of productivity in Csonda works against it when it comes to comparative advantage. The opportunity cost of producing sundials in Csonda is greater than in that in Northwest Queoldiola precisely because Csonda is more productive, more productive in the production of turnips. Because each Csonda worker can produce a lot of turnips, producing sundials rather than turnips results in a relatively high opportunity cost.

In contrast, Northwest Queoldiola is less productive in turnip production and thus foregoes fewer turnips when producing sundials, with a resulting lower opportunity cost.

The key to the law of comparative advantage, however, is not absolute productivity, but relative productivity. If one nation incurs a relatively HIGH opportunity cost when producing one good, then it necessarily incurs a relatively LOW opportunity cost when producing another good. Foregoing a lot of turnips to produce one sundial means foregoing relatively few sundials when producing turnips.

This is why EVERY nation has a comparative advantage in the production of something. EVERY nation has at least one good that it can produce at a lower opportunity cost than another nation. When comparing any two goods producing by any two nations, EACH nation necessarily is able to produce ONE of the goods at a lower opportunity cost.

This is why the law of opportunity cost works.

Beyond Foreign Trade

While the law of comparative advantage is generally studied in the confines of international trade, it applies to other areas of production, as well. Perhaps the most important is labor. Although some workers are absolutely more productive, due to natural talent, acquired skills, education, etc., they are not relatively more productive. Other workers with less talent, skills, or education, are bound to have a comparative advantage in the production of something.

Consider the example of Lawrence Alexander III, the best and the brightest. Lawrence has an absolute advantage over everyone in everything he does. He is smarter, a better athlete, more skilled, and more talented than anyone.

However, in spite of, and even because of, Lawrence's documented superiority in ALL activities, he does NOT have a comparative advantage in ALL activities. His high level of productivity means that he also incurs a high opportunity cost. Others are able to provide some activities at a relatively lower opportunity cost.

For example, Lawrence, might be able to craft furniture, better than anyone else, but he actually purchases his furniture from others. He is unmatched as an actor and singer, yet he is entertained by watching others perform. He is intelligent enough to have pursued any field of academic study in college, including economics, but he did not.

In contrast to the exceptional abilities of Lawrence Alexander III, Benny Vukovich is not particularly talented, skilled, or educated. He is not particularly productive in any way. However, in spite of, and even because of, Benny's limited production capabilities, he does have a comparative advantage in the production of "odd jobs." He foregoes very little alternative production and thus has a relatively low opportunity cost when he engages in "odd job" production.

The low opportunity cost and corresponding low wage is why Lawrence hires Benny to do odd jobs, such as cleaning his rain gutters. Lawrence gives up a great deal of valuable production when he cleans gutters, Benny gives up very little. It's a win-win for both Lawrence and Benny. Benny has a job and Lawrence has clean gutters.

The "silver lining" offered by the law of comparative advantage is that everyone, not matter how untalented, unskilled, or uneducated, can provide a productive activity at a relatively lower opportunity cost.

<= LAWLAW OF DEMAND =>


Recommended Citation:

LAW OF COMPARATIVE ADVANTAGE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2017. [Accessed: December 13, 2017].


Check Out These Related Terms...

     | international economics | international finance | foreign trade | international trade | absolute advantage | comparative advantage | gains from trade |


Or For A Little Background...

     | exports | imports | net exports | foreign sector | specialization | opportunity cost | production | technical efficiency | voluntary exchange |


And For Further Study...

     | balance of trade | balance of trade surplus | balance of trade deficit | balance of payments | international market | foreign trade policies | tariffs | import quotas | export subsidies | terms of trade | foreign exchange market |


Related Websites (Will Open in New Window)...

     | World Trade Organization | General Agreement on Tariffs and Trade |


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