Page 85 - Introduction to Business

CHAPTER 2 The Environment of Business 59

read about the living standards of folks in the former Soviet bloc to get a feel for
their life prior to 1990. Even to this day, people in these transition economies are
not as well off as people in free market or emerging market economies, although
they are slowly getting there.

Theory of Absolute and Comparative
Advantage in Trade
At the heart of international trade theory is the fact that trade encourages countries
to specialize in the production of goods and services that they turn out most effi-
ciently. There are two basic theories that try to explain this behavior: the theory of
absolute advantage in production and the theory of comparative advantage in pro-
duction. These theories are best explained with the help of examples.

Theory of Absolute Advantage. Let’s take two countries, Brazil and the
United States, in a hypothetical example and try to determine what each of these
countries would export if they opened their countries to free trade. Let us assume
that because of soil and climatic conditions, Brazil is more efficient (measured in
pounds of coffee beans produced per acre of farmland) in the production of coffee
than the United States. Let’s further assume that for the same reason (soil and cli-
mate), the United States is more efficient than Brazil in the production of corn.
From this it is obvious that it will make more sense for Brazil to concentrate on cof-
fee production only. Part of the coffee that is produced will be kept for local con-
sumption and the remainder exported to the United States. The United States, on
the other hand, can do the same by concentrating on corn production, saving some
for domestic consumption and exporting the rest to Brazil. The gains from trade are
obvious. Citizens from both Brazil and the United States will enjoy the benefits of
lower-cost coffee and corn because of trade. If there were no trade, the United
States would have to produce its own coffee, which could be expensive, and
Brazil would have to grow its own corn, which would be inefficient and at a high cost
to its citizens. In the language of international trade, we will say that Brazil has an
absolute advantage in coffee production and the United States has an absolute absolute advantage The ability of one
advantage in corn production. An absolute advantage exists when one country can country to produce a good or service
more efficiently than another
produce a good—such as coffee or corn—more efficiently than the other.

Theory of Comparative Advantage. Now suppose that one country has an
absolute advantage over another in the production of two (or more) products.
Should trade between these two countries occur? The answer is yes! Let’s analyze
the rationale behind this assertive answer.
Let’s continue with the Brazil-U.S. case that we just explored. Let’s now make
two small changes and assume that Brazil can produce both coffee and corn more
efficiently (again, measured in terms of pounds of coffee or corn per acre of
farmland) than the United States, and that Brazil can produce five times more cof-
fee than the United States but only two times more corn than the United States,
using the same quantity of resources. Brazil has an absolute advantage over the
United States in the production of both coffee and corn. However, in which com-
modity, coffee or corn, does Brazil have a greater production advantage than the
United States? It is in the production of coffee, because Brazil can produce five comparative advantage The ability of
times as much, compared with only twice as much corn. So, what should Brazil do? one country that has an absolute
Well, Brazil should produce the commodity in which it has the greatest advantage, advantage in the production of two or
more goods (or services) to produce
that is, coffee. You will notice that Brazil not only has an absolute advantage in cof-
one of them relatively more efficiently
fee production, it also has a comparative advantage in coffee production over corn than the other

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