hello everyone welcome to business

school 101

the united states is one of the

wealthiest nations in the world

yet we continue to trade with other

countries have you ever considered why

this is the case

if the u.s is so powerful then how does

it benefit from international

trade to answer this question we need to

understand two important terms in the

international business field

the absolute advantage and the

comparative advantage

by definition a country has an absolute

advantage in manufacturing a product

over another country

if it uses fewer resources to

manufacture that product

in other words a country has an absolute

advantage when it manufactures a product

more efficiently than any other country

for example extracting oil in saudi

arabia is basically just a matter of

drilling a hole

in contrast literally striking oil in

other countries could involve

considerable exploration

and costly technologies for drilling and

extraction
therefore saudi arabia requires less

resources than other countries to

produce the same amount of oil

as a result we can say that saudi arabia

maintains the absolute advantage in oil

production

economists suggest that two countries

can benefit from engaging in trade

by specializing in the production of

goods in which each country has an

absolute advantage

to better understand this logic let's

use a simplified example and assume that

there are only two countries

the united states and china they are

engaging in trade that both countries

can only produce two types of goods

planes and trucks before we go any

further please keep in mind the

international trade doesn't actually

look like this in real life

there are obviously more than two

countries in the world and they produce

much more than just two types of goods

however for the sake of learning we are

going to simplify the underlying logic

of international trade

which can be extended to the real

business world
okay let's say that the united states

can produce either 100 planes

or 2500 trucks and china can produce

either 20 planes

or 8 000 trucks in this imaginary

international market

one plane can be traded for 200 trucks

for the united states the production of

one plane

will cost one percent of its total

resources while the production of one

truck

will cost point zero four percent of its

total resources

similarly for china the production of

one plane will cost

five percent of its total resources and

the production of one truck will cost

point zero one two five percent of its

total resources

since the u.s uses less of its resources

in china

to produce planes we can say that the

u.s holds the absolute advantage in

plane production

similarly because china uses less of its

resources in the u.s

to produce trucks china holds the

absolute advantage in truck production

therefore if the us wants to have one

thousand trucks then it has two options

option one the us chooses to produce

trucks itself

this way the us would need to spend 40

percent of its total resources

option two the us chooses to spend five

percent of its total resources

to produce five planes and then trades

those planes with china for one thousand

trucks

when we compare these two options it is

not difficult to conclude that option

two

is better for the us because it can save

a lot of the country's resources

while still obtaining the same number of

trucks therefore

the us benefits from trading with china

now how can china also benefit from this

trade

if china wants to have five planes then

it also has two options

option one china decides to produce the

plants itself

which will cost 25 percent of its total

resources

option two china spends 12.5 percent

of its total resources to produce 1 000

trucks
and then trades those trucks with the us

for five planes

so china also benefits from the trade by

saving half of its resources

by studying these examples we now can

understand that both countries can

benefit from trading by specializing in

the production of goods

in which each country has an absolute

advantage

however this is not always the case in

the real world

what if one country holds the absolute

advantage in both products

will that country still be able to

benefit from trading with other

countries

to answer these questions we need to

understand another important term

the comparative advantage

by definition if a country can

manufacture a product at a lower

opportunity costs in another country

then it has a comparative advantage for

manufacturing that product

opportunity cost refers to the loss of

potential gain from other alternatives

when one alternative is chosen i know

this sounds a little confusing

so let's use an example to explain this

time let's assume that there are only

two countries

the united states and china engaging in

trade and that both countries only

produce two goods

planes and trucks china can still

produce either 20 planes or 8 000 trucks

however this time the united states can

either produce 100 planes

or 10 000 trucks in this imaginary

international market

one plane can still be traded for 200

trucks

for the united states the production of

one plane will cost one percent of its

total resources

while the production of one truck will

cost point zero one percent of its total

resources

similarly for china the production of

one plane will cost five percent of its

total resources

and the production of one truck will

cost point zero one two five percent of

its total resources

in this scenario the us spends less

resources on both plane and truck

production than china

in other words the us holds the absolute

advantage on the productions of both

planes and trucks

so how can the u.s still benefit from

trading with china

to answer this question we need to

calculate the opportunity cost for each

country

as i mentioned earlier the opportunity

cost refers to the loss of potential

gain

from other alternatives when one

alternative is chosen

because the u.s can spend its resources

to produce either 100 planes

or 10 000 trucks in this example the

opportunity cost for the us to produce

one plane

is 100 trucks and the opportunity cost

for the us

to produce one truck is .01 planes

similarly because china can produce

either 20 planes or 8

000 trucks the opportunity cost for

china to produce one plane

is 400 trucks and the opportunity cost

for china to produce one truck

is .0025 planes

compared with the u.s china has less

opportunity costs to produce one truck

so we can say that china holds that

comparative advantage for truck

production

in contrast the u.s has less opportunity

costs to produce one plane

so we can say that the us holds

comparative advantage for plane

production

now let's still assume that the us needs

1 000 trucks

and that it still has two options option

one

the u.s spends 10 percent of its total

resources to produce those trucks itself

option two the u.s spends five percent

of its total resources to produce five

planes

and then trades those planes with china

for one thousand trucks

as you can see option two is still

better for the us

because it can save half of the

country's resources while still

obtaining the same number of trucks

we can conclude from this example that

even though one country holds the

absolute advantage for both products

it can still benefit from trading by

specializing in the production of goods

in which it has a comparative advantage

in general the absolute and comparative

advantage theories

help us immensely in understanding why

countries should get involved in global

trade

however these theories also suffer many

limitations

first we have not taken the product

feature and quality as well as the cost

of resources into consideration

for example one percent of american

resources

might cost a different amount than one

percent of china's resources

also trucks made in the us might have

different product features and quality

than trucks made in china

second we have assumed that resources

can move freely from the manufacturing

of one product

to another within a country in reality

this is not always the case

especially during an unusual period such

as the trade war or a global pandemic

third we have failed to acknowledge

transportation costs between countries

although the absolute advantage and

comparative advantage theories may have

drawbacks

they are still valuable because they

illustrate the fundamental logic of

global trade

so what do you think about the absolute

and comparative advantage

do they make sense to you please leave

your thoughts in a comment below

thanks for watching and i will see you

next time