Opportunity
cost is the value of what is foregone in order to have something else. This
value is unique for each individual. You may, for instance, forgo ice cream in
order to have an extra helping of mashed potatoes.
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For you, the mashed potatoes
have a greater value than dessert. But you can always change your mind in the
future because there may be some instances when the mashed potatoes are just not
as attractive as the ice cream. The opportunity cost of an individual's
decisions, therefore, is determined by his or her needs, wants, time and
resources (income).
This is important to the PPF because a country will decide how to best allocate
its resources according to its opportunity cost. Therefore, the previous
wine/cotton example shows that if the country chooses to produce more wine than
cotton, the opportunity cost is equivalent to the cost of giving up the required
cotton production.
Let's look at another example to demonstrate how opportunity cost ensures
that an individual will buy the least expensive of two similar goods when given
the choice. For example, assume that an individual has a choice between two
telephone services. If he or she were to buy the most expensive service, that
individual may have to reduce the number of times he or she goes to the movies
each month. Giving up these opportunities to go to the movies may be a cost that
is too high for this person, leading him or her to choose the less
expensive service.
Remember that opportunity cost is different for each individual and nation.
Thus, what is valued more than something else will vary among people and
countries when decisions are made about how to allocate resources.
C. Trade, Comparative Advantage and Absolute Advantage
Specialization and Comparative Advantage
An economy can focus on producing all of the goods and services it needs to
function, but this may lead to an inefficient allocation of resources and hinder
future growth. By using specialization, a country can concentrate on the
production of one thing that it can do best, rather than dividing up its
resources.
For example, let's look at a hypothetical world that has only two countries
(Country A and Country B) and two products (cars and cotton). Each country can
make cars and/or cotton. Now suppose that Country A has very little fertile land
and an abundance of steel for car production. Country B, on the other hand, has
an abundance of fertile land but very little steel. If Country A were to try to
produce both cars and cotton, it would need to divide up its resources. Because
it requires a lot of effort to produce cotton by irrigating the land, Country A
would have to sacrifice producing cars. The opportunity cost of producing both
cars and cotton is high for Country A, which will have to give up a lot of
capital in order to produce both. Similarly, for Country B, the opportunity cost
of producing both products is high because the effort required to produce cars
is greater than that of producing cotton.
Each country can produce one of the products more efficiently (at a lower cost)
than the other. Country A, which has an abundance of steel, would need to give
up more cars than Country B would to produce the same amount of cotton. Country
B would need to give up more cotton than Country A to produce the same amount of
cars. Therefore, County A has a comparative
advantage over Country B in the production of cars, and Country B has a
comparative advantage over Country A in the production of cotton.
Now let's say that both countries (A and B) specialize in producing the goods
with which they have a comparative advantage. If they trade the goods that they
produce for other goods in which they don't have a comparative advantage, both
countries will be able to enjoy both products at a lower opportunity cost.
Furthermore, each country will be exchanging the best product it can make for
another good or service that is the best that the other country can produce.
Specialization and trade also works when several different countries are
involved. For example, if Country C specializes in the production of corn, it
can trade its corn for cars from Country A and cotton from Country B.
Determining how countries exchange goods produced by a comparative advantage
("the best for the best") is the backbone of international trade theory. This
method of exchange is considered an optimal allocation of resources, whereby
economies, in theory, will no longer be lacking anything that they need. Like
opportunity cost, specialization and comparative advantage also apply to the way
in which individuals interact within an economy.
Absolute Advantage
Sometimes a country or an individual can produce more than another country, even
though countries both have the same amount of inputs. For example, Country A may
have a technological advantage that, with the same amount of inputs (arable
land, steel, labor), enables the country to manufacture more of both cars and
cotton than Country B. A country that can produce more of both goods is said to
have an absolute advantage. Better quality resources can give a country an absolute
advantage as can a higher level of education and overall technological
advancement. It is not possible, however, for a country to have a comparative
advantage in everything that it produces, so it will always be able to benefit
from trade.