Back To CourseBusiness 100: Intro to Business
26 chapters | 139 lessons | 12 flashcard sets
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Meet Guenther and Maria. Guenther is the prime minister of a country that lies in the northern latitudes of the globe with a fairly temperate climate, and Maria is the leader of a nation still in the Northern Hemisphere, but its climate is Mediterranean. Their countries are participants in globalization and global trade, which is creating a truly global market for the first time in history.
Globalization is the process of creating a truly global market and involves an overall increase of international trade, which includes the flow of labor, services, goods and capital across international borders. A true global market is an integrated market for global trade where buyers and sellers 'meet' from all over the globe to trade with little barriers to trading. Of course, a pure global market doesn't exist yet, but globalization is bringing it closer to a reality. Globalization can provide many benefits to Guenther and Maria's countries. Let's see why.
Let's assume for the purposes of our discussion that Guenther and Maria's countries are the only two in the world. Guenther's country is endowed with fertile soil, which its farmers use to grow hearty grains amenable to the country's colder climate. In fact, the ground is so fertile that there is excess capacity of grain, so some farmers left tilling and took up brewing beer.
Over the centuries, Guenther's countrymen have become expert brewers of all sorts of beer, from light lagers to the darkest stouts. They brew a particular type of stout that uses a special variety of grain found only in Guenther's country. Some people in the southernmost part of the country started vineyards about 100 years ago. The wine produced is as good as wine produced anywhere else but is more time consuming and costly to produce.
Maria's coastal country is much farther south. The farmers in her country were also fortunate to have fertile soil. But rather than turning to the brewing of beer, Maria's countrymen became vintners. The climate and soil were perfect for grapes, and the wine produced is excellent.
In fact, one type of wine uses a grape that requires the perfect combinations of soil and climate found only in Maria's country. Not even the master vintners of Guenther's country can produce it because the grapes will not grow in their country. Some of the folks up in the northern reaches of Maria's country brew beer, but it's no match in quality to the brew produced by Guenther's country.
We can say that Guenther's country has an absolute advantage in the production of their special stout and that Maria's country has an absolute advantage in production of their special wine. British economist Adam Smith first developed the theory for absolute advantage. A country has an absolute advantage in the production of goods or services for which the country has the best resources and specialized skills.
Since Guenther's countrymen are master brewers that possess a rare grain needed for the stout, we can say it has an absolute advantage in the production of the stout. On the other hand, Maria's country has master vintners who have sole access to the special grape used to make the unique wine.
Keep in mind that even if the special grains or grapes were imported, the absolute advantage remains because of the added costs of importing and the specialized skill of each country in producing the particular product. They just do it better and more efficiently.
The theory of absolute advantage argues that Guenther's country should focus its production on the unique stout and Maria's country should focus its production on the unique wine. Guenther's country will then export the unique stout to Maria's country, and Maria's country will export its unique wine to Guenther's country. Focusing your production and exports on your goods and services in which you have an absolute advantage, and importing goods and services that you don't, will lead to efficient and prosperous trade for all parties.
Let's assume that a tragic frost in Maria's country destroyed the year's harvest of the unique grape, making it impossible to produce the wine that gave it an absolute advantage. You'll also recall that Guenther's country produces wine as good as Maria's country (except for the unique wine from the grapes destroyed in the frost).
Due to the frost damage, Maria's country does not currently have an absolute advantage in production of any product, and Guenther's country can produce just as good of wine and produce better beer. Is Maria's country out of luck? Is her country a loser in the great global marketplace? Not according to the theory of comparative advantage.
The theory of comparative advantage, first proposed by David Ricardo, permits Guenther's and Maria's countries to both benefit from trade even though Maria's country no longer has an absolute advantage. Under the theory of comparative advantage, countries can specialize in goods or services for which they have a lower opportunity cost.
An opportunity cost is the value of the next best alternative that you give up in order to pursue a certain activity. The classic example of opportunity costs is 'guns and butter' (defense vs. social programs). The more guns you produce, the less butter can be produced. If you decide to produce more butter, the less guns can be produced.
Let's illustrate comparative advantage with our two countries. Let's assume that one cask of wine equals the value of one barrel of beer. Guenther's country must forgo three barrels of beer for each cask of wine it produces. The opportunity cost for producing one cask of wine is three barrels of beer. Maria's country must forgo three casks of wine for every barrel of beer produced. The opportunity cost for Maria's country producing one barrel of beer is three casks of wine.
We can see that Guenther's country has a comparative advantage of producing beer compared to wine, and Maria's country has a comparative advantage in producing wine. It makes economic sense for Guenther's country to produce and export beer and import wine from Maria's country and for Maria's country to export wine and import beer. Both countries produce more value by focusing on their comparative advantage.
Now let's take what we've just learned back to the real world. The world currently consists of more than 180 countries. Each country has an abundance of some resources and a deficit of other resources. Likewise, different countries have the ability to specialize in certain goods and services based upon their natural resources, education system, political and legal system, and available capital and infrastructure.
Pursuant to the theory of comparative advantage, each country has the ability to benefit from trade by focusing their production and exports on those products and services with the lowest opportunity costs and importing goods and services with the higher opportunity costs. This, theoretically, maximizes efficiency in the global market. Trade also allows countries to increase their wealth and standard of living for their citizens from the gains made by exports and goods and services provided by imports that are not otherwise available to them or available at a much higher cost if produced locally.
Let's review what we've learned. Globalization is the process of moving to a global market. The global market is a market that spans the entire world where goods, services, capital and labor are freely traded. Global trade has the ability to increase the wealth of nations and the standard of living of their citizens. Globalization and global trade are aided by the economic concepts of absolute and comparative advantage.
A country has an absolute advantage in the production of goods or services for which the country has the best resources and specialized skills. Even if a country doesn't have an absolute advantage, it does have a comparative advantage in the production of goods or services at a lower opportunity cost than other goods and services. Countries export goods and services in which they have a competitive advantage and import goods and services where they don't.
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Back To CourseBusiness 100: Intro to Business
26 chapters | 139 lessons | 12 flashcard sets