Determination of factor prices and in international trade
How is opportunity cost applicable to the determination of factor prices and in international trade?
A profit, benefit or value of something, which must be forfeited to achieve or acquire something else. Because every resource has alternative uses, each choice, action or decision possesses an opportunity cost.
Answer and Explanation
Opportunity cost is applicable in international trade and to determine factor prices through comparative advantage. When countries use comparative advantage to establish services and goods that they should produce, the world output increases. Previous studies indicate that there exist two types of cost advantage which are comparative and absolute cost advantage.
Absolute Merit or advantage is achieved when a nation, compared to its competing countries, is better in terms of production or cost efficiency. Comparative advantage indicates the manner wherein a particular country compares with others in terms of cost efficiency or production. Consider an example of two countries specializing in car and truck production. The first country produces 35 and 21 million cars and trucks respectively. On the other hand, the second country produces 30 and 6 million cars and trucks respectively. Thus, the first country possesses absolute advantage in the production of both cars and trucks. Nevertheless, the comparative advantage is higher in truck (3.5) than in car production (1.17).
While referring to the principle of comparative advantage, the first country should focus on producing trucks and the second one should specialize in car production. With such a strategy, both countries evade unnecessary competition for resources and market of their products. Thus, comparative advantage can enable countries to reduce factor prices and increase market prices by specializing in goods and services that they produce best.