Economics of Comparative Advantage
Learn About This Lesson
After completing this lesson, you will be able to:
- Understand that everybody has a comparative advantage at something.
- Explain that both poor and rich countries gain from international trade, even when developed countries may have the capability of producing everything themselves.
- Understand that all people have opportunity costs since they give up work they could have done when they take on other tasks. Thus, it makes sense for skilled people to trade with or hire others for some tasks or services (since others often have a comparative advantage).
- Understand how the concept of comparative advantage helps explain international trade in agriculture and other goods, and is also situations they might encounter in their life.
Inquire: The Trade-offs of Trade
In this lesson, we look at some of the cornerstones of the free enterprise system. Many critics of market economies claim that trade is often unfair, enriching the developed world at the cost of workers in poor countries. They maintain that the West is prosperous because the rest of the world is so poor; companies like Walmart are profitable because their workers earn low wages and suppliers are pressured to lower their costs.
By understanding opportunity costs and comparative advantage, you’ll discover why trade is beneficial to both sides of the transaction. Economists use the term opportunity cost to indicate what must be given up in order to obtain something that is desired. Every choice has an opportunity cost associated with it that can be measured in metrics of time and money. When a person (or a country) can do something, or produce something, at a lower opportunity cost than another person (or country) can, the first person/country is said to have the comparative advantage. One’s comparative advantage is different from one’s absolute advantage. An absolute advantage occurs when a person (a business or a country) can accomplish a task better than others can. You may be surprised to learn that everybody has a comparative advantage at something, even if they don’t have an absolute advantage at anything.
Over 320 million people live in the United States, and the U.S. economy is highly developed yet American companies do not produce all the goods and services we need.
Watch: Trade in a Global Economy
Read: Comparative Advantage and Gains from Trade
People exchange goods or dollars for other goods or services they want. With each exchange or trade, people expect to be better off (otherwise they wouldn’t make the trade). These are the gains from trade. The widening scope of trade enables people and companies to specialize on producing those goods and services they are best at producing. Economists use the phrase comparative advantage to connect another concept, opportunity cost, with trade.
Let’s see how people can gain from trade. The intuition is perhaps easiest to grasp when we think about people growing food. Consider two people: Rick and Carl. Rick can produce five potatoes in a day or five carrots. Carl can produce two potatoes or ten carrots. Since Rick can produce more potatoes in a day than Carl can, he has an absolute advantage in potato production. Since Carl can produce ten carrots in a day, he has an absolute advantage in carrot production compared to Rick. Intuition is likely telling you Rick should specialize in potatoes and Carl should specialize in carrots, because that’s what they do best. Rick, the potato specialist, can trade with Carl, the carrot specialist, and they’re both better off.
We can be more precise about this by looking at the opportunity cost of producing each good for Rick and Carl. We divide what we give up by what we get in order to learn what everything we get costs us. Rick gives up five carrots in order to produce five potatoes. Therefore, his opportunity cost of a potato is one carrot: five carrots divided by five potatoes. Conversely, his opportunity cost of a carrot is one potato: five potatoes divided by five carrots. We do the same math to find Carl’s opportunity cost of producing potatoes and carrots. Every potato costs Carl five carrots: ten carrots divided by two potatoes. Every carrot costs Carl one-fifth of a potato: two potatoes divided by ten carrots.
We compare opportunity cost to learn who is the low-cost and the high-cost producer of each good. First, think about potatoes. Every potato costs Rick one carrot to produce, while it costs Carl five carrots to produce. Rick, therefore, is the low-cost producer of carrots. Every carrot, meanwhile, costs Rick one potato to produce, while it costs Carl one-fifth of a potato to produce. Carl is the low-cost producer of carrots. The low-cost producer has a comparative advantage in the production of a given good. Rick, in this case, has a comparative advantage in carrots, while Carl has a comparative advantage in potatoes.
To see how they gain from trade, consider this. Suppose Rick offers Carl a potato for three carrots. Is it a good deal for Rick? Is it a good deal for Carl? It’s clearly a good deal for Rick. There are two ways he can get carrots; he can grow them himself, or he can buy them from Carl. If he grows carrots himself, he only gets one carrot for every potato he gives up. If he trades with Carl at three carrots per potato, he gets three carrots for every potato he gives up. It is clearly better for Rick to specialize and trade.
It’s also a good deal for Carl. If he wants potatoes, he can either grow them himself or buy them from Rick. If he grows potatoes himself, each potato costs him five carrots. If he can buy them from Rick for three carrots each, he saves two carrots per potato. Rick and Carl are both better off because of the trade. This seems intuitive because Rick has an absolute advantage in potatoes while Carl has an absolute advantage in carrots.
How do these principles apply to countries instead of people like Rick and Carl and their produce. While every society must choose how much of each good it should produce, it does not need to produce every single good it consumes. Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology or skills.
Suppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce a lot of sugar cane per acre but not much wheat. Conversely, the U.S. can produce a lot of wheat per acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true; the U.S. has a lower opportunity cost of producing wheat than Brazil.
When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. In our example, Brazil has a comparative advantage in sugar cane and the U.S. has a comparative advantage in wheat. When countries engage in trade, they specialize in the production of the goods that they have comparative advantage in, and trade part of that production for goods they do not have comparative advantage in. With trade, goods are produced where the opportunity cost is lowest, so total production increases, benefiting both trading parties.
Special Guest Lecture by Professor Art Carden
Reflect: The Comparative Advantage of Young Workers
How do you feel about young workers starting at companies as interns or new hires?
Expand: What if One Person is Really Unproductive?
Can two people gain from trade even if one person is much better at something than the other person? You bet.
Let’s consider a scenario. Britney can produce ten apples or five oranges in a day. Miley can produce 20 apples or 40 oranges in a day. In this example, Britney has an absolute advantage in nothing. Absolute advantage is when an individual or company has the ability to produce the most products for the least input in costs in the most efficient way. By this definition, Miley has an absolute advantage, because she could produce more apples, or more oranges, in any given day than Britney could.
At first, it looks like Britney has nothing to offer Miley, but that changes when we look at their opportunity costs. In the time it would take Britney to produce ten apples, she could produce five oranges. Each apple, therefore, only costs her one-half of an orange. This means each orange costs her two apples. In the time it would take Miley to produce 20 apples, she could produce 40 oranges. Each apple, therefore, costs her two oranges. This means each orange costs half an apple. Britney has a comparative advantage in apple production, because she has a lower opportunity cost than Miley. Miley has a comparative advantage in apples, because she has a lower opportunity cost than Britney.
If they specialize, Britney should specialize in apples, because she gives up fewer oranges per apples than Miley. Miley should specialize in oranges, because she gives up fewer apples per orange than Britney. Deciding what to specialize in reflects the comparative advantage, and minimizes the total opportunity cost. Comparative advantage, rather than absolute advantage, is the basis for trade, and through specialization and the theory of comparative advantage, trade allows people to have more of what they want and more than they would be able to produce on their own.
Let’s see just how much they gain from trade with an example. To keep things as easy as we can, let’s assume they each spend half their time growing apples and half their time growing oranges. Given their production possibilities, this means Britney enjoys five apples and two and a half oranges per day. Miley enjoys ten apples and 20 oranges per day. Now, suppose they specialize. Britney moves to seven apples and one and a half oranges per day, while Miley moves to nine apples and 22 oranges per day. Then, Britney swaps Miley an apple for an orange. After the trade, Britney ends up with six apples and two and a half oranges. Recall that before they specialized, Britney was enjoying five apples and two and a half oranges per day. She’s better off on net by one apple because of the trade.
A lot of commentators and politicians think that if one person or one country gains from trade, another must lose. If Britney is better off, it stands to reason that she is better off at Miley’s expense, right? Well, not so fast. After specialization and trade, Miley enjoys ten apples and 21 oranges. Before they specialized, Miley was enjoying ten apples and 20 oranges. As a result of specialization and trade, she’s better off to the tune of one orange.
Economies of scale and comparative advantage let us make bigger and better oranges, grapes, and everything else.
Having a comparative advantage is not the same as being the best at something. In fact, someone can be completely unskilled at doing something, yet still have a comparative advantage at doing it! How can that happen?
Ricardo also opposed the protectionist Corn Laws, which restricted imports of wheat. In arguing for free trade, Ricardo formulated the idea of comparative costs, today called comparative advantage, a very subtle idea that is the main basis for most economists’ belief in free trade today. The idea is this: a country that trades for products it can get at lower costs from another country is better off than if it had made the products at home.
The key to the United States’ success in the green technology sector is provision of the economic, regulatory, and legal support for the development and implementation of new green technologies.
New York Times, (January 19, 2011)
Finding the best land and climate for orchards and crops is a challenge. Over time, trade between regions allows growers to produce more, and the rest of us to consume more at lower costs. (Comparative advantage applied to people “growing” computer chips as well.)
“We each do bring a distinct set of skills, talents, and abilities to the table; and market economies give us reason to develop them so that we can help others and profit ourselves. The relief here is that we don’t have to be like Brady and have an absolute advantage to profit — we can hone our comparative advantages and thrive in the process… The concept of comparative advantage is core to the economic way of thinking. It has everything to do with our relative opportunity costs — that is, the value of the forgone opportunities associated with making a choice…”
Reuters, July 27, 2017
Comparative Advantage (12:04)
“Comparative advantage is one of the deepest and most profound ideas in economics. Should Martha Stewart iron her own shirts? No. We explain why and the implications for trade across countries. If you have covered this material before, consider it optional. This video will be useful for any student in a principles of economics class.”
Marginal Revolution University
- Absolute advantageWhen a person can accomplish one or more tasks better than others, he or she is said to have an absolute advantage. Similarly, a country, as a collection of people and firms, could have an absolute advantage in producing a great many goods and services compared to other countries.
- Comparative advantageWhen a person (or a country) can do something, or produce something, at a lower opportunity cost than another person (or country) can.
- Gains from TradeTrade creates wealth. People exchange what they have (money or goods) for something they want more of. People don’t exchange things of equal value. If values were equal, they would have no motivation to trade. Instead both sides exchange what they have (a good or money) for what they want(...)
- Opportunity CostEvery choice has a cost measured by what’s given up. Each good we purchase has a cost separate from the money cost. Opportunity cost is what now can’t be purchased because of what we did buy. Going to a movie, we give up the next valued good we could have purchased with the ticket money, and(...)
- Scope of tradeTwo people on an island can benefit from focusing on tasks at which they are best at, and exchanging goods. Another ten or 20 people on the island allow additional specialization and gains from trade. This increasing scope of trade allows for a wider specialization.
- SpecializationAs people focus on a single task, they usually learn to do the task more quickly and with fewer mistakes. Auto mechanics learn during training and with experience repairing many, many cars. Specialization enables them, over time, to diagnose a wider range of problems and repair them more quickly.
License and Citations
Authored and curated by Art Carden Ph.D. and Gregory F. Rehmke M.A. for The TEL Library. CC BY NC SA
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