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Comparative Advantage and Gains From Trade

Comparative Advantage and Gains From Trade

Author: Kate Eskra

This lesson will explain comparative advantage and gains from trade.

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Hi. Welcome to Economics. This is Kate. This tutorial is called Comparative Advantage and Gains From Trade. As always, my key terms will be in red, and my examples are in green.

In this tutorial, we'll be looking at the difference between absolute and comparative advantage, and we'll talk about how we can apply these two different concepts to specialization and trade. I want to start out with-- I know-- although a slightly cheesy example, it's a good one to get us started thinking about this.

Tom and Sue, maybe their plane crashed. But for whatever reason, they're stuck on a deserted island. So there's only two people, and they have to figure out how to get some things done. To simplify the model, let's talk about only there needing to be two different activities that have to be performed-- building a shelter and searching for food. How are they going to decide who should do what? Maybe they'll use their special knowledge that each of them have. They probably have very different skill sets. They certainly probably have different preferences as to what they would like to do.

Let's take a look at their production capabilities. Tom can either build a shelter in four hours if he devotes all of his time to building shelter, or he can spend his time gathering food. And he can gather enough food for a whole day in three hours. Sue is going to take a little bit longer. She is going to take eight hours to build a shelter. If she focuses on gathering food, she can gather enough food for a day in four hours.

So Tom, as you can see, is better at both activities. He's quicker at building the shelter, and he's also quicker at gathering food. That's in economics what we call an absolute advantage, which is the capacity to produce a higher number of goods or services using the same production resources as competitors. When I simplify it for myself, I think about it as who is better at it. And plain and simple, it's easy to see given numbers who is better at what activity.

So now that we know Tom has an absolute advantage of both activities, does that mean that Tom should do everything while Sue just sits there and watches him? I think common sense would tell you obviously no, that's not the case. So how should they divide the tasks then? Well, what they have to do is figure out who has the lower cost for each activity. This is the theory of comparative advantage. We need to look at who is going to give up less in terms of the other good or the other activity.

So comparative advantage is a trading advantage achieved over another company, another competitor, another country due to lower opportunity cost. Remember, this is a very important economic concept meaning what's sacrificed or what's given up. So again, when I simplify comparative advantage in my mind, I think about it as who gives up less.

If they're going to go about this and do it in the most efficient way, they would specialize in the task for which they have the lower opportunity cost. So how we would look at this problem is we would look at who gives up less in terms of food gathering when building a shelter. So the cost here isn't money. It's in terms of what they're giving up the opportunity to do. So whoever gives up less in terms of food gathering when they're building a shelter should build the shelter. Whoever gives up less in terms of shelter building when gathering food should gather the food.

There is that hypothetical situation. But I don't think any of us, hopefully, are going to find ourselves in that deserted island situation. So let's talk about comparative advantage in real life. I'll show you some numbers in this situation as to how to calculate opportunity cost.

Why is it that we trade with other countries? People have very different opinions as to whether international trade is good or bad. But in this tutorial, we're going to focus on the benefits of specialization and trade. The basis for trade is the idea that countries have very different natural resources, very different technologies available, and they have very different labor in terms of either the skills and education of their workforce or the cost of their workforce.

Some countries definitely have an advantage in labor-intensive raw materials, and others are going to have the advantage in capital-intensive goods. What I want to do, I'm going to show you an example now, and it's going to be an example of a two-factor model. A two-factor model is one that indicates the two determinants of production are capital and labor.

If we're looking at two countries producing two different things-- here I'm giving you the output in a production period. That production period may be 60 days. It could be anything. The United States and Mexico are the two countries. This chart is telling us that the United States can either devote all of their time to cars and produce 21 cars in a production period, or they could produce seven textiles, whereas Mexico in that same production period can produce either eight cars or four textiles.

The first thing I talked about this tutorial was absolute advantage. And as you can see, the United States is who is better at it. The United States can produce more of both in that same production period. So we need, in order to figure out who should produce each one-- because should the United States produce both and Mexico do nothing? As I illustrated with Tom and Sue, no, that's not the case. We need to look at opportunity cost.

Here's how you would look at it. Here are the opportunity costs of producing cars and textiles. Each of these are in terms of the other good. Every time the United States produces one car, they give up one third of a textile. You can see I took 7 divided by 21 to figure that out. Whereas Mexico, if they focus on cars, they would give up one half of a textile. Conversely, if the United States focuses on textiles, they would give up three cars for every one textile-- 21 divided by 7-- or Mexico would give up two cars, 8 divided by 4.

Now let's look at who has the lower opportunity cost. If we look at cars, one third is less than one half, so the United States enjoys the comparative advantage because it's the lower cost in terms of producing cars. Mexico gives up fewer cars when they produce textiles, so they have the lower cost of producing textiles.

Here is that again. Even though the United States has the absolute advantage in both goods, the United States has the comparative advantage, then, in producing cars. I highlighted that in green. Mexico would have the comparative advantage in producing textiles. If they specialise in trade, what's going to end up happening is they'll both end up with more cars and more textiles.

So even though, like I said, countries can enjoy an absolute advantage in both goods or in many, many goods, we end up still better off when we specialize in where we have a comparative advantage. Just like Tom and Sue can get more accomplished by specializing, so can we.

The key idea that I want you to remember is that trade allows countries to enjoy more of both goods. They get to move beyond the constraints that they used to face with their resources and their productivity. So both goods can end up being produced at the lowest opportunity cost, and that's going to result in both players being better off.

There's a couple of other applications that I just want to bring up where we can look at this in our own lives. An example here for you is an attorney can, let's say, bill $200 per hour when she's working on a case. She's also a really fast typist. She can type 120 words per minute, whereas her secretary can only type 100 words per minute. Should the attorney fire her secretary and do the typing herself?

What in the world does this have to do with comparative advantage? Well, it does. Think about it. Should the attorney really fire her secretary and do all her typing herself? The answer is no, because we have to look at what she gives up to the opportunity to do whenever she types. What is the attorney's cost of typing? She's giving up the opportunity to bill $200 per hour. She can't bill while she's just typing. She has to be working on a case.

Does her secretary face that same opportunity cost when she types? No, because she doesn't have a law degree. So the cost is much lower for the secretary to type 100 words per minute even though she is slightly slower, because she's not giving up the opportunity that the attorney does. So the cost is much higher for the attorney. That's why it's worth it for the attorney to pay a secretary an hourly wage to do the typing.

Finally, I wanted to end with a thought here to let you think about how much specialization really does go on in the world today. As knowledge increases, it becomes a necessity for people to specialize. I am a teacher, so I focus on teaching. I allow scientists and doctors and attorneys to specialize in what they are good at. Even within these fields, there's so much specialization that goes on. And we're all better off because of it. We allow other people to specialize in what they are good at, and then we trade for their services or for their goods.

What did you learn in this tutorial? We talked about the differences between absolute and comparative advantage. And finally, I wanted to leave you with the idea that people and nations benefit when they specialize in whatever they enjoy the lower opportunity cost or comparative advantage on and then trade. Thanks so much for listening.

Notes on "Comparative Advantage and Gains from Trade"

Terms to Know

Two-Factor Model

A model that indicates the two determinants of production are capital and labor.

Absolute Advantage

The capacity to produce a higher number of goods or services using the same production resources as competitors.

Comparative Advantage

A trading advantage achieved over another company due to lower opportunity cost.