It can be argued that world output would increase when the principle of is applied by countries to determine what goods and services they should specialise in producing. Comparative advantage is a term associated with 19th Century English economist David Ricardo. Show Ricardo considered what goods and services countries should produce, and suggested that they should specialise by allocating their scarce resources to produce goods and services for which they have a comparative cost advantage. There are two types of cost advantage – absolute, and comparative. Absolute advantage means being more productive or cost-efficient than another country whereas comparative advantage relates to how much productive or cost efficient one country is than another. ExampleIn order to understand how the concept of comparative advantage might be applied to the real world, we can consider the simple example of two countries producing only two goods - motor cars and commercial trucks. Comparative advantageUsing all its resources, country A can produce 30m cars or 6m trucks, and country B can produce 35m cars or 21m trucks. This can be summarised in a table. In this case, country B has the absolute advantage in producing both products, but it has a comparative advantage in trucks because it is relatively better at producing them. Country B is 3.5 times better at trucks, and only 1.17 times better at cars. However, the greatest advantage - and the widest gap - lies with truck production, hence Country B should specialise in producing trucks, leaving Country A to produce cars. Economic theory suggests that, if countries apply the principle of comparative advantage, combined output will be increased in comparison with the output that would be produced if the two countries tried to become self-sufficient and allocate resources towards production of both goods. Taking this example, if countries A and B allocate resources evenly to both goods combined output is: Cars = 15 + 15 = 30; Trucks = 12 + 3 = 15, therefore world output is 45 m units. Opportunity cost ratios It is being able to produce goods by using fewer resources, at a lower , that gives countries a comparative advantage. The gradient of a PPF reflects the opportunity cost of production. Increasing the production of one good means that less of another can be produced. The gradient reflects the lost output of Y as a result of increasing the output of X. Having a comparative advantage in X, Country A sacrifices less of Y than Country B. In terms of two countries producing two goods, different PPF gradients mean different opportunity costs ratios, and hence specialisation and trade will increase world output. Only when the gradients are different will a country have a comparative advantage, and only then will trade be beneficial. Identical PPFsIf PPF gradients are identical, then no country has a comparative advantage, and opportunity cost ratios are identical. In this case, international trade does not confer any advantage. A person has a comparative advantage at producing something if he can produce it at lower cost than anyone 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? First, let’s get some more vocabulary. Someone who is the best at doing something is said to have an absolute advantage. Michael Jordan has an absolute advantage at basketball. For all I know, Michael Jordan may also be the fastest typist in the world, giving him an absolute advantage at typing, too. Since he’s better at typing than you, can’t he type more cheaply than you? That is, if someone has an absolute advantage in something, doesn’t he automatically have a comparative advantage in it? The answer is no! If Jordan takes time out from shooting hoops to do all his own typing, he sacrifices the large income he earns from entertaining fans of basketball. If, instead, his secretary does the typing, the secretary gives up an alternative secretarial job—or perhaps a much lower salary playing basketball. That is, the secretary is the lower-cost typist. The secretary, not Michael Jordan, has the comparative advantage at typing! The trick to understanding comparative advantage is in the phrase “lower cost.” What it costs someone to produce something is the opportunity cost—the value of what is given up. Someone may have an absolute advantage at producing every single thing, but he has a comparative advantage at many fewer things, and probably only one or two things. (In Jordan’s case, both basketball and also as an endorser of Nike.) Everyone Has a Comparative AdvantageAmazingly, everyone always has a comparative advantage at something. Let’s look at another example. Suppose you and your roommate want to clean the house and cook a magnificent Chicken Kiev dinner for your friends one night. The easy case is when you are each better at one activity. If you are an accomplished chef, while your roommate doesn’t know the range from the oven; and if after you vacuum the carpet the dust bunnies have shifted from under the sofa to under the coffee table, while your roommate can vacuum, dust, and polish the silverware faster than you can unwrap the vacuum-cleaner cord, then you and your roommate will each be better off if you cook and your roommate cleans. It’s easy to see that you each have a comparative advantage in one activity because you each have an absolute advantage in one activity. But what if your roommate is a veritable Martha Stewart, able to cook and clean faster and better than you? How can you earn your keep toward this joint dinner? The answer is to look not at her absolute advantage, but at your opportunity costs. If her ability to cook is much greater than yours but her ability to clean is only a little better than yours, then you will both be better off if she cooks while you clean. That is, if you are the less expensive cleaner, you should clean. Even though she has an absolute advantage at everything, you still each have different comparative advantages. The moral is this: To find people’s comparative advantages, do not compare their absolute advantages. Compare their opportunity costs. The magic of comparative advantage is that everyone has a comparative advantage at producing something. The upshot is quite extraordinary: Everyone stands to gain from trade. Even those who are disadvantaged at every task still have something valuable to offer. Those who have natural or learned absolute advantages can do even better for themselves by focusing on those skills and buying other goods and services from those who produce them at comparatively low cost. (Even more surprising is that the absolutely disadvantaged may gain more from the resulting trade than the absolutely advantaged; but that’s a different topic.) When David Ricardo first illustrated the importance of comparative advantage in the early 1800s, he solved a problem that had eluded even Adam Smith. Comparative advantage explains why a country might produce and export something its citizens don’t seem very skilled at producing when compared directly to the citizens of another country! (For example, in the past few years India has become a major supplier of phone-answering services for the American market, even though their English-language skills are not up-to-par.) The explanation of the apparent paradox is that the citizens of the importing country must be even better at producing something else, making it worth it for them to pay to have work done by the exporting country. Amazingly, the citizens of each country are better off specializing in producing only the goods at which they have a comparative advantage, even if one country has an absolute advantage at producing each item. One of the clearest explanations of comparative advantage ever written was in fact one of the first explanations ever written. In 1821, James Mill saw that Ricardo’s exposition was hard to understand, so he clarified it in his Elements of Political Economy, excerpted Explanations since Mill’s typically rely on ever-updated examples and extensions to the understanding of opportunity costs other than just labor, but Mill’s exposition still retains the fresh clarity of someone trying to sort out for himself a topic that is naturally confusing. Excerpts
Additional ReadingsBiography of David Ricardo in the Concise Encyclopedia of Economics.
Treasure Island: The Power of Trade. Part I. The Seemingly Simple Story of Comparative Advantage, by Russ Roberts on Econlib
“A Brief History of the Concept of Comparative Advantage,” by Morgan Rose. “A Brief History of International Trade Policy,” by Douglas A. Irwin. Getting Ricardo Wrong. Arnold Kling on EconLog.
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