Comparative and Absolute Advantages
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Dave Anderson: Hi. I'm Dave Anderson. I was just wondering could we have class outside? We'd go to a neighborhood nearby. Yes? Sweet.
Let's chalk and talk here. They have a long driveway and they would probably love to learn more about comparative and absolute advantage. Suppose the countries of Sandland and Beachland make buckets and shovels. Let's draw graphs that measure the quantity of buckets on the vertical axis and the quantity of shovels on the horizontal axis. We'll show the country's production possibilities curves for a given amount of resources and time, say, a day.
For simplicity, we'll assume that the resources are not specialized for the production of these two goods, which makes the production possibilities curves straight lines, as you might recall from the video on production possibilities curves. If Beachland makes nothing but buckets, it can make 40 buckets per day.
If it makes only shovels, it can make 20 shovels per day. It can also make any combination along its production possibilities curve, such as 20 buckets and 10 shovels. Sandland can make, at most, 60 buckets or, at most, 60 shovels, or any combination along its production possibilities curve, such as 50 buckets and 10 shovels.
Now, let's talk about advantages the countries might have in producing the goods. A country has an absolute advantage in making a particular good if it can make more of that good than the other country with a given amount of resources and time. So this one's easy. Sandland can produce more buckets and more shovels, so it has the absolute advantage in producing both goods.
Even though Sandland has an absolute advantage in policing everything, the countries can still benefit from international trade, because it's the existence of the comparative advantage that determines the ability to benefit from international trade and it determines which countries should specialize in which goods.
A country has a comparative advantage in making a particular good if it can make that good at a lower opportunity cost than another country. We can easily determine who has a comparative advantage in what if we take a look at each country's opportunity costs. To find opportunity costs on a straight line production possibilities curve, it is easiest to look from one extreme in production to the other.
When Beachland increases its shovel production from 0 to 20, the number of buckets it can make decreases by 40. So it's opportunity cost is 2 buckets per shovel. When Sandland increases its shovel production from 0 to 60, its opportunity cost is 60 buckets. So its opportunity cost is 1 bucket per shovel.
Looking in the other direction, when Beachland increases its bucket production from 0 to 40, it's opportunity cost is 20 shovels, which is 1/2 shovel per bucket. When Sandland increases its bucket production from 0 to 60, its opportunity cost is 60 shovels, which is one shovel per bucket.
Take a look at this table and see if you can tell who has a comparative advantage in making shovels. Sandland has a comparative advantage in making shovels, because it's opportunity cost of one is less than Beachland's opportunity cost of 2.
Beachland has a comparative advantage in making buckets, because it's opportunity cost of 1/2 is less than Sandland's opportunity cost of 1. So Sandland should specialize in making shovels and trade some of them for buckets from Beach, land.
Here's a trick for finding the range of prices in terms of buckets per shovel that would make both sides better off than if the countries made everything for themselves. These mutually beneficial terms of trade can be found as any price that falls between the seller's opportunity cost of making the item and the buyer's opportunity cost of making the item.
So for shovels, the most Beachland would pay for a shovel is this opportunity cost of making a shovel, two buckets. The least Sandland would accept for a shovel is its opportunity cost of making a shovel, 1 bucket. So the terms of trade between 1 bucket per shovel and 2 buckets per shovel are mutually beneficial.
Let's explore two other scenarios. If the production possibilities curves look like this, Beachland has the absolute advantage in making buckets and Sandland has the absolute advantage in making shovels. Who has the comparative advantage in making buckets?
Beachland gives up 25 shovels for 50 buckets. So its opportunity cost is 1.2 shovel per bucket, whereas Sandland gives up 40 shovels for 10 buckets. So it's opportunity cost is 4 shovels per bucket. So Beachland has the comparative advantage in making buckets. Using the same process, we can verify that Sandland, again, has the comparative advantage in making shovels.
In this case, the slopes of the production possibilities curves are the same. So the opportunity costs are the same. Both countries give up 1.2 third shovel per bucket and 3 buckets per shovel. In this unusual situation, no one has a comparative advantage in anything. And there are no gains from trade. But whenever the slopes of the production possibilities curves are different, each country has a comparative advantage in something. And each country can gain from trade.
Now, go enlighten your friends and neighbors about the virtues of international trade.
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