Episode 34: Comparative Advantage & Trade

Back in the 1700s, Adam Smith was the first
person to formalize a model of international trade. Smith figured out that if countries
specialized in producing those items where they had absolute advantage (absolute advantage
means that your country can produce the good the lower resource cost than other countries
in production), and purchased items where they had an absolute disadvantage in production,
they be better off. So if Country A could produce food using less labor than Country
B, and Country B could produce furniture using less labor than Country A, then it will be
mutually beneficial for the countries to trade with each other. About 100 years later, David Ricardo pointed
out a flaw in the model: he argued that while England, let’s say, had absolute advantage
in most types of products (that is, England could produce most items using fewer resources),
it could still gain by specializing in production according to comparative advantage, rather
than absolute advantage. Comparative advantage means that your country can produce at the
lowest indirect, or opportunity cost. I saw an example several years ago, in Todd Buccholz’s
From Here Economy, that has become my absolute favorite for illustrating the different types
of productive advantages, and the resulting trade patterns: he uses Gilligan’s Island. In his example, the world is like Gilligan’s
Island. On the island, the only two people who seem to produce anything are the Skipper
and Gilligan. Because their group is marooned on an island, Gilligan and Skipper need to
provide for the basic necessities for their five passengers: food and shelter (inexplicably,
the passengers all seem to have enough clothing to last for years, even though it was supposed
to be a three-hour pleasure cruise). Since they’re on island, it’s natural that they’ll
be eating lot of fish dinners and then, they’ll also need to build huts for shelter. To build a single hut — framing it, adding
walls, thatching the roof — Skipper needs 20 hours. Gilligan, on the other hand, is
not very competent; he tends to knock the hut over a time or two before completion,
and takes 45 hours to finish a hut. Skipper came get down to the lagoon, catch enough
fish for seven people, come back, clean the fish and cook the fish dinner in 10 hours.
Gilligan? He falls into the lagoon, loses his equipment, and initially burns the dinner,
taking 15 hours total to produce an edible fish dinner. One more piece of information I’m going to
need, here: how many resources do each of our producers have to work with? Well, Skipper
is a pretty average guy, working 40 hours a week, 50 weeks a year (he takes the occasional
week’s vacation on the other side of the island to unwind), for a total of 2000 hours.
Gilligan, on the other hand, isn’t as skilled as the Skipper at producing, but he’s got
a good heart and will work extra hard until he makes things right. In the end, Gilligan
works 3600 hours per year. Think about it: isn’t that the way things work in the real
world? Which countries are more like the Skipper — skilled labor, but not as much of it — and
which countries are more like Gilligan, with lots of unskilled labor? OK, in terms of who should be producing which
product, what would Adam Smith say? Remember, Smith thought that specialization should be
dictated by who has absolute advantage, that is, who can produce at the lowest resource
cost. In this case, Skipper actually produces both items using less labor hours, so he has
absolute advantage in both products. Smith would say that Skipper should produce both
products. What should Gilligan do? Well, he can’t really hurt anyone, if he sits in
his own little corner of the island and produces both as well. Let’s say that the two producers
each split their resources – time — evenly among the two products. Skipper will spend 1000 hours on hut building
and 1000 hours on fish dinners. In the end, Skipper builds 50 huts and creates 100 fish
dinners. In the meantime, Gilligan will spend 1800 hours on hut building, and 1800 hours
on fishing. Ultimately, he will build 40 huts and create 120 fish dinners. In total, the
overall island production between the two producers is 90 huts, and 220 fish dinners. Now, what would David Ricardo say? Remember,
Ricardo thought that specialization should be dictated by who has the comparative advantage
— that is, who can produce at the lowest opportunity cost (you can go back to Episode
8 if you need a refresher on opportunity cost). How do we know where the comparative advantage
lies? Well, let’s start by taking a look at Skipper: every hut he builds takes 20 hours;
had he used the 20 hours on fishing, he could have produced 2 fish dinners. So Skipper’s
opportunity cost of producing one hut is that he sacrifices 2 fish dinners. What about Gilligan?
He takes 45 hours to build a hut, in which time he could’ve produced 3 fish dinners.
This means that Skipper has comparative advantage in hut production. Now, some of you might be thinking, “Well
of course Skipper has comparative advantage — he’s better at everything!” This is not
necessarily true; let’s look at fish dinners. To produce a fish dinner takes the Skipper
10 hours, or he sacrifices 1/2 of a hut. Gilligan takes 15 hours, but he sacrifices only 1/3
of a hut. Gilligan actually has the comparative advantage in fishing, because he sacrifices
less, or has the lowest opportunity cost. According to Ricardo, Skipper should devote
himself and his resources solely to producing huts. If he uses all 2000 hours on hut production,
he can produce a total of 100 huts. Gilligan uses all of his resources for fishing, and
can produce 240 fish dinners. What do you notice about total island production? Specialization
according to comparative advantage yields total output of 100 huts and 240 fish dinners,
compared to the 90 huts and 220 fish dinners that are produced when following specialization
according to absolute advantage. What does this mean in the real world? Specialization
according to comparative advantage leads to increased global production, which means better
living standards for everyone. NEXT TIME: Trade restrictions

71 thoughts on “Episode 34: Comparative Advantage & Trade

  1. I've listened to at least 10 different descriptions of comparitive advantage and it always went over my head. This time it made sense. Thank you!

  2. Not all of the episodes exist yet — in fact, I just completed the "reasons for trade restrictions" a few minutes ago. I won't have a chance to do anything on "Types of Trade Restrictions" until over the summer.

  3. [LOL] by stating they had enough clothes for years eventhough it was a 3 hour tour!!! Great explnation too! πŸ˜‰

  4. @liverpoool4lyf I meant England, but that's because I'm a poor historian — I was referring to Smith's time (late 1700s), and the "United Kingdom of Great Britain & Northern Ireland" wasn't until 1927. However, it looks like England & Scotland were declared a "United Kingdom" in 1707. In any case, my "map" shows the entire UK, so I'm certainly inconsistent somewhere…

  5. Great explanation, but what if the island doesn't need any more huts and people need more fish? I guess another way of saying this is what if the demand for huts is low and the demand for fish is high?

  6. @4everFitnessBlog Well, comparative advantage is only a theory of the production piece, so you are correct — the demand side will come into play as well.

    Luckily, the entertainment industry decided that there needed to be a 20-year reunion TV show, in which the castaways escape, and then come back to the island to open a resort, so they needed all the huts they could get. πŸ™‚

  7. gilligan's island needs to get back on the coconut standard. if you're going to have a leaf-based currency, you need something to back it up. anybody can go pick a leaf off a tree, but you can only grow so many coconuts per year.

  8. Meanwhile, the Professor can invent ways to maximize productivity.

    I'm going to look for that book at my library. Anything that uses Gilligan's Island to teach something gets points from me, and the book's title is too cute not to notice.

    Thanks for this.

  9. When you're talking about England, you showed the UK!
    – other than that, LOVE the video πŸ˜€

  10. I think I may get an A on my Micro final exam today due to the indescribable help these videos have provided while taking the course. Thank you SO much for making this material more understandable! πŸ™‚

  11. It's a lovely theory of Dave's…..eminently fair and rational with all parties benfitting from this cornucopia of output……but do remember…"Real" trade is a very messy business of relative power and the rules of the game are significantly less fair and equitable.

  12. Hah! See, the error you're making is assuming that neoclassical economics has a relationship with the real world. Properly trained economists have this curiosity beaten out of them.

  13. If you are referring to Say's Law you are quoting the bastardization of Keynes not what it actually is. Say's Law says that all demand comes from some former source of supply. Or money doesn't create wealth in and of it's self someone has to supply something first.

    Regarding the comment you were responding to, if all they needed was fish then no trade is occurring which would make the example irrelevant.

    And the Law of Comparative advantage does happen in the real world.

  14. But that's absurd. Businesses produce (supply) in response to demand, not the other way around. Supply makes demand possible because it dishes out the wages with which people buy things, but no business ever increases production with the intention of raising aggregate salaries enough for people to afford their wares. They only supply when there is effective demand.

  15. That is not what I said.You are again talking about the idea that "Supply creates its own demand."

    If a business wants to buy something (i.e. Demand) then they have to pay for it with, either some former profits (i.e. Supply) or a loan (i.e. Supply from someone else.)

    This concept is easier to see with no money involved.
    If I can only trade things, I have to first make or gather something that someone else wants before I can trade for anything.

    I have to supply before I can demand.

  16. "This concept is easier to see with no money involved."
    This is EXACTLY what is wrong with neoclassical theory! Money is considered a veil. In reality, money is core to economic activity no company saves up in order to invest. None. They take out loans, and loans are only possible with money. A company does not need supply to take out a loan, they only need demand. This is why banks hoard money in economic crisis: lack of demand, not supply, because demand comes first.

  17. I did mention loans in my previous comment, you probably just missed that part.
    A loan IS supply, it's just not the supply created by the person who is using it. The bank gets money from me supplying my labor and saving money. If no one saved money there would be nothing for the banks to loan out.
    I am not talking about the pure mechanics of "which comes first" because obviously people don't supply stuff if there is not a perceived demand. I'm talking about the purchasing power … Cont.

  18. Cont. behind it.
    You are thinking too shallowly about money. Money represents something, it is not an end in and of its self. This goes all the way back to "The Wealth of Nations" were Adam Smith looked at the notion that gold (money) had inherent value, when in actuality the value came from what could be produced.

    Money is worthless paper if there is no productivity i.e. (supply) to back it up.
    That is the essence of Say's law.

  19. When have deposits ever limited the amount of money banks loan out during expansive periods of the business cycle? They develop financial innovations, riskier, higher yield accounts in order to duck RR. The increasing incidence of bubbles in our economy is clear proof of this: investment goes up when there is optimism (about the level of demand) in the market, regardless of what "backs up" the paper money.

  20. ….
    After the crash, as is the case today, there is a massive hoarding of cash by firms and banks. No amount of supply, either through tax cuts for the rich or loose monetary policy, will unlock that money. They are waiting for demand.
    Of course money "represents something", but that something changes violently in the real economy.
    And yes, money is often pursued as an end in itself. The financial sector is increasingly removed from "what" of investments (like bad mortgages). RanOutOfRoom.

  21. Feel free – all of the videos I've posted are Creative Commons licensed Attribution-NonCommercial-NoDerivs 3.0 Unported License, so you can use them, as long as they are not altered or for commercial use).

  22. Yes but collecting the coconuts still takes effort and time, they don't just roll into circulation ready to be exchanged, do they? The coconuts must represent the value of what they were introduced into circulation for, no more, no less, at all times. When a foreign entity usurps the local authorities and charges the locals 3 coconuts for the issuance of 1 (as if that 1 was theirs to begin with) that is theft of coconut circulation by unwarranted interest.

  23. Thank you very much! Wherever I was unsure about Specialisation and Comparative Advantage, I went back and watch your video and it all made so much sense! xxx

  24. Nice animation, thank you very much.
    However, there seems to be a mistake.
    If I draw the PPC's for the captain (50huts or 100 fish dinners) and Gilligan (40 & 120), the curves intersect. Intersecting lines indicate there in absolute advantage for each country/person in one of the products, hence, we don't have to bother with comparative advantage. Your example is correct when both persons work for the same amount of hours. In that case, we have camparative adv., as the curves don't intersect.

  25. The one downside of this video is it overcomplicates the scenario slightly. It would have been better and clearer to say each of them work the same number of hours. Time is considered a resource, and it would have been easier to see if you made them each work the same number of hours.

  26. Hi Mam, How do you solve this problem mathematically? I tried something but ended up with 4 unknown variables. πŸ™Β 

  27. Hi thanks sooo much for these uploads! Econs is incredibly boring to read and your videos are the only way I understand the subject matter. So yeahhhh. You're awesome, mjmfoodie πŸ˜‰

  28. Hi thanks sooo much for these uploads! Econs is incredibly boring to read and your videos are the only way I understand the subject matter. So yeahhhh. You're awesome, mjmfoodie πŸ˜‰

  29. Thank you for making Economics easier to study, your videos are so very helpful making the reading content easier to absorb. Thank you πŸ™‚Β 

  30. so lets say Germany has comparative advantage in making steel and America has comparative advantage in making movies. We let Germany make all the steel while we make all the movies. Then war happens and Germany refuses to trade their steel for our movies. What to do )-:

  31. You may want to note that ricardos theory builds on the immobility of capital. In the real world the richer part can move his capital to the poorer country and outcompete the indigenous producer. He is not limited as the captain in the example.

  32. Great video. I use this in my interpreting classes. There's a ton of great aspects of language use and the content is useful. Thank you.

  33. 0:07 why did you use a photo of my dad without my permission. I will be contacting the authorities if this video is not removed immediately >:(

  34. These comments are kinda goofy but thank you so much for always putting so much time and effort into your videos. It really makes economics topics much easier to understand.

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