In the previous tutorial, we learned about specialization, which is when an individual,
company, or country specializes in producing one thing or one part of a task, and relies on
others to produce everything else or complete the other parts of the task. We also learned about why
specialization is so important. This is because it leads to more efficiency, higher
productivity and higher standards of living. To better illustrate this, in this tutorial we are
going to look at the difference between absolute advantage and comparative advantage. Absolute
advantage means a person or nation can produce more of something than another person or nation
using the same amount of resources. Comparative advantage, on the other hand, means a person or
nation can produce something most efficiently given all the products it could potentially
produce. This considers the opportunity cost of producing one good over another. In other words,
comparative advantage is the circumstance in which an entity gives up comparatively less, or has a
lower opportunity cost, than some other entity, when making the same amount of the same product.
First, let’s look more closely at absolute advantage. Say you have two people,
Harry and Lloyd. They are both carpenters, and to keep things simple at first, let’s say they both
build rocking chairs. If Harry can build two chairs in a day and Lloyd can only build one,
it is certainly the case that Harry has an absolute advantage over Lloyd.
Of course in the real world things are rarely this simple. So now to make things a little trickier,
let’s say Harry and Lloyd are both carpenters who build tables and birdhouses. In one day,
Harry can make either three birdhouses or one table. Lloyd can make either two birdhouses
or one table per day. Based on this information, we know that Harry is more productive than Lloyd
in making birdhouses. In economic terms, time is the limited resource, and Harry has an absolute
advantage over Lloyd, because he can make one more birdhouse given the same amount of time.
Now, let’s look more closely at comparative advantage with the same example. Again,
Harry can make three birdhouses or one table. Lloyd can make two birdhouses or one table. For
comparative advantage, we need to figure out what makes more sense for Harry and Lloyd to produce.
In order to do that, it is useful to compare opportunity costs. Harry sacrifices three
birdhouses for every table he produces. So, the opportunity cost of making one table is three
birdhouses, the three birdhouses he could have built in the time it takes him to build one table.
And the opportunity cost of making one birdhouse is 1/3 of a table. Now let’s look at Lloyd.
The opportunity cost of Lloyd making one table is just two birdhouses, while the opportunity cost
of Lloyd making one birdhouse is 1/2 of a table. According to the law of comparative advantage,
each person should produce the good for which there is a lower opportunity cost
than other producers. Harry’s opportunity cost for making one birdhouse, one third of a table,
is lower than Lloyd’s opportunity cost for making one birdhouse, one half of a table. Therefore, it
makes more sense for Harry to make birdhouses. And this works out well for Lloyd, too. It looks like
Lloyd’s opportunity cost for making one table, two birdhouses, is lower than Harry’s opportunity cost
for making one table, three birdhouses. Therefore, it makes more sense for Lloyd to make tables.
If Harry focuses on birdhouses and Lloyd makes tables, they will end up with three birdhouses
and a table at the end of the day, as opposed to two birdhouses and one table if they were to swap.
Now with this very simplistic example understood, let’s apply absolute advantage and comparative
advantage to entire countries. Suppose two countries, Country A and Country B,
are able to produce both coffee and sugar. However, Country A’s climate and soil are such
that it can more easily produce coffee, making two tons of coffee per hour as opposed to only one ton
of sugar per hour. Country B’s climate and soil are such that it can more easily produce sugar,
making three tons of sugar per hour as opposed to just one ton of coffee per hour. Therefore,
we can say that Country A has an absolute advantage producing coffee,
and Country B has an absolute advantage producing sugar. But now, let’s look at a more accurate
way to conceptualize specialization, which is through their relative comparative advantage.
For Country A, the opportunity cost of one ton of coffee is a half a ton of sugar. For Country B,
the opportunity cost of one ton of coffee is three tons of sugar. Since Country A has a
lower opportunity cost than Country B, Country A has a comparative advantage in producing coffee.
Now, let’s look at producing sugar. For Country A, the opportunity cost of one ton of sugar
is two tons of coffee. For Country B, the opportunity cost of one ton of sugar
is one third of a ton of coffee. Country B has the lower opportunity cost, and therefore
has the comparative advantage in producing sugar. So hypothetically, Country A should
be exporting coffee to Country B, and Country B should be exporting sugar to Country A.
What we have just demonstrated is an economic concept known as interdependence. Interdependence
is the shared need of countries for the resources, goods, services, labor, and knowledge supplied by
other countries. Because of interdependence, a drought in Guatemala that diminishes their
coffee crop might mean more expensive coffee the next time you visit your favorite artisanal coffee
shop. Perhaps this shop would turn to another country that produces coffee, like Brazil,
to get its coffee beans in order to avoid raising prices. In any case, this is just one example of
interdependence, which illustrates how many of the economies in the world are intimately connected.