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 TRANSCRIPT EPISODE 34: COMPARATIVE ADVANTAGE