Back To CourseEconomics 102: Macroeconomics
15 chapters | 111 video lessons
Jon has taught Economics and Finance and has an MBA in Finance
In the late 1700s, the famous economist Adam Smith wrote this in the second chapter of his book The Wealth of Nations:
'It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy...What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.'
He's observing two important principles of economics. The first one is that nations behave in the same way as individuals do: economically. Whatever is economical for people is also economical on a macroeconomic, or large, scale. The second thing he's observing is what we call the Law of Comparative Advantage. When a person or a nation has a lower opportunity cost in the production of a good, we say they have a comparative advantage in the production of that good.
Everyone has something that they can produce at a lower opportunity cost than others. This theory teaches us that a person or a nation should specialize in the good that they have a comparative advantage in.
So, let's explore this concept of comparative advantage using some examples from everyday life. For example, Sally can either produce 3 term papers in one hour or bake 12 chocolate chip cookies. Now let's add a second person, Adam, and talk about the same two activities, but as we'll see, Adam has different opportunity costs than Sally does. Adam is capable of producing either 8 term papers or 4 cookies in an hour. If we express both of these opportunity costs as equations, then we have:
For Sally, 3 term papers = 12 cookies.
For Adam, 8 term papers = 4 cookies.
We can ask two different questions about opportunity cost because we have two different goods. The first question we want to know is: what is the opportunity cost of producing 1 term paper? Reducing these equations down separately gives us:
For Sally, 1 term paper = 4 cookies. For Adam, 1 term paper = 0.5 cookies.
So, in this case, who has the lowest opportunity cost of producing 1 term paper? Adam does. Now, let's look at the same scenario from the opposite perspective and answer the second question: what is the opportunity cost of producing 1 cookie?
Now, I know that, in reality, no one is going to produce exactly 1 cookie unless it were a very, very big cookie, but when we reduce the equations down to 1 cookie, we can easily compare on an apples-to-apples basis (or cookie-to-cookie basis). So, let's take a look at the equations again:
For Sally, we have 12 cookies = 3 term papers.
For Adam, we have 4 cookies = 8 term papers.
Reducing these equations down gives us 1 cookie = 0.25 term papers for Sally, and for Adam 1 cookie = 2 term papers.
So, how do we decide who should produce term papers and who should be produce cookies? According to who has the lowest opportunity costs. That's what the law of comparative advantage says.
Who has the lowest opportunity cost of baking cookies? Sally does. Who has the lowest opportunity cost of producing term papers? Adam does.
So, we have two goods and two different people who have two different opportunity costs. The law of comparative advantage tells us that both of these people (Adam and Sally) will be better off if instead of both producing term papers and cookies, they decide to specialize in producing one good and trade with each other to obtain the other good.
This leads us to the conclusion that we should specialize. Individuals should specialize in the goods or services they produce. Firms and corporations should also specialize in what they have a lower opportunity cost of producing, and nations should specialize, as well. Whoever has the lowest cost relative to someone else can trade with them, and everyone gains something by trading.
Now that we've explored the law of comparative advantage, we need to make an important distinction. When a person or country has an absolute advantage, that means they can produce more of a good or service with the same amount of resources than other people or countries can. Another way to say it is they can produce it more cheaply than anybody else. This is a measure of how productive a person or country is when they produce a good or service. For example, let's say that country A can produce a ton of wheat in less time than any other nation with the same amount of resources. In this case, country A has an absolute advantage in the production of wheat.
Let's take another look at Sally and Adam, this time from the perspective of their labor productivity. As you can see, it takes Sally a 1/4 hour to produce 1 cookie, which is lower than the 1 hour that it takes Adam. Therefore, Sally is the most productive. She has an absolute advantage in the production of cookies.
In addition, it takes Sally 1 full hour to produce a term paper, while Adam can produce the same term paper in half the time - it's a 1/2 hour to produce a term paper for Adam; therefore, Adam has an absolute advantage in producing term papers.
But the theory of comparative advantage is based on lower opportunity costs, not based on absolute advantage. It is possible to have the absolute advantage in the production of two goods (in other words, you have the ability to make both goods the quickest, cheapest, and the best) and still benefit from trading with someone else who has a lower opportunity cost.
For example, let's say country A can either produce 10 cars or 10 computers. This means that they have the exact same opportunity costs for these two goods, and we can reduce this equation down to 1 car = 1 computer. Now, if country B can produce either 4 cars or 8 computers, then their opportunity cost of producing 1 computer is equal to 1/2 a car (after we reduce that equation down).
I want you to notice something, though. On the corresponding graph, you can see that country A can produce cars and computers better, faster and cheaper than country B because their production possibility curve is outward (or to the right) of country B's production possibility curve. But look at the slope of country B's curve. It is steeper. Even though country A has an absolute advantage in the production of cars and computers, it still makes sense for them to trade with country B, who has a lower opportunity cost of producing computers. (It's 1/2 a car!) So, the law of comparative advantage leads us to the conclusion that these two countries will trade with each other - cars for computers. Country B will specialize in computers (because they have the lowest opportunity cost in this) while country A will specialize in cars.
To summarize what we've learned in this lesson, the law of comparative advantage says that a person or a nation should specialize in the good they produce at the lowest opportunity cost. Everyone has something that they can produce at a lower opportunity cost than others, and by trading with others, everyone is better off.
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Back To CourseEconomics 102: Macroeconomics
15 chapters | 111 video lessons