Comparative Advantage, Specialization & Exchange

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  • 0:01 Absolute Advantage
  • 1:22 Comparative Advantage
  • 4:34 Defending Comparative…
  • 6:08 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

Companies and individuals are often faced with the question of, 'What should we do?' This lesson examines comparative advantage, a valuable economic concept that helps firms and people determine how to focus their efforts.

Absolute Advantage

With so many people and so many goods to be produced across an economy, there are inevitably situations in which a person or firm has to choose what to produce.

Let's say that your best friend thinks that he can produce trashy TV or medical research. The thing is, so can you. Ah yes, competition. Now say in a given month, you can produce 4 episodes of trashy TV or 1 new headache drug. Your friend, however, can only produce 2 episodes, but 2 new headache drugs. Since you produce more trashy TV episodes, you have an absolute advantage in producing bad TV.

An absolute advantage occurs when a producer is able to make more of a given good than all of its competitors. Likewise, your friend has the absolute advantage in producing headache drugs. We can use that information to help produce as much of each good as possible, but first, what should you each do?

Economics tells us that we should specialize. As such, you should concentrate on making trashy TV, while your friend researches new headache medicine. Society will gain 2 new headache drugs and will endure 4 new episodes of bad TV.

Comparative Advantage

However, what do you do if suddenly your best friend gets a new video camera that allows him to make 6 episodes of trashy TV a month? Suddenly, he has the absolute advantage in both researching new drugs and making trashy TV shows, since he can research 2 new drugs to your 1, and he can make 6 episodes of bad TV while you can make only 4. Suddenly, your friend has an absolute advantage in producing both TV shows and headache medicine. Does that mean that you should suddenly switch what you're doing or just give up?

According to one of the great minds of economics, David Ricardo, that is not necessarily the case. Ricardo realized that the real cost of a good to a company is its opportunity cost, which is what it costs us to do something in terms of whatever else we would be doing or getting. So, if you have Choice A and Choice B where you can only choose one, and you choose Choice A, then Choice B is the opportunity cost.

For every episode of bad TV you make, it costs you a quarter of the research needed to make a new drug, since you can make 4 episodes of TV in the amount of time it takes you to research one new headache cure. Likewise, each new headache drug costs you 4 episodes of TV. For your friend, the numbers change. Originally, before the new camera, each episode of TV cost him half a new headache drug and each headache drug cost him 2 episodes of TV. So look at those numbers. Who can do it cheaper? It only costs you a quarter of a headache drug's research to make an episode of bad TV, whereas it would cost him a half. Likewise, it would cost you 4 episodes of TV to make one drug, whereas it costs your friend only 2. Therefore, your friend can make new drugs for cheaper.

Now plug in the new numbers from your friend's new video camera. Suddenly, the costs change. Your friend can now make 6 episodes of bad TV per month. Therefore, each episode of TV costs him one third of a new headache drug, while you still only pay a quarter of a headache drug for each episode of trashy TV. You can still make it cheaper. Likewise, while each headache drug now costs him 3 episodes of bad TV, it still costs you 4, meaning that it's still cheaper for him.

Being able to produce a good cheaper with regards to opportunity cost is called a comparative advantage. As trashy TV episodes are cheaper for you to produce, you have the comparative advantage in making them. Your friend can produce drugs for cheaper, so he has the comparative advantage in researching them.

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