Comparative Advantage: Definition and Examples

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  • 0:57 Comparative Advantage
  • 1:30 Examining Opportunity Costs
  • 4:31 Specialization
  • 5:07 Absolute Advantage
  • 8:21 Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

Understand the definition of comparative advantage, using two goods as an example. This key lesson incorporates the basic foundations of economics into one foundational theory explaining what goods and services that people,and nations, should produce and for whom they should produce it.

Comparative Advantage

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.

Examining Opportunity Costs

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.

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