Comparative advantage and gains from trade
Comparative Advantage and Absolute Advantage Showing that a party benefits from trade as long as there is a comparative advantage (and not necessarily an absolute advantage)
Comparative Advantage and Absolute Advantage
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- What I want to do in this video is
- make sure we understand the difference between
- "comparative advantage" and "absolute advantage".
- What we saw in the last video is that
- Patty had a comparative advantage in plates
- relative to Charlie because
- her opportunity cost of producing one plate was
- lower than Charlie's opportunity cost of producing a plate.
- Hers was one-third of a cup, his was three cups.
- So, that's why it made sense for her to specialize in plates.
- Charlie on the other hand had
- a comparative advantage in cups;
- his opportunity cost for producing a cup
- was only a third of a plate,
- while Patty's was three plates.
- So that's why he specialized in cups.
- Now, we can't confuse this with absolute advantage.
- Absolute advantage in a given product just means that
- you are more productive
- at that thing given the same inputs.
- And so if I were to just give you this graph,
- and you didn't know how many workers Charlie or Patty had
- and how many inputs they're using to produce
- either thirty cups in a day or thirty plates in a day,
- you actually could not make any statement
- about absolute advantage.
- But if we assume that in all of these scenarios
- they have the same number of inputs,
- so if we think about plates . . .
- If we say they each have one employee,
- maybe it's themselves,
- and given that one input,
- or the same number of inputs,
- Patty is able to produce more plates than Charlie,
- then it is true that Patty would have
- an absolute advantage in plates.
- And if given the same number of inputs,
- Charlie is able to produce more cups than Patty,
- then he would have an absolute advantage in cups.
- But it is not because of that absolute advantage
- that he is specializing in it.
- In fact, we don't even know what their inputs were.
- It might be that he doesn't have an absolute advantage.
- Maybe Charlie needs
- a hundred people to produce his thirty cups,
- while Patty can produce ten cups with one person.
- So in that case,
- actually Patty would have an absolute advantage,
- but it just wouldn't be obvious from this right over here.
- But to make everything clear,
- I want to do a scenario where
- Charlie improved his productivity in some way and
- he actually has the absolute advantage in both products,
- and still show that as long as
- they have different comparative advantages,
- then it still makes sense for them to specialize.
- So let's do another scenario.
- So Charlie has improved dramatically.
- So let's draw our little graph here.
- That's our cups axis, this is still our plates axis.
- Cups and plates . . .
- and let's just put some more markers here...
- ten, twenty, thirty and forty.
- And ten, twenty, thirty and forty, and
- let's still put Patty, let's assume Patty hasn't changed,
- so this is her PPF, so that is Patty's PPF, just like that.
- But let's say that Charlie has improved dramatically.
- And so Charlie's PPF looks like this.
- So this is Charlie's PPF now looks like this.
- So in a given day he can produce
- - and let's just assume
- they're using the same number of inputs-
- so using the same number of inputs in a given day
- he can produce forty cups
- when Patty can only produce ten.
- So he has the absolute advantage in cups.
- Or, in the same given day using the same inputs,
- he could produce forty plates
- while Patty can only produce thirty.
- So now Charlie, all of a sudden,
- has an absolute advantage in both products.
- But we'll see it still makes sense for them to specialize
- because they have different comparative advantages;
- they have different opportunity costs.
- So let's figure this out.
- So we have all the same numbers for Patty -
- actually, let me copy and paste Patty's numbers right here.
- Actually we have access to her numbers right over here
- so I don't have to copy and paste it.
- But let's think of Charlie's new numbers now.
- So this is the PPF for Charlie.
- So this is our new PPF for Charlie.
- Maybe he did some investment or R&D
- to get this new, awesome, productive PPF.
- So he's expanded his PPF.
- So what is his opportunity costs?
- Say he's sitting here - so he's producing 40 cups -
- what would be his opportunity cost of producing 40 plates?
- Well to produce those forty plates,
- he would have to give up those forty cups.
- So his opportunity cost of forty plates
- is equal to forty cups.
- Or you divide both sides by forty:
- his opportunity costs for one plate is equal to one cup.
- And this makes math very easy:
- his opportunity cost for one cup is equal to one plate.
- Now given this new reality - so we've already established
- Charlie has an absolute advantage in both.
- Using the same inputs he can do more of either of them.
- And remember,
- when you're talking about absolute advantage
- you have to think about the amount of inputs you use.
- Who's more productive in that way?
- But let's think about comparative advantage.
- If we think about plates,
- who has a lower opportunity cost for producing a plate?
- Patty hasn't changed.
- Her opportunity cost for producing a plate
- is one-third of a cup.
- Charlie's opportunity cost for producing a plate
- has improved, but it's still worse than Patty's.
- He has to spend one cup to make a plate,
- she only has to give up one-third of a cup to make a plate.
- So Patty still has a comparative advantage in plates.
- And if we look at the opportunity cost in cups,
- the opportunity cost for Charlie to make 1 cup is 1 plate.
- So it's actually a little bit worse than it was before,
- but as we'll see it ends up being a good thing,
- he's just overall more productive.
- But his opportunity cost for one cup,
- he's giving up one plate now,
- when before he was producing one third of a plate.
- And that's because in the other scenario,
- he was more one-sided, I guess is one way to say it.
- But his opportunity cost for producing a cup
- is still cheaper than Patty's.
- Her opportunity cost of producing a cup is three plates:
- her opportunity cost.
- While his is only one plate.
- So he still has the comparative advantage in cups.
- So Charlie should still specialize in cups . . .
- and Patty should still specialize in plates.
- And to show that they can still get an outcome that
- is beyond even Charlie's Production Possibilities Frontier,
- let's think about how they could trade.
- So Charlie's going to specialize in cups;
- he's going to sit right over there producing forty cups a day.
- And Patty's going to specialize in plates,
- and she's going to sit right there
- - let me use a different color, I don't want to use this color -
- she's going to sit right there and produce thirty plates a day.
- So how could they trade for mutual benefit?
- Well any trade that is -
- assuming that they don't want to have only plates
- or they don't only want to have cups.
- Any trade that is cheaper
- than their opportunity cost will be a good one.
- So for example, Patty is sitting here producing only plates.
- Her opportunity cost for a cup is three plates.
- So she would be willing to trade
- anything less than three plates for a cup,
- assuming that she wants it.
- Because, if she had to make the cups herself,
- she would have to give up three plates.
- So let's say that Patty would be willing to trade one cup
- sorry, one plate -
- actually she'd be willing to trade two plates for one cup.
- She's be willing to trade that,
- because if she had to make the cups herself,
- she'd have to give up three plates for one cup.
- So she's willing to trade two plates for one cup.
- And let's see if Charlie would be willing
- to trade two plates for one cup.
- So he has all of these cups -
- how many cups does he have to give away for a plate?
- Well he has to give away one cup for a plate.
- Now he would have to give away one cup for two plates,
- or he would have to give up half a cup for a plate.
- Either way, this is better than his opportunity cost of
- trying to get that incremental plate.
- So he would be willing to do that too:
- two plates for one cup.
- He'd be willing to do one cup for two plates.
- And to see how that would improve,
- he could have forty cups
- or he could trade one of them away -
- Actually, let's do a scenario
- where he trades ten of the cups away.
- So now he only has twenty cups,
- but for those twenty cups he traded away -
- Actually, that's a bad example
- because Patty won't have enough cups.
- So let's say he trades away ten cups.
- Let's say he trades away ten cups for twenty plates.
- So Charlie trades 10 cups for 20 plates.
- So now he trades ten cups and he gets twenty plates.
- So now he'll end up at this scenario over here,
- which was beyond, which was unattainable,
- when he was working by himself,
- when he didn't specialize and get gains from trade.
- So this is a good scenario for him.
- He's able to get outcomes he otherwise
- would not have been able to get.
- He could, depending on how he trades,
- he could get outcomes, well up to a certain point,
- because Patty only has thirty cups.
- So at best he can take all of Patty's cups.
- So he can get something along that line over there.
- But if we look at the same scenario,
- Patty traded twenty plates for ten cups:
- where does that put her?
- So she traded twenty plates, so she's down ten plates
- but she got ten cups, so that put her right over here.
- Once again, beyond her Production Possibilities Frontier,
- so this would look like
- a pretty good situation for Patty as well.
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