Nobel Laureate Paul Samuelson was once asked by someone
rather skeptical of the value of theoretical economics to provide just
one example of a truly significant result from the discipline. Without
hesitation, Samuelson responded with two words: "Comparative advantage."
But significant though it may be, the theory of comparative advantage
is also rather difficult to understand and perhaps equally hard to explain.
Labor needed to produce a bushel of carrots
or a barrel of beer (hypothetical)
|| 3 person-hours
|| 10 person-hours
|| 5 person-hours
It helps to start by describing "absolute advantage,"
a far more intuitive concept, using an example with two countries and
two commodities. If France can produce 1 bushel of carrots with 3
person-hours of labor and Germany requires 10 person-hours to produce
the same bushel of carrots, France has an absolute advantage in carrot
production. Suppose that Germany can produce 1 barrel of beer with half
a person-hour of labor, while France takes twice as much labor to produce
that amount of beer. Germany, then, has an absolute advantage in beer
production. In this case, it is apparent, France and Germany would gain
through trade if France produced the carrots and Germany produced the
beer. Both nations can obtain the other product more cheaply by buying
it from its neighbor.
But what if France is actually better at producing both commoditiesthat
is, if it has an absolute advantage in both carrots and beer? According
to comparative advantage theory, it still might be advantageous to both
countries to specialize in one good and trade for the other. Let's again
assume that France can produce 1 bushel of carrots with 3 person-hours
of labor and 1 barrel of beer with 1 person-hour of labor. But now we
assume that Germany takes 10 person-hours to produce a bushel of carrots
and 5 person-hours to produce a barrel of beer. For both products, France
is far more productive. Nonetheless, Germany and France can both gain
by specializing and trading according to their comparative advantages.
The trick is to see which commodity France is "more better"
at producing (compared to Germany) and which commodity Germany is "less
worse" at producing.
Since it takes France just 1 unit of labor to produce a barrel of beer
but it takes Germany 5 units, it looks like France might be "more
better" at beer production. After all, if France devoted all its
labor to beer production, it would only have to trade a small fraction
of its beer to Germany to buy the carrots it needs. Its productivity
advantage in carrots is only 10 to 3, but in beer, it's 10 to 2 (that
is, 5 to 1).
And indeed, by devoting its resources to beer-making, France can gain
through trade. Two barrels of beer traded to Germany will buy a bushel
of German carrots, but to produce that bushel of carrots at home, the
French would have to sacrifice enough labor to produce 3 barrels of
beer. Thus, the Frencheven though they're more productive than
the Germans in both commoditiescan get cheaper carrots by producing
just beer and trading some of it to the Germans.
Germany, in turn, will benefit by specializing in carrot production
and trading carrots for beer. If they trade 1 bushel of carrots to Franceat
a cost of 10 of their person-hoursthey can obtain 3 barrels of
beer. But producing 3 barrels of beer at home would have taken them
15 person-hours of labor. They, too, have gained through trade. Both
countries benefit through trade by capitalizing on their comparative
advantage, even though one of them has absolute advantages in both goods.
Why either nation would want carrots rather than beer remains a mystery.
Return to: Trading