Comparative Advantage: Powerful, but not obvious

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.

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 commodities—that 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 French—even though they're more productive than the Germans in both commodities—can 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 France—at a cost of 10 of their person-hours—they 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.

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