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Comparative Advantage

Inspired by Bobby’s recent post.

Two countries, A and B.

Citizens of A can produce 10 bottles of milk a day or 10 loaves of bread.
Citizens of B can produce 5 bottles of milk a day or 2 loaves of bread.
These differences are due to superior technology or circumstances in country A. Country A has what is called a absolute advantage in both bread and milk, so why would country A care about what county B could do?

Comparative advantage is why.

Say that both countries have 10 people, and people like to eat as much bread and milk as possible. In addition, people prefer to have one bottle of milk with each loaf of bread, if possible. Now lets say there are 70 people in each country.

In country A alone, 35 people make milk, and 35 people make bread. 350 bottles and loaves are created each day, and each person gets to consume 5 bottles of milk and 5 loaves on bread. Everyone is fairly happy.

In country B alone, 50 people make bread, and 20 people make milk, producing 100 loaves of bread and 100 bottles of milk a day. People get to consume 10/7 of a loaf and 10/7 of a bottle each day. People in country B look to country A with envy.

Now lets consider the possibility that these two countries trade. Why would they do this? Remember, everyone wants to consume as much as possible. Why would country A trade, then? Wouldn’t they lose out? No, says comparative advantage. Take a look:

While A has an absolute advantage in all goods, B has a “comparative advantage” in milk. This is because to produce five more bottles of milk, B only gives up two loaves of bread. For A to produce five more bottles of milk, A must give up five loaves of bread, an unhappy proposition. (If this doesn’t make sense, recall that a Citizen of A can produce 10 bottle OR 10 loaves, and a citizen of B can produce 5 bottles OR 2 loaves, but each citizen can’t produce both at the same time.)

Now, since B has a comparative advantage in milk, lets have all 70 B people produce milk – for a total of 350 bottles of milk. Then lets take 35 A people and have them produce bread – for 350 loaves of bread. We’ll then take the rest of the A people and split them between milk and bread – for another 175 loaves of bread, and another 175 bottles of milk. If you are keeping track, you may have noticed that the total world production just went up – without increasing anybody’s ability to produce. Before, we had 450 loaves of bread and 450 bottles of milk (350 from A + 100 from B of each). And now we have 175 + 350 = 525 bottles and 525 loaves of bread. 75 extra bottles and loaves are floating around the world.

But, you say, B has only milk, and A has way too much bread. So, the two countries trade at a rate they both find acceptable. Because of the comparative advantages of each nation, this rate will naturally fall somewhere between a milk to bread ratio from 1:1 to 5:2. Lets say it settles in at 2 bottles of milk for a loaf of bread. So B trades 234 bottles of milk to A for 117 loaves of bread. They now have 116 milks and 117 loaves, and each person gets to consume more milk and bread in B (before, they only had 100 of each).

Over in A, they now have 234 bottles + 175 bottles = 409 bottles and 525 – 117 = 408 loaves of bread. Once again, each person gets more (before, they only had 350 of each). All of this comes about, remember, without any increases in productive capability – just specialization and trade.

One Response to “Comparative Advantage”

  1. Ryan Says:

    The Desert Island Game teaches about comparative advantage in a Flash environment.

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