Comparative Advantage
Even if a person or country is not best at making anything, they can still produce and prosper.
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First watch this video, Comparative Advantage and the Tragedy of Tasmania. https://www.youtube.com/watch?v=cwx9fZOL81c
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Mostly summarized from the Mankiw book:
Suppose LeBron James can mow his lawn faster than anyone else.
Should he mow his own lawn?
James can mow his lawn in 2 hours.
In that same 2 hours, he could film a television commercial for Nike and earn $50,000.
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Dave, the boy next door, can mow James' lawn in 4 hours.
In that same 4 hours, Dave could work at McDonald's and earn $40.
James has an absolute advantage over Dave in mowing lawns because he can do the work in a smaller amount of time.
But Dave has a comparative advantage in lawn mowing, because
· James' opportunity cost of mowing the lawn is $50,000, not making the Nike commercial
· Dave’s opportunity cost of mowing the lawn is $40, not working at McDonalds
Rather than mowing his own lawn, James should make the commercial and hire Dave to mow the lawn.
As long as James pays Dave more than $40 and less than $50,000, both of them are better off.
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Just as individuals can benefit from specialization and trade with one another so can different countries.
Imagine a world with just two countries, the United States and Japan, and two goods, food and cars.
Per Figure 1:
The two countries produce cars equally well
· a U.S. worker can produce 1 car per month (his input fraction to the process per day x 30)
· a Japanese worker can also produce 1 car per month
Because the U.S. has more farmland, it is better at producing food
· a U.S. worker can produce 3 tons of food per month
· a Japanese worker can produce only 1 ton of food per month
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The principle of comparative advantage says each good should be produced by the country having the smaller opportunity cost of producing that good.
Japan has a comparative advantage in producing cars
Therefore, Japan should
· produce more cars than it wants for its own use
· export more cars to the U.S.
· import more food from the U.S.
The United States should
· produce more food than it wants for its own consumption
· export more food to Japan
· import more cars from Japan
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Per Figure 1 Case #2 by not making any cars the U.S. can produce 3 more tons of food for a total of 6 tons.
By not producing any food Japan can make one more car for a total of 2 cars.
In this example, with specialization based on comparative advantage total production increases:
· from 2 cars and 4 tons of food
· to 2 cars and 6 tons of food
Then the surplus of food and cars can be traded between the U.S. and Japan.
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Through specialization and trade both the U.S. and Japan can have more food and more cars.
The key point in all trade, from individuals to global:
· most important is comparative advantage, being able to do one thing better than another thing
· not absolute advantage, being able to do everything better
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International trade can make some individuals worse off, even as it makes the country as a whole better off.
When the U.S. exports food and imports cars
· American farmers gain employment
· American autoworkers lose employment
But overall, total production increases and job creation is greater than job destruction.
In the long run both trade between individuals and trade between countries allow all people and countries to increase total production and wealth and achieve greater prosperity.
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