Comparative+advantage+and+trade

=**Comparative Advantage and Trade**= by Todd Mehringer, Eric Fenstermaker, and Jason Strachman

The idea of a competitive advantage starts out rather simple and in fact quite intuitive. If one entity (a country, a region, or individual) can produce a good at a lower cost than a second given entity, and if the second entity can produce some other good at a lower cost than the first entity can produce them, then clearly it would be advantageous for the first entity to trade the relatively cheaper good for the second entity’s relatively cheaper good. In this way both entities gain from trade. This concept is defined as an absolute advantage.1

In economics, the theory of comparative advantage explains why it can still be beneficial for two entities to trade if one entity has a lower relative cost of producing all goods. Immediately this premise may seem to be counterintuitive, it seems to directly contradict absolute advantage. However, what matters most is not the absolute cost of production of a good, but the opportunity cost that is given up to not produce a unit of the other good. Comparative advantage is critical to understanding modern international trade theory.2

Early Beginnings of the Theory

The earliest traces of theory that free trade could be of an advantage for countries can be traced to what Adam Smith wrote in “The Wealth of Nations” in 1776, “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.” Comparative advantage was first described by Robert Torrens. Torrens spoke of the advantage in 1815 in an essay on England’s corn trade. He concluded that it was to England's advantage to trade various goods with Poland in return for corn, even though it might be possible to produce that corn more cheaply in England than Poland.4

Although Torrens first spoke of the theory, the model describing the theory is commonly referred to as the "Ricardian model". David Ricardo formalized the idea using a simple, numerical example in his 1817 book titled, On the Principles of Political Economy and Taxation. Without the numerical representation, the idea can be easily misunderstood. It is easy to use the absolute advantage theory to immediately discount the idea of comparative advantage. The idea appeared again in James Mill's Elements of Political Economy in 1821. Finally, the concept became a key feature of international political economy upon the publication of Principles of Political Economy by John Stuart Mill in 1848.5 Stanislaw Ulam once challenged Nobel laureate Paul Samuelson to name one theory in all of the social sciences which is both true and nontrivial. Several years later, Samuelson responded with David Ricardo's theory of comparative advantage.4

Example 1. As mentioned earlier, a numerical example is the easiest way to understand comparative advantage. Instead of using Ricardo’s example of English cloth, and Portuguese wine, I will offer an original example. Instead of using international economies, the theory can be represented by any two entities. I will illustrate the theory with a father and daughter. A 10 year old daughter asks her father to help him with the yard work (the market). The daughter has never helped with the yard work before. The only objective in this case is to finish the yard work in the shortest amount of time possible (the outcome). It is completely counterintuitive to think that the complete job can be finished first with the daughters help. Clearly the father can complete each of the tasks necessary in yard work more quickly than the daughter (the father can produce each good more cheaply than the daughter). First let’s define the duties of yard work (the goods produced) as; mowing the grass, raking the grass on to piles, and finally putting the piles of grass into bags for discarding. The grid below describes the time required (the cost) of each activity.
 * Activity (good) || Fathers Time (cost) || Daughters Time (cost) ||
 * Mowing the grass || 2 ½ hours || 4 hours ||
 * Raking the grass onto piles || 1 hour || 2 hours ||
 * Bagging the piles of grass || 1/2 hour || 1 hour ||
 * Totals || 4 hours || 7 hours ||

As the grid shows, the father can complete each activity (the goods) more efficiently (cheaper) than the daughter. However the yard work (the economy) can be completed most efficiently if the daughter helps (the market is most efficient with trade). If the daughter starts raking the grass onto piles approximately 1 hour after the father starts mowing, the daughter will have raked over 3/4ths of the yard by the time the father has completed the mowing. The father starts bagging the piles of grass when he is done mowing. The daughter finishes raking before he catches up to her with the bagging of the piles of grass. The grid below shows the total time (cost) with the father and daughter working together (exercising free trade). If the father uses the daughter’s help (engages in free trade), the yard work (economy) is completed faster (operates more efficiently) than it would have been without her help (without free trade).
 * Activity (good) || Time for each Activity ||
 * Mowing the grass || 2 1/2 hours ||
 * Raking the grass onto piles and bagging the piles of grass || 1/2 hour ||
 * Totals || 3 hours ||
 * Totals || 3 hours ||

It needs to be stated clearly that the only reason the job was completed more efficiently is because the daughter completed the task of raking **while** the father was first mowing and then bagging. It stresses the importance of trading the correct goods. If the daughter would have completed the mowing instead of the raking, the total time (expense) would have made the yard work take longer. The grid below shows that it would take a total of 5 ½ hours if the daughter mowed the grass instead of doing the raking. In this case, the time to mow the grass took 4 hours instead of the 2 ½ hours it would have taken if the father would have mowed. The father could not have completed any other tasks while the daughter was mowing. It stresses the importance of allocating the tasks appropriately (trading the appropriate goods).
 * Activity (good) || Time for each Activity ||
 * Mowing the grass || 4 hours ||
 * Raking the grass onto piles || 1 hour ||
 * Bagging the piles of grass || 1/2 hour ||
 * Totals || 5 1/2 hours ||

This example illustrates the concept of comparative advantage and offers a useful way of interpreting the results.

1. Cohn, Theodore H. (2005 (third edition)). __Global Poltical Economy Theory and Practice.__ Pearson Education, Inc.. ISBN 0-321-20949-4. 2. Suranovic, Steven M. __International Trade Theory and Policy__ 3. Smith, Adam .An Inquiry into the Nature And Causes of the Wealth of Nations (1776). (Book IV, Section ii, 12) 4. http://en.wikipedia.org/wiki/Comparative_advantage 5. Irwin (1996) International Trade Theory and Policy

**Exam Questions**

 * 1) Suppose company A can produce 10000 computers or 1000 televisions per day, while producer B can produce 14000 computers or 2000 televisions per day. Which of the following is true?**

A) Company B has a comparative advantage in televisions. B) Company B has a comparative advantage in computers. C) Company A has a comparative disadvantage in computers. D) None of the above.

__The correct answer would be A, because company A has a 10000/1000=10 cost per television while Company B only has a 14000/2000=7 per televsion. 7 is lower then 10 so the comparative advantage for televisions is company B.__


 * 2) Suppose company A can produce 10000 computers or 1000 televisions per day, while producer B can produce 14000 computers or 2000 televisions per day. Which of the following is true?**

A) Company A is relatively more efficient producing televisions. B) Company A is relatively more efficient producing computers. C) Company A is relatievely less efficient at producing both computers and televisions. D) All of the above.

__The answer is B. Again let's look at the advantages, Company A is more efficient producing computers because 1000/10000=.1 where as 2000/14000=.1429. .1 < .1429 therefore A is more efficient.__


 * 3) Jimmy has the ability to produce either 4000 cookies or 1500 brownies. Mark has the ability to produce either 5000 cookies or 2000 brownies. Therefore**

A) Mark is more efficient making cookies. B) Mark is not efficient making either cookies or brownies. C) Mark is more efficient making brownies. D) Mark should make dounuts.

__The answer is A. Mark is much more efficient making cookies because 2000/5000=2.5 verses Jimmy's 1500/4000=2.667. Again Mark's cookie making < Jimmy's cookie making therefore mark is more efficient.__


 * 4) Jimmy has the ability to produce either 4000 cookies or 1500 brownies. Mark has the ability to produce either 5000 cookies or 2000 brownies.**

A) Mark has a comparative advantage making cookies. B) Jimmy has a comparative advantage making brownies. C) Mark has a comparative advantage making brownies. D) Both A and B.

__The answer is D. Mark has the comparative advantage because he only has to give up 2.5 cookies for every 1 brownie verses Jimmy giving up 2.667 cookies for every brownie. Jimmy on the other hand only has to give up .375 brownies to get 1 cookie verses Mark giving up .4 brownies to get 1 cookie. Therefore Jimmy should make brownies and Mark should make cookies.__


 * 5) Suppose for the same costs Country A can produce 10000 computers or 1000 widgets per day, while Country B can produce 14000 computers or 2000 widgets per day. Which of the following is true?**

A) Country A should not produce anything and should purchase everything from Country B. B) Country B should not produce anything and should purchase everything from Country A. C) Country B should produce computers and trade some of the computer to Country A for widgets. D) Neither country should produce anything and should look for other countries to purchase from.

__The answer is C. It is the fundamental argument of comparative advantage. In economics, the theory of comparative advantage explains why it can still be beneficial for two entities to trade if one entity has a lower relative cost of producing all goods. Country B has lower relative costs of producing all goods, however to produce widgets it incurrs an opportunity cost of not producing computers. Comparative advantage is critical to understanding modern international trade theory.__


 * 6) Country A can produce Widgets for $5 per widget and computers for $300 a computer. Country B can produce widgets at $7.50 per widget and computers for $250 a computer. Which of the following statements is true:**

A) This is an example of comparative advantage, Country A should produce computers and purchase Widgets from Country B B) This is an example of comparative advantage, Country A should produce widgets and purchase computers from Country B C) This is an example of absolute advantage, Country A should produce computers and purchase Widgets from Country B D) This is an example of absolute advantage, Country A should produce widgets and purchase computers from Country B

__Answer is D. This is a textbook example of absolute advantage. Both countries gain from engaging in trade. Country A produces widgets more efficiently than country B, and Country B produces computers more efficiently than Country A, so Country A should produce widgets, and trade with Country B for computers. Coparative advantage is if Country A is more efficient at producing both products but should choose to trade with country B because of opportunity costs.__


 * 7) A father who is experienced at yard work allows his son to help with some of the processes of the yardwork. It is important that the processes that the son completes can be done while the father is busy with another process. This is an example of what important economic theory:**

A) This is an example of Cournot's Oligopoly B) This is an example of comparative advantage C) This is an example of absolute advantage D) This is an example of elasticity of demand

__The answer is B, comparative advantage. This example helps explain how an entity that holds an efficiency of production of all goods can still benefit in trading with the entity over which it holds the advantage. In this example the father is more proficient in all aspects of yardwork, however if the son can complete one of the processes while the father is completing another process, it is in the father's best interest to do so. This is the premise of the economic theory of comparative advantage in regards to trade.__