Rose’s explanation of the gains from trade, though correct, poses a puzzle: If Rose is better at both raising cattle and growing potatoes, how can Frank ever specialize in doing what he does best? Frank doesn’t seem to do anything best. To solve this puzzle, we need to look at the principle of comparative advantage.
As a first step in developing this principle, consider the following question: In our example, who can produce potatoes at a lower cost—Frank or Rose? There are two possible answers, and in these two answers lie the solution to our puzzle and the key to understanding the gains from trade.
3-2a Absolute Advantage
One way to answer the question about the cost of producing potatoes is to compare the inputs required by the two producers. Economists use the term absolute advantage when comparing the productivity of one person, firm, or nation to that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.
absolute advantage the ability to produce a good using fewer inputs than another producer
In our example, time is the only input, so we can determine absolute advantage by looking at how much time each type of production takes. Rose has an absolute advantage both in producing meat and in producing potatoes because she requires less time than Frank to produce a unit of either good. Rose needs to input only 20 minutes to produce an ounce of meat, whereas Frank needs 60 minutes. Similarly, Rose needs only 10 minutes to produce an ounce of potatoes, whereas Frank needs 15 minutes. Based on this information, we can conclude that Rose has the lower cost of producing potatoes, if we measure cost in terms of the quantity of inputs.
3-2b Opportunity Cost and Comparative Advantage
There is another way to look at the cost of producing potatoes. Rather than comparing inputs required, we can compare opportunity costs. Recall from Chapter 1 that the opportunity cost of some item is what we give up to get that item. In our example, we assumed that Frank and Rose each spend 8 hours a day working. Time spent producing potatoes, therefore, takes away from time available for producing meat. When reallocating time between the two goods, Rose and Frank give up units of one good to produce units of the other, thereby moving along the production possibilities frontier. The opportunity cost measures the trade-off between the two goods that each producer faces.
opportunity cost whatever must be given up to obtain some item
Let’s first consider Rose’s opportunity cost. According to the table in panel (a) of Figure 1, producing 1 ounce of potatoes takes 10 minutes of work. When Rose spends those 10 minutes producing potatoes, she spends 10 minutes less producing meat. Because Rose needs 20 minutes to produce 1 ounce of meat, 10 minutes of work would yield ½ ounce of meat. Hence, Rose’s opportunity cost of producing 1 ounce of potatoes is ½ ounce of meat.
The Opportunity Cost of Meat and Potatoes
Opportunity Cost of:
1 oz of Meat 1 oz of Potatoes
Frank the farmer 4 oz potatoes ¼, oz meat
Rose the rancher 2 oz potatoes ½ oz meat
Now consider Frank’s opportunity cost. Producing 1 ounce of potatoes takes him 15 minutes. Because he needs 60 minutes to produce 1 ounce of meat, 15 minutes of work would yield ¼ ounce of meat. Hence, Frank’s opportunity cost of 1 ounce of potatoes is ¼ ounce of meat.
Table 1 shows the opportunity costs of meat and potatoes for the two producers. Notice that the opportunity cost of meat is the inverse of the opportunity cost of potatoes. Because 1 ounce of potatoes costs Rose ½ ounce of meat, 1 ounce of meat costs Rose 2 ounces of potatoes. Similarly, because 1 ounce of potatoes costs Frank ¼ ounce of meat, 1 ounce of meat costs Frank 4 ounces of potatoes.
Economists use the term comparative advantage when describing the opportunity costs faced by two producers. The producer who gives up less of other goods to produce Good X has the smaller opportunity cost of producing Good X and is said to have a comparative advantage in producing it. In our example, Frank has a lower opportunity cost of producing potatoes than Rose: An ounce of potatoes costs Frank only ¼ ounce of meat, but it costs Rose ½ ounce of meat. Conversely, Rose has a lower opportunity cost of producing meat than Frank: An ounce of meat costs Rose 2 ounces of potatoes, but it costs Frank 4 ounces of potatoes. Thus, Frank has a comparative advantage in growing potatoes, and Rose has a comparative advantage in producing meat.
comparative advantage the ability to produce a good at a lower opportunity cost than another producer
Although it is possible for one person to have an absolute advantage in both goods (as Rose does in our example), it is impossible for one person to have a comparative advantage in both goods. Because the opportunity cost of one good is the inverse of the opportunity cost of the other, if a person’s opportunity cost of one good is relatively high, the opportunity cost of the other good must be relatively low. Comparative advantage reflects the relative opportunity cost. Unless two people have the same opportunity cost, one person will have a comparative advantage in one good, and the other person will have a comparative advantage in the other good.
3-2c Comparative Advantage and Trade
The gains from specialization and trade are based not on absolute advantage but on comparative advantage. When each person specializes in producing the good for which he or she has a comparative advantage, total production in the economy rises. This increase in the size of the economic pie can be used to make everyone better off.
In our example, Frank spends more time growing potatoes, and Rose spends more time producing meat. As a result, the total production of potatoes rises from 40 to 44 ounces, and the total production of meat rises from 16 to 18 ounces. Frank and Rose share the benefits of this increased production.
We can also look at the gains from trade in terms of the price that each party pays the other. Because Frank and Rose have different opportunity costs, they can both get a bargain. That is, each of them benefits from trade by obtaining a good at a price that is lower than his or her opportunity cost of that good.
Consider the proposed deal from Frank’s viewpoint. Frank receives 5 ounces of meat in exchange for 15 ounces of potatoes. In other words, Frank buys each ounce of meat for a price of 3 ounces of potatoes. This price of meat is lower than his opportunity cost for an ounce of meat, which is 4 ounces of potatoes. Thus, Frank benefits from the deal because he gets to buy meat at a good price.
Now consider the deal from Rose’s viewpoint. Rose buys 15 ounces of potatoes for a price of 5 ounces of meat. That is, the price of potatoes is ⅓ ounce of meat. This price of potatoes is lower than her opportunity cost of an ounce of potatoes, which is ½ ounce of meat. Rose benefits because she gets to buy potatoes at a good price.
The story of Rose the rancher and Frank the farmer has a simple moral, which should now be clear: Trade can benefit everyone in society because it allows people to specialize in activities in which they have a comparative advantage.
3-2d The Price of the Trade
The principle of comparative advantage establishes that there are gains from specialization and trade, but it raises a couple of related questions: What determines the price at which trade takes place? How are the gains from trade shared between the trading parties? The precise answer to these questions is beyond the scope of this chapter, but we can state one general rule: For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs.
In our example, Frank and Rose agreed to trade at a rate of 3 ounces of potatoes for each ounce of meat. This price is between Rose’s opportunity cost (2 ounces of potatoes per ounce of meat) and Frank’s opportunity cost (4 ounces of potatoes per ounce of meat). The price need not be exactly in the middle for both parties to gain, but it must be somewhere between 2 and 4.
To see why the price has to be in this range, consider what would happen if it were not. If the price of meat were below 2 ounces of potatoes, both Frank and Rose would want to buy meat, because the price would be below each of their opportunity costs. Similarly, if the price of meat were above 4 ounces of potatoes, both would want to sell meat, because the price would be above their opportunity costs. But there are only two members of this economy. They cannot both be buyers of meat, nor can they both be sellers. Someone has to take the other side of the deal.
A mutually advantageous trade can be struck at a price between 2 and 4. In this price range, Rose wants to sell meat to buy potatoes, and Frank wants to sell potatoes to buy meat. Each party can buy a good at a price that is lower than his or her opportunity cost. In the end, each person specializes in the good for which he or she has a comparative advantage and is, as a result, better off.
Quick Quiz Robinson Crusoe can gather 10 coconuts or catch 1 fish per hour. His friend Friday can gather 30 coconuts or catch 2 fish per hour. What is Crusoe’s opportunity cost of catching 1 fish? What is Friday’s? Who has an absolute advantage in catching fish? Who has a comparative advantage in catching fish?
FYI The Legacy of Adam Smith and David Ricardo
Economists have long understood the gains from trade. Here is how the great economist Adam Smith put the argument:
It is a maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes but employs a tailor. The farmer attempts to make neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbors, and to purchase with a part of its produce, or what is the same thing, with the price of part of it, whatever else they have occasion for.
This quotation is from Smith’s 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, which was a landmark in the analysis of trade and economic interdependence.
Smith’s book inspired David Ricardo, a millionaire stockbroker, to become an economist. In his 1817 book Principles of Political Economy and Taxation, Ricardo developed the principle of comparative advantage as we know it today. He considered an example with two goods (wine and cloth) and two countries (England and Portugal). He showed that both countries can gain by opening up trade and specializing based on comparative advantage.
Ricardo’s theory is the starting point of modern international economics, but his defense of free trade was not a mere academic exercise. Ricardo put his beliefs to work as a member of the British Parliament, where he opposed the Corn Laws, which restricted the import of grain.
The conclusions of Adam Smith and David Ricardo on the gains from trade have held up well over time. Although economists often disagree on questions of policy, they are united in their support of free trade. Moreover, the central argument for free trade has not changed much in the past two centuries. Even though the field of economics has broadened its scope and refined its theories since the time of Smith and Ricardo, economists’ opposition to trade restrictions is still based largely on the principle of comparative advantage. image
3-3 Applications of Comparative Advantage
The principle of comparative advantage explains interdependence and the gains from trade. Because interdependence is so prevalent in the modern world, the principle of comparative advantage has many applications. Here are two examples, one fanciful and one of great practical importance.
3-3a Should Tom Brady Mow His Own Lawn?
Tom Brady spends a lot of time running around on grass. One of the most talented football players of all time, he can throw a pass with a speed and accuracy that most casual athletes can only dream of. Most likely, he is talented at other physical activities as well. For example, let’s imagine that Brady can mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should?
To answer this question, we can use the concepts of opportunity cost and comparative advantage. Let’s say that Brady can mow his lawn in 2 hours. In that same 2 hours, he could film a television commercial and earn $20,000. By contrast, Forrest Gump, the boy next door, can mow Brady’s lawn in 4 hours. In that same 4 hours, Gump could work at McDonald’s and earn $40.
“They did a nice job mowing this grass. “
IN THE NEWS Economics within a Marriage
An economist argues that you shouldn’t always unload the dishwasher just because you’re better than your partner at it.
You’re Dividing the Chores Wrong
By Emily Oster
No one likes doing chores. In happiness surveys, housework is ranked down there with commuting as activities that people enjoy the least. Maybe that’s why figuring out who does which chores usually prompts, at best, tense discussion in a household and, at worst, outright fighting.
If everyone is good at something different, assigning chores is easy. If your partner is great at grocery shopping and you are great at the laundry, you’re set. But this isn’t always—or even usually—the case. Often one person is better at everything. (And let’s be honest, often that person is the woman.) Better at the laundry, the grocery shopping, the cleaning, the cooking. But does that mean she should have to do everything?
Before my daughter was born, I both cooked and did the dishes. It wasn’t a big deal, it didn’t take too much time, and honestly I was a lot better at both than my husband. His cooking repertoire extended only to eggs and chili, and when I left him in charge of the dishwasher, I’d often find he had run it “full” with one pot and eight forks.
After we had a kid, we had more to do and less time to do it in. It seemed like it was time for some reassignments. But, of course, I was still better at doing both things. Did that mean I should do them both?
I could have appealed to the principle of fairness: We should each do half. I could have appealed to feminism—surveys show that women more often than not get the short end of the chore stick. In time-use data, women do about 44 minutes more housework than men (2 hours and 11 minutes versus 1 hour and 27 minutes). Men outwork women only in the areas of “lawn” and “exterior maintenance.” I could have suggested he do more chores to rectify this imbalance, to show our daughter, in the Free To Be You and Me style, that Mom and Dad are equal and that housework is fun if we do it together! I could have simply smashed around the pans in the dishwasher while sighing loudly in the hopes he would notice and offer to do it himself.
But luckily for me and my husband, I’m an economist, so I have more effective tools than passive aggression. And some basic economic principles provided the answer. We needed to divide the chores because it is simply not efficient for the best cook and dishwasher to do all the cooking and dishwashing. The economic principle at play here is increasing marginal cost. Basically, people get worse when they are tired. When I teach my students at the University of Chicago this principle, I explain it in the context of managing their employees. Imagine you have a good employee and a not-so-good one. Should you make the good employee do literally everything?
Usually, the answer is no. Why not? It’s likely that the not-so-good employee is better at 9 a.m. after a full night of sleep than the good employee is at 2 a.m. after a 17-hour workday. So you want to give at least a few tasks to your worse guy. The same principle applies in your household. Yes, you (or your spouse) might be better at everything. But anyone doing the laundry at 4 a.m. is likely to put the red towels in with the white T-shirts. Some task splitting is a good idea. How much depends on how fast people’s skills decay.
To “optimize” your family efficiency (every economist’s ultimate goal—and yours, too), you want to equalize effectiveness on the final task each person is doing. Your partner does the dishes, mows the lawn, and makes the grocery list. You do the cooking, laundry, shopping, cleaning, and paying the bills. This may seem imbalanced, but when you look at it, you see that by the time your partner gets to the grocery-list task, he is wearing thin and starting to nod off. It’s all he can do to figure out how much milk you need. In fact, he is just about as good at that as you are when you get around to paying the bills, even though that’s your fifth task.
If you then made your partner also do the cleaning—so it was an even four and four—the house would be a disaster, since he is already exhausted by his third chore while you are still doing fine. This system may well end up meaning one person does more, but it is unlikely to result in one person doing everything.
Once you’ve decided you need to divide up the chores in this way, how should you decide who does what? One option would be randomly assigning tasks; another would be having each person do some of everything. One spousal-advice website I read suggested you should divide tasks based on which ones you like the best. None of these are quite right. (In the last case, how would anyone ever end up with the job of cleaning the bathroom?)
To decide who does what, we need more economics. Specifically, the principle of comparative advantage. Economists usually talk about this in the context of trade. Imagine Finland is better than Sweden at making both reindeer hats and snowshoes. But they are much, much better at the hats and only a little better at the snowshoes. The overall world production is maximized when Finland makes hats and Sweden makes snowshoes.
We say that Finland has an absolute advantage in both things but a comparative advantage only in hats. This principle is part of the reason economists value free trade, but that’s for another column (and probably another author). But it’s also a guideline for how to trade tasks in your house. You want to assign each person the tasks on which he or she has a comparative advantage. It doesn’t matter that you have an absolute advantage in everything. If you are much, much better at the laundry and only a little better at cleaning the toilet, you should do the laundry and have your spouse get out the scrub brush. Just explain that it’s efficient!
In our case, it was easy. Other than using the grill—which I freely admit is the husband domain—I’m much, much better at cooking. And I was only moderately better at the dishes. So he got the job of cleaning up after meals, even though his dishwasher loading habits had already come under scrutiny. The good news is another economic principle I hadn’t even counted on was soon in play: learning by doing. As people do a task, they improve at it. Eighteen months into this new arrangement the dishwasher is almost a work of art: neat rows of dishes and everything carefully screened for “top-rack only” status. I, meanwhile, am forbidden from getting near the dishwasher. Apparently, there is a risk that I’ll “ruin it.”
Ms. Oster is a professor of economics at the University of Chicago. image
Source: Slate, November 21, 2012. The article is found in the link: http://www.slate.com/articles/double_x/doublex/2012/ll/dividing_the_chores_who_should_cook_and_who_should_clean.2.html
In this example, Brady has an absolute advantage in mowing lawns because he can do the work with a lower input of time. Yet because Brady’s opportunity cost of mowing the lawn is $20,000 and Gump’s opportunity cost is only $40, Gump has a comparative advantage in mowing lawns.
The gains from trade in this example are tremendous. Rather than mowing his own lawn, Brady should make the commercial and hire Gump to mow the lawn. As long as Brady pays Gump more than $40 and less than $20,000, both of them are better off.
3-3b Should the United States Trade with Other Countries?
Just as individuals can benefit from specialization and trade with one another, as Frank and Rose did, so can populations of people in different countries. Many of the goods that Americans enjoy are produced abroad, and many of the goods produced in the United States are sold abroad. Goods produced abroad and sold domestically are called imports. Goods produced domestically and sold abroad are called exports.
imports goods produced abroad and sold domestically
exports goods produced domestically and sold abroad
To see how countries can benefit from trade, suppose there are two countries, the United States and Japan, and two goods, food and cars. Imagine that the two countries produce cars equally well: An American worker and a Japanese worker can each produce one car per month. By contrast, because the United States has more and better land, it is better at producing food: A U.S. worker can produce 2 tons of food per month, whereas a Japanese worker can produce only 1 ton of food per month.
The principle of comparative advantage states that each good should be produced by the country that has the smaller opportunity cost of producing that good. Because the opportunity cost of a car is 2 tons of food in the United States but only 1 ton of food in Japan, Japan has a comparative advantage in producing cars. Japan should produce more cars than it wants for its own use and export some of them to the United States. Similarly, because the opportunity cost of a ton of food is 1 car in Japan but only ½ car in the United States, the United States has a comparative advantage in producing food. The United States should produce more food than it wants to consume and export some to Japan. Through specialization and trade, both countries can have more food and more cars.
In reality, of course, the issues involved in trade among nations are more complex than this example suggests. Most important among these issues is that each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off. When the United States exports food and imports cars, the impact on an American farmer is not the same as the impact on an American autoworker. Yet, contrary to the opinions sometimes voiced by politicians and pundits, international trade is not like war, in which some countries win and others lose. Trade allows all countries to achieve greater prosperity.
Quick Quiz Suppose that a skilled brain surgeon also happens to be the world’s fastest typist. Should she do her own typing or hire a secretary? Explain.
You should now understand more fully the benefits of living in an interdependent economy. When Americans buy tube socks from China, when residents of Maine drink orange juice from Florida, and when a homeowner hires the kid next door to mow the lawn, the same economic forces are at work. The principle of comparative advantage shows that trade can make everyone better off.
Having seen why interdependence is desirable, you might naturally ask how it is possible. How do free societies coordinate the diverse activities of all the people involved in their economies? What ensures that goods and services will get from those who should be producing them to those who should be consuming them? In a world with only two people, such as Rose the rancher and Frank the farmer, the answer is simple: These two people can bargain and allocate resources between themselves. In the real world with billions of people, the answer is less obvious. We take up this issue in Chapter 4, where we see that free societies allocate resources through the market forces of supply and demand.
Each person consumes goods and services produced by many other people both in the United States and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services.
There are two ways to compare the ability of two people to produce a good. The person who can produce the good with the smaller quantity of inputs is said to have an absolute advantage in producing the good. The person who has the smaller opportunity cost of producing the good is said to have a comparative advantage. The gains from trade are based on comparative advantage, not absolute advantage.
Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage.