Comparative vs Absolute Advantage

1. Comparative vs Absolute Advantage

2. Absolute Advantage • A person is said to have an absolute advantage over others if s/he is the best at doing something. • For example: Lance Armstrong can be considered to have an absolute advantage over others in cycling. • But having an absolute advantage in one area does not guarantee that the person or business has an absolute advantage over other areas.

3. Comparative Advantage • A person has a comparative advantage if s/he can produce something at a lower cost than others. • This is not the same as being the best at something.

4. For example, Lance Armstrong probably has a secretary to help with typing and office functions for his LiveStrong bracelet business. • He is probably not the fastest typist in the world, but his secretary can type faster than him. She gives up other potentially higher paying jobs to be his secretary. Therefore, she is the lower-cost typist and has a compartive advantage in typing. For Lance to do his own typing, his time used on other business activities is more expensive than the secretary's time.

5. To find people's comparative advantage, compare their opportunity costs. • E.g. if you are great at cleaning and your roommate is studying to be a chef, it makes sense for you to divide the household chores. You clean; your roommate would cook. You each have an absolute advantage in one area.

6. But what if your roommate was Martha Stewart. She clearly has an absolute advantage in both areas – cooking and cleaning. • You then need to look at your opportunity costs. • Her ability to cook is much greater than yours, but if her ability to clean is only a little greater, then you will both be better off if she cooks and you clean. Having one person do everything is not as efficient. • Theoretically, you are the 'least expensive' cleaner and therefore should clean.

7. With Comparative Advantage, everyone wins through trade. • Those with absolute advantages can buy goods and services from businesses who produce them at a comparatively lower cost. Excerpts taken from http://www.econlib.org/library/Topics/Details/comparativeadvantage.html

8. For example: • If Portugal uses only 80 people to produce wine for the country, but needs 90 people to produce cloth, it is advantageous to produce wine for export and trade for cloth from another country with a comparative advantage when making cloth. • From On the Principles of Political Economy and Taxation by David Ricardo. London: John Murray, 1821. First published 1819

9. Second Example: Think of the following scenario: If all of the resources of the two countries were fully allocated, this is what they could produce. Food Fish Northland 100 tonnes 100 tonnes Southland 400 tonnes 200 tonnes Who has the absolute advantage and what is the comparative advantage? Look at the oppportunity costs. http://en.wikipedia.org/wiki/Comparative_advantage

10. How to Calculate Opportunity Cost: • Select one alternative • Divide what you are losing by what you gain from choosing that alternative. • For example, if Southland chooses to produce food, the opportunity cost is: 200 = 0.5 400 Southland loses 0.5 tonnes of fish for every tonne of food they produce.

11. Conversely, if Southland decides to produce fish, the opportunity cost would be: 400 = 2 200 Southland loses 2 tonnes of food to produce 1 tonne of fish.

12. Answers: • With full employment of all resources, Southland has the absolute advantage of producing both goods. • But… when comparing opporuntity costs: • Northland's opportunity cost of producing 1 tonne of food is 1 tonne of fish (vice versa) • Southland's opportunity cost of producing 1 tonne of food is 0.5 tonnes of fish. • Southland's opportunity cost of producing 1 tonne of fish is 2 tonnes of food.

13. Therefore, Southland has the comparative advantage in food production, but Northland has the comparative advantage in fish production. • Both countries are better off if Southland produces food to trade for Northland's fish.