[This entry is based upon a reply to a friend, who requested an explanation of comparative advantage.]

Imagine that you and someone whom you know need each to produce reports that will involve both pages of text and pages of diagrams. Imagine further that you can produce ten pages of text in a day or five pages of diagrams in a day, while this other person can produce five pages of text or three pages of diagrams.

You have an absolute advantage in the production of each good here. None-the-less, if you are able to trade (text for diagrams), both of you can gain.

For every page of diagrams that you produce, you have to forgo production of two pages of text. For every page of diagrams that the other person produces, he must forgo production of one and two-thirds pages of texts.

Slow as he may be at each task, he has a comparative advantage in the production of diagrams. Setting aside transaction costs, if someone will trade text for diagrams at a ratio of better than five-to-three, then he can profitably make diagrams to trade for text. You, meanwhile, have a comparative advantage in the production of text. Setting aside transaction costs, if someone will trade diagrams for text at a ratio of better than one-to-two, then you can profitably make text to trade for diagrams. So trading at something between 1 2/3 pages of text and 2 pages of text per page of diagrams should work for you both.

The only way that each of two parties could not have a comparative advantage in something would be if everyone had exactly the same production trade-off ratios. That's not bloody likely.[1]

We certainly don't require that one party be worse at both things for each party to have a comparative advantage in something. Here

each party has an absolute advantage in something, and a comparative advantage in that same thing. Such examples come freely to mind; and, because in such examples comparative advantage is in the same product as absolute advantage, such examples foster a confusion that absolute advantage determines where one should specialize or (worse) what one should produce. (The latter is worse because it mistakenly implies that one should never trade for something in which one has an absolute advantage.)

Comparative advantage underlies virtually all trade,[2] whether we're talking about two people or two firms or two nations. But it is in international trade that comparative advantage is most often discussed.

This attention is because lay-people are most likely to think that international trade or proper trade policy is instead somehow determined by absolute advantage. The fear that one country can somehow suck up everything through unregulated trade is almost always founded on a belief that absolute advantage (from cheap labor in the undeveloped world or from advanced technology in the developed world) determines who profits.

But explanations in terms of absolute advantage lack coherence. Returning to the original example of producing reports (where you have the absolute advantage in both products), there is no way for you to leave the other person worse-off through trade, unless he can be persuaded to trade at a ratio worse (inclusive of transaction costs) than he can produce for himself. Maybe he's dumb enough for that, but he could be dumb enough for that even if he had the absolute advantage in both.

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[1] On the other hand, it is quite possible that the ratios could be close-enough that the costs of transaction (including transportation) could swamp-out the potential gains-from-trade.

[2] Off the top of my head, I doubt that there are actually any exceptions. For example, when one buys what may seem an over-priced product, as an act of pity or of charity, which product one could have produced for oneself, either the premium may be viewed as a purchase of something beyond the overt product, or the transaction may be decomposed into a trade coupled with a simple gift.

Tags: absolute advantage, comparative advantage, trade

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