The Beauty and Importance of Comparative Advantage

As part of an educational video series I’m helping to create, I recently came up with a numerical example illustrating the principle of “comparative advantage.” Specifically, it shows how even if a less economically developed country is less productive in every industry, it can still make a more advanced country better off to engage in trade with its weaker peer. For those wanting more of the history in economic thought, I refer you to my personal podcast episode on the topic. In the present article, however, I’ll dive right into the example:

The assumptions behind this story are as follows: There are two possible product lines, namely TVs and jet aircraft. The US has 100 workers that it can assign to either task, while Mexico has 50. Moreover, the US workers (because of superior training and equipment) have the absolute advantage in both lines: A given US worker can make either 1000 TVs or 4 jets per year, while a Mexican worker can only produce 500 TVs or 1 jet. (We assume that within each country, the workers are interchangeable.)

Because the US has the absolute advantage in both lines, one might suppose that there are no gains from trade. Yet that is incorrect. The rest of this example will show how everybody can end up consuming more of both goods, if the US and Mexico specialize and then trade.

Situation #1: No foreign trade; all consumption is produced internally.

In the first scenario, we see what happens if the Americans and Mexicans can only consume the goods that are physically produced within their borders. To keep the numbers simple, assume each country devotes half of its workforce to each good. That means the US produces 50 x 1000 = 50,000 TVs and 50 x 4 = 200 jets during the year. By the same reasoning, Mexico can produce and consume 12,500 TVs and 25 jets. This is one example of the “consumption package” that is available to the citizens of the US and of Mexico, if they insist on “buying local” and only enjoy goods produced within their borders.

Situation#2: Each Country Specializes In Its Comparative Advantage

Now suppose we open up the border to trade. For a specific example of the possibilities, suppose Mexico devotes all 50 of its workers to TV production, while the US moves 10 of its workers out of TV production and into aircraft. As the table indicates, in this new configuration, the US produces 40 x 1000 = 40,000 TVs and 60 x 4 = 240 jets. Mexico produces 50 x 500 = 25,000 TVs.

Finally, suppose the members of each country trade at the ratio or “price” of 400 TVs per jet. At that price, finally suppose that the US imports 12,000 TVs and exports 30 jets. From the Mexican point of view, of course, the trade flows are booked as importing 30 jets and exporting 12,000 TVs.

Looking at the production supplemented by the trade flows, the new consumption package is as follows: The US has the 40,000 TVs it still produced, plus the imported 12,000 TVs, for a total of 52,000. It produced 240 jets but exported 30, leaving it with 210 for Americans. Thus the Americans actually consume 52,000 TVs and 210 jets. Similar reasoning shows that the Mexicans in this second configuration end up with 13,000 TVs and 30 jets.

The Gains From Specialization and Trade

Finally, let us compare the final consumption package in each country, with the original amounts that were available in the “buy local” scenario. The US has gained 2,000 TVs and 10 jets, while the Mexicans have gained 500 TVs and 5 jets.

This result may be surprising. Since the US workers were better at both TVs and jet production, one might have supposed that there would be no benefit to Americans from trading with Mexico. Yet as this example shows, that reasoning is simply incorrect. Although the US had the absolute advantage in both lines, it only had the comparative advantage in jet production. (This result has to do with the fact that the US advantage is 2-to-1 in TV production, but 4-to-1 in jet production.)

It is still true that countries benefit from importing those goods that can be produced abroad at a “lower cost.” However, we have to be careful about how we’re measuring “cost.” If we took worker-hours as our metric, we might erroneously conclude that TVs are “cheaper to produce” in the US versus Mexico, since it takes half as many worker-hours to make a TV in the US as it does in Mexico.

Yet that’s not the right metric. (The flaw is in supposing that a worker-hour has the same economic value in both countries. This is obviously false, if workers are more productive—and hence are paid higher wages—in the US.) If we measure the opportunity cost of TV production in terms of forfeited potential aircraft, then we see that the cost of TV production is lower in Mexico. Specifically, if the US wants to domestically produce 1000 more TVs in a given year, it must sacrifice 4 jets (that could have been produced that year if the worker had stayed in aircraft production). But if Mexico wants to domestically produce 1000 more TVs in a given year, it must move 2 workers out of jet production, thereby forfeiting the potential 2 jets that they could have made during the year. Thus, in terms of forfeited aircraft, 1000 TVs have a cost of production of 4 jets in the US but only 2 jets in Mexico. This is the sense in which it’s cheaper to make TVs in Mexico than in the US, and why it therefore boosts total output if Mexico concentrates on TV production to allow the US to tilt more heavily toward aircraft production.

Conclusion

The above example is of course quite simple, but it distills the essence of comparative advantage in the context of international trade. Again, the critical point is that even a country with workers superior in every line of production, can still enrich itself by cooperating and trading with an “inferior” country. This has relevance to the debate over “Super AI.” Even if a robot intelligence outstripped humanity and was more productive in every avenue, the AI system would still enrich itself by cooperating with humanity and trading with us.

Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.

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