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Comparative Advantage and Gains From Trade (Part 1)

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Let’s talk a little bit about the idea of the specialization of labor and potential gains from trade. The overarching question we are going to be thinking about right now is supposed we have a professor and his secretary. We have a following setup. You will notice that the professor is more productive both at research, because he can produce one page of research in one hour rather than only 1/10 to the page. And, he is more productive at typing. He can type four page per hour as opposed to his secretary who can type two page per hour. The resulting question is then, does it make sense for the professor to do his own typing or are there gains from trade to be had in its very simple two person economy.

The first economic concept that I want to talk about regarding the potential for trade is the concept of absolute advantage. Absolute advantages refers to how efficiently each party can produce and which party can produce faster, essentially.

If you look at our setup here, the professor has in economic terms, an absolute advantage in both research and in typing. We say that this is true because the professor is more productive. He can produce one page of research per hour whereas his secretary can only produce one-tenth of a page. Similarly, he has an absolute advantage in typing because he can type four pages per hour as opposed to the secretary who can only type two pages per hour.

But rather than think about just absolute productivity, what would happen if we instead thought about each of these activities in terms of what had to be given up. Again we define the term opportunity cost as what has to be given up in order to get something.

Here, the opportunity cost of typing is how much research has to be given up to get one page of typing. In this case, we can say the following: it takes the professor 15 minutes on average to type one page because he can type four pages per hour. Well, in that 15 minutes he could have, again, on average produced ¼ of the page of research. So in order to type one page he has to give up ¼ of a page of research.

So his opportunity cost of typing one page is in fact ¼ of a page of research. Now, if we think about the secretary, one page of typing for the secretary takes her 30 minutes. In 30 minutes, she can only produce 1/20 of a page of research. So, her opportunity cost of one page of typing is just 1/20 of the page of research.

Now rather than absolute advantage let’s think about another economic measure called Comparative Advantage. Now one party is said to have a comparative advantage in an activity over another if they have a lower opportunity cost of producing that activity.

In this example here, the secretary has a comparative advantage over the professor in typing because she doesn’t have to give up as much to type one page. Similarly if we were to go down here, we can think about the opportunity cost of research in terms of how much typing has to be given up.

The professor can produce one page of research per hour. So to produce that one page of research, he has to give up four pages of typing. The secretary on the other hand would take 10 hours to produce one page of research. Well in those 10 hours she could have typed 20 pages. So in order to produce one page of research, she has to give up 20 pages of typing.

Coming back to the concept of a Comparative Advantage we can see here that the professor has the comparative advantage in research because he has to give up less typing to get a page of research done.

There are two things that are helpful to learn about this setup. First, you probably notice that there’s a relationship between the opportunity cost both for the professor and for the secretary. So if the opportunity cost of typing is ¼ of a page of research, then the opportunity cost of research in terms of typing is just the reciprocal of that; or four. Similarly, if the opportunity cost of typing in terms of research is one over 20 for the secretary, then it’s going to be the reciprocal, namely 20 if we are thinking about the opportunity cost of research in terms of typing.

Second thing that’s helpful to note is that, unless both parties in our very simple economy have exactly the same opportunity cost, one of them will always have a comparative advantage in one of the activities and the other one will have a comparative advantage in the other activity. In this case we see that the professor has a Comparative Advantage in research and the secretary has a Comparative Advantage in tying.

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