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 importance.
Should Tiger woods mow his own lawn?
Tiger Woods spends a lot of time walking around on grass. One of the most talented golfers of all time, he can hit a drive and sink a putt in a way that most casual golfers only dream of doing. Most likely he is talented at other activities too. For example, let’s imagine that woods 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 Woods can mow his lawn in 2 hours. In that same 2 hours, he could he could film a television commercial for Nike and earn $10,000. By contrast Forrest Gump, the boy next done, can mow wood’s lawn in 4 hours. In that same 4 hours he could work at McDonald’s and earn $20.
In this example, woods opportunity cost of mowing the lawn is $10,000 and Forrest’s opportunity cost is $20 woods has an absolute advantage in mowing lawns because he can do the work with a lower input of time. Yet Forrest has a comparative advantage in mowing lawns because he has lower opportunity costs
The gains from trade in this example are tremendous. Rather than mowing his own lawn, Woods should make the commercial and hire Forrest to mow the lawn. As long as Woods pays Forrest more than $20 and less than $20 and les than $10,000 both of them are better off.
Should the US trade wit other countries?
Just as individuals can benefit from specialization and trade with one another as the farmer and rancher 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 US are sold abroad. Goods produced abroad and sold domestically are called imports. Goods produced domestically and sold abroad are called exports.
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 1 car per month . By contrast, because US has more and better land, it is better at producing food: A US 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 tins in the US 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 these to the US. Similarly because the opportunity cost of a ton of food is 1 car in Japan but only ½ cars in the US, the US has a comparative advantage in producing food. The US 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.
The principle of comparative advantage shows that trade can make everyone beer off. You should now understand more fully the benefits of living in an interdependent economy. But 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?
A world with only two people such as the rancher and the farmer, the answer is simple. These two people can directly bargain and allocate resources between themselves. In the real world with billions of people the answer is less obvious.