The rancher’s explanation of the gains from trade, though correct, poses a puzzle: If the rancher is better at both raising cattle and growing potatoes, how can the farmer ever specialize in doing what he does best? The farmer doesn’t seem to do anything best. To solve this puzzle, we need to look at the principle of comparative advantage.
As a first step in developing this principle, consider the following question: In our example, who can produce potatoes at lower cost – the farmer or the rancher? There are two possible answers, and in these two answers lie the solution to our puzzle and the key to understanding the gains from trade.
Absolute Advantage: One way to answer the question about the cost of producing potatoes is to compare the inputs required by the two producers. Economists use the term absolute advantage when comparing the productivity of one person, firm, or nation to that of another. The producer that requires a smaller quantity of inputs to produce good is said to have an absolute advantage in producing that good.
In our example, time is the only input, so we can determine absolute advantage by looking at how much time each type of production takes. The rancher has an absolute advantage both in producing meat and in producing potatoes because she requires less time than the farmer to produce a unit of either good. The rancher needs to input only 20 minutes to produce an ounce of meat, whereas the farmer needs 60 minutes. Similarly the rancher needs only 10 minutes to produce an ounce of potatoes, whereas the farmer needs 15 minutes. Based on this information we can conclude that the rancher has the lower cost of producing potatoes, if we measure cost by the quantity of inputs.
Opportunity Cost and Comparative Advantage: There is another way to look at the cost of producing potatoes. Rather than comparing inputs required, we can compare the opportunity costs. Recall that the opportunity cost of some item is what we give to get that item. In our example, we assumed that the farmer and the rancher each send 8 hours a day working. Time spent producing potatoes, therefore takes away from time available for producing neat. As the rancher and farmer reallocate time between producing the two goods, they move along their production possibility frontiers; they give up units of one good to produce units of the other. The opportunity cost measures the trade off between the two goods that each producer faces. Let’s first consider the rancher’s opportunity cost. Producing 1 ounce of potatoes takes 10 minutes of work. When the rancher spends those 10 minutes producing potatoes, she spends 10 minutes less producing meat. Because the rancher needs 20 minutes to produce 1 ounce of meat, 10 minutes of work would yield ½ ounce of meat. Hence, the rancher’s opportunity cost of producing 1ounce of potatoes is ½ ounce of meat.
Now consider the farmer opportunity cost. Producing 1 ounce of potatoes takes him 15 minutes. Because he needs 60 minutes to produce 1 ounce of meat 15 minutes of work would yield ¼ ounce of meat. Hence, the farmer’s opportunity cost of 1 ounce of potatoes is ¼ ounce of meat.
Notice that the opportunity cost of meat is the inverse of the opportunity cost of potatoes. Because 1 ounce of potatoes costs the rancher ½ ounce of meat 1 ounce of meat costs the rancher 2 ounces of potatoes. Similarly, because 1 ounce of potatoes costs the farmer ¼ ounce of meat, 1 ounce of meat costs the farmer 4 ounces of potatoes.
Economists use the term comparative advantage when describing the opportunity cost of two producers. The producer who gives up less of other goods to produce Good X has the smaller opportunity cost. Good X and is said to have a comparative advantage in producing it. In our example, the farmer has a lower opportunity cost of producing potatoes than does the rancher: An ounce of potatoes costs the farmer only ¼ ounce of meat, but it costs the rancher ½ ounce of meat. Conversely, the rancher has a lower opportunity cost of producing meat than does the farmer. An ounce of meat costs the rancher 2 ounces of potatoes, but it costs the farmer 4 ounces of potatoes. Thus, the farmer has a comparative advantage in growing potatoes. Thus, the farmer has a comparative advantage in growing potatoes and the rancher has a comparative advantage in producing meat.