Comparative Advantage and Absolute Advantage

What I want to do in this video is

make sure we understand the difference between

"comparative advantage" and "absolute advantage".

What we saw in the last video is that

Patty had a comparative advantage in plates

relative to Charlie because

her opportunity cost of producing one plate was

lower than Charlie's opportunity cost of producing a plate.

Hers was one-third of a cup, his was three cups.

So, that's why it made sense for her to specialize in plates.

Charlie on the other hand had

a comparative advantage in cups;

his opportunity cost for producing a cup

was only a third of a plate,

while Patty's was three plates.

So that's why he specialized in cups.

Now, we can't confuse this with absolute advantage.

Absolute advantage in a given product just means that

you are more productive

at that thing given the same inputs.

And so if I were to just give you this graph,

and you didn't know how many workers Charlie or Patty had

and how many inputs they're using to produce

either thirty cups in a day or thirty plates in a day,

you actually could not make any statement

about absolute advantage.

But if we assume that in all of these scenarios

they have the same number of inputs,

so if we think about plates . . .

If we say they each have one employee,

maybe it's themselves,

and given that one input,

or the same number of inputs,

Patty is able to produce more plates than Charlie,

then it is true that Patty would have

an absolute advantage in plates.

And if given the same number of inputs,

Charlie is able to produce more cups than Patty,

then he would have an absolute advantage in cups.

But it is not because of that absolute advantage

that he is specializing in it.

In fact, we don't even know what their inputs were.

It might be that he doesn't have an absolute advantage.

Maybe Charlie needs

a hundred people to produce his thirty cups,

while Patty can produce ten cups with one person.

So in that case,

actually Patty would have an absolute advantage,

but it just wouldn't be obvious from this right over here.

But to make everything clear,

I want to do a scenario where

Charlie improved his productivity in some way and

he actually has the absolute advantage in both products,

and still show that as long as

they have different comparative advantages,

then it still makes sense for them to specialize.

So let's do another scenario.

So Charlie has improved dramatically.

So let's draw our little graph here.

That's our cups axis, this is still our plates axis.

Cups and plates . . .

and let's just put some more markers here...

ten, twenty, thirty and forty.

And ten, twenty, thirty and forty, and

let's still put Patty, let's assume Patty hasn't changed,

so this is her PPF, so that is Patty's PPF, just like that.

But let's say that Charlie has improved dramatically.

And so Charlie's PPF looks like this.

So this is Charlie's PPF now looks like this.

So in a given day he can produce

- and let's just assume

they're using the same number of inputs-

so using the same number of inputs in a given day

he can produce forty cups

when Patty can only produce ten.

So he has the absolute advantage in cups.

Or, in the same given day using the same inputs,

he could produce forty plates

while Patty can only produce thirty.

So now Charlie, all of a sudden,

has an absolute advantage in both products.

But we'll see it still makes sense for them to specialize

because they have different comparative advantages;

they have different opportunity costs.

So let's figure this out.

So we have all the same numbers for Patty -

actually, let me copy and paste Patty's numbers right here.

Actually we have access to her numbers right over here

so I don't have to copy and paste it.

But let's think of Charlie's new numbers now.

So this is the PPF for Charlie.

So this is our new PPF for Charlie.

Maybe he did some investment or R&D

to get this new, awesome, productive PPF.

So he's expanded his PPF.

So what is his opportunity costs?

Say he's sitting here - so he's producing 40 cups -

what would be his opportunity cost of producing 40 plates?

Well to produce those forty plates,

he would have to give up those forty cups.

So his opportunity cost of forty plates

is equal to forty cups.

Or you divide both sides by forty:

his opportunity costs for one plate is equal to one cup.

And this makes math very easy:

his opportunity cost for one cup is equal to one plate.

Now given this new reality - so we've already established

Charlie has an absolute advantage in both.

Using the same inputs he can do more of either of them.

And remember,

when you're talking about absolute advantage

you have to think about the amount of inputs you use.

Who's more productive in that way?

But let's think about comparative advantage.

If we think about plates,

who has a lower opportunity cost for producing a plate?

Patty hasn't changed.

Her opportunity cost for producing a plate

is one-third of a cup.

Charlie's opportunity cost for producing a plate

has improved, but it's still worse than Patty's.

He has to spend one cup to make a plate,

she only has to give up one-third of a cup to make a plate.

So Patty still has a comparative advantage in plates.

And if we look at the opportunity cost in cups,

the opportunity cost for Charlie to make 1 cup is 1 plate.

So it's actually a little bit worse than it was before,

but as we'll see it ends up being a good thing,

he's just overall more productive.

But his opportunity cost for one cup,

he's giving up one plate now,

when before he was producing one third of a plate.

And that's because in the other scenario,

he was more one-sided, I guess is one way to say it.

But his opportunity cost for producing a cup

is still cheaper than Patty's.

Her opportunity cost of producing a cup is three plates:

her opportunity cost.

While his is only one plate.

So he still has the comparative advantage in cups.

So Charlie should still specialize in cups . . .

and Patty should still specialize in plates.

And to show that they can still get an outcome that

is beyond even Charlie's Production Possibilities Frontier,

let's think about how they could trade.

So Charlie's going to specialize in cups;

he's going to sit right over there producing forty cups a day.

And Patty's going to specialize in plates,

and she's going to sit right there

- let me use a different color, I don't want to use this color -

she's going to sit right there and produce thirty plates a day.

So how could they trade for mutual benefit?

Well any trade that is -

assuming that they don't want to have only plates

or they don't only want to have cups.

Any trade that is cheaper

than their opportunity cost will be a good one.

So for example, Patty is sitting here producing only plates.

Her opportunity cost for a cup is three plates.

So she would be willing to trade

anything less than three plates for a cup,

assuming that she wants it.

Because, if she had to make the cups herself,

she would have to give up three plates.

So let's say that Patty would be willing to trade one cup

sorry, one plate -

actually she'd be willing to trade two plates for one cup.

She's be willing to trade that,

because if she had to make the cups herself,

she'd have to give up three plates for one cup.

So she's willing to trade two plates for one cup.

And let's see if Charlie would be willing

to trade two plates for one cup.

So he has all of these cups -

how many cups does he have to give away for a plate?

Well he has to give away one cup for a plate.

Now he would have to give away one cup for two plates,

or he would have to give up half a cup for a plate.

Either way, this is better than his opportunity cost of

trying to get that incremental plate.

So he would be willing to do that too:

two plates for one cup.

He'd be willing to do one cup for two plates.

And to see how that would improve,

he could have forty cups

or he could trade one of them away -

Actually, let's do a scenario

where he trades ten of the cups away.

So now he only has twenty cups,

but for those twenty cups he traded away -

Actually, that's a bad example

because Patty won't have enough cups.

So let's say he trades away ten cups.

Let's say he trades away ten cups for twenty plates.

So Charlie trades 10 cups for 20 plates.

So now he trades ten cups and he gets twenty plates.

So now he'll end up at this scenario over here,

which was beyond, which was unattainable,

when he was working by himself,

when he didn't specialize and get gains from trade.

So this is a good scenario for him.

He's able to get outcomes he otherwise

would not have been able to get.

He could, depending on how he trades,

he could get outcomes, well up to a certain point,

because Patty only has thirty cups.

So at best he can take all of Patty's cups.

So he can get something along that line over there.

But if we look at the same scenario,

Patty traded twenty plates for ten cups:

where does that put her?

So she traded twenty plates, so she's down ten plates

but she got ten cups, so that put her right over here.

Once again, beyond her Production Possibilities Frontier,

so this would look like

a pretty good situation for Patty as well.