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Week 16: Comparative Advantage

What's the use in trade and specialisation and how should you choose a career? 

 

What is a comparative advantage?

If you are better than me at being a lawyer and you are also better than me at cleaning houses, you have an absolute advantage in both these activities. Does that mean that you should do both, and that both of us are better off if you do both? Not necessarily. Suppose you earn $100 per hour being a lawyer and $20 per hour cleaning, but I only earn $10 at work and $15 per hour cleaning. This means you have an absolute advantage at both ($100 is more than $10 and $20 is more than $15). However, the difference between what I make per hour and what you make per hour cleaning is only $5, compared to a whopping $90 difference between our wages working as a lawyer. I’m ‘least bad’  at cleaning your house, in other words I have a comparative advantage at cleaning, so both of us would be better off if you paid me to clean your house and devoted all your time to earning the big bucks at that fancy law firm. You may be better than me at everything, but I still have the comparative advantage at cleaning your house - ha! Generally, people should do the action that they’re the least bad at, working to their comparative advantage. 

Examples of comparative advantage

Ever wondered why most call centres are outsourced to India, when a lot of people (irrationally or otherwise) prefer to speak to someone in their own country? A lot of people fear their country entering free trade, thinking they will be out-produced by a country with an absolute advantage in several areas, which would lead to imports, but no exports. Comparative advantage stipulates that countries should specialize in a certain class of products for export, but import the rest - even if the country holds an absolute advantage in all products. See the entry on positive- and zero-sum situations for a brief explanation of why.

Another area where we see this applied is the division of labour and specialisation in society. If I’m doing what’s best for myself personally, I should look for the jobs that are to my comparative advantage. Perhaps a lot of people could be a doctor, so even if I had an absolute advantage in medicine (and that’s a big if), I could have a comparative advantage in working on a new startup, or doing biomedical research. It’s best for everyone individually and for society if we work where we have a comparative advantage.

Also check out

  1. Comparative advantage and gains from trade, Khan Academy (video)
  2. Comparative Advantage, Library of Economics and Liberty.

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