Hey everyone. Noah Zerbe here. This is one of a series of short videos introducing key concepts in international political economy. In this video we look at the idea of comparative advantage. Other videos deal with topics like gross domestic product, balance of trade, and key institutions in the global economy. So let's get started with comparative advantage. The idea that international trade benefits all parties involved is rooted in the central idea of economics: absolute and comparative advantage. Absolute advantage is relatively easy to understand and apply. First articulated by Adam Smith as a rejection of the idea of mercantilism, absolute advantage exists when a country can produce goods relatively more efficiently than another country. That is to say, it can produce more of a particular good with less effort and using fewer resources than another country. In this hypothetical example, the United States has absolute advantage in producing oranges, while Canada has absolute advantage in producing maple syrup. Let's say that both countries want both goods. If they divide their time equally between the two, the United States would produce 50 oranges and one maple syrup, while Canada would produce 50 maple syrup and one orange. Globally, we'd have total production of 102 units 51 oranges and 51 syrups. But if each country were to specialize and produce what they have an absolute advantage in and then trade, global production would increase. Canada would produce 100 syrups but no oranges, while the United States would produce 100 oranges but no syrup. If they traded at a one-to-one ratio-- which this exercise suggests they would-- each country would then be able to consume 50 of each goods after trading. When we graph, this we see the same thing. If we assume that both countries want oranges and syrups equally, without trade each is forced to divide their production and produce some of each good. If the United States divides its production evenly, it produces 50 oranges in one syrup and consumes at this point on the production possibility frontier. Similarly, if Canada divides its production evenly it produces 50 syrups and one orange and consumes at this point on its production possibility frontier. But if each country specializes in trades, the United States then produces a hundred oranges and Canada produces a hundred syrup. Each country winds up at a point on their production possibility frontier that neither could have reached without specialization in trade. The United States winds up consuming 50 oranges--the same as it would without trade-- and 50 syrup--49 more than it could consume without trade. And Canada winds up consuming 50 syrup, again the same as it would have without trade, and 50 oranges, which is 49 more than it would have consumed without trade. Absolute advantage can exist for a number of reasons, including climate (as the US oranges and Canadian syrup example sort of suggests) as well as things like access to raw material, specific labor conditions, or a host of other factors. But the key takeaway here is that absolute advantage suggests that positive sum games are possible. Indeed, the recognition of absolute advantage was central to Adam Smith's rejection of mercantilism and the embrace of free trade. But is it possible for a country to have absolute advantage in both goods and still benefit from trade? According to the theory of comparative advantage, the answer is yes. The theory of comparative advantage was first articulated by the British economist David Ricardo in 1817, though its historical roots go back much further than that. Put simply, comparative advantage refers to the situation that exists when a country can produce goods relatively more efficiently than another good in comparison with another country, even if in absolute terms it cannot. Now i'll warn you that comparative advantage has been described by Paul Krugman, a Nobel Prize winning economist, as one of the most powerful yet most counter-intuitive ideas in economics. But understanding it is central to understanding international trade today. Let's take this hypothetical example of two small island states in the South Pacific: Palau and Kiribati. Let's say that this chart represents how many coconuts and how many fish can be produced by each island on a day if they dedicate all of their labor to the production of that good. Who has the absolute advantage in coconut production: Palau or Kiribati? Palau does, because they can produce 30 coconuts per day compared to only 20 in Kiribati. And what about fish production? Who has the absolute advantage in fish? Again, it's Palau, who can produce 40 fish to Kiribati's 10. So Palau, in absolute terms, is better at producing both fish and coconuts. They can produce more coconuts and more fish than Kiribati did. But can they still benefit from specialization and trade? The answer is yes, because of comparative advantage. But to understand why comparative advantage works, we need to first understand the concept of opportunity cost. In economics, opportunity cost refers to the cost or benefit of what you give up when you make a choice. It's the cost or benefit of the next best foregone alternative, the loss of a potential gain eliminated when one alternative is chosen. The opportunity cost of attending classes whatever you might have done if you weren't here. You could be watching tv, hanging out with friends sleeping, eating, whatever. The opportunity cost of going out to dinner is what you could have spent the money or time on if you didn't go out to dinner. Opportunity cost reflects the relationship between scarcity and choice, the idea that every choice or decision involves foregoing some other option in making some other decision. It's a central principle of economics and it helps to explain the concept of comparative advantage. Let's look at the opportunity cost of each country's options in the example we just looked at. If Oalau chooses to focus on just coconut production, it gains 30 coconuts but loses or gives up 40 fish. Its opportunity cost for one coconut is one and one third fish. Conversely, if Palau chooses to focus on just fishing, it gains 40 fish but gives up 30 coconuts. Its opportunity cost for fishing is three quarters of a coconut. Similarly if Kiribati chooses to focus on coconuts it gives up one fish for every two coconuts it gains. Its opportunity cost for coconuts is half a fish. And conversely if Kiribati chooses to focus on fishing, it gains 10 fish but gives up 20 coconuts. The opportunity costs for one fish is two coconuts. Now if we compare each country's opportunity cost for fish and coconuts, a slightly different picture may emerge. Palau has absolute advantage in the production of both fish and coconuts, but Kiribati has comparative advantage in the production of coconuts. That is to say, its opportunity cost for producing coconuts--giving up half a fish--is lower than Kiribati's opportunity cost for producing coconuts. It has to give up one and one third fish for each coconut. And conversely Palau has comparative advantage in producing fish. It gives up fewer coconuts per fish than Kiribati would. So in this example, Palau has the lower opportunity cost for fish. So they should specialize in fish production. And conversely, Kiribati has a relatively more efficient production of coconut, so it should focus on that. It's possible to graph the production combinations for each country. This graph is sometimes called the production possibilities frontier, or PPF. Looking at Palau's production possibilities frontier, we see they could choose to produce 30 coconuts and no fish, 40 fish and no coconuts, or anything in between. And by way of comparison, Kiribati's PPF shows us that they could produce 20 coconuts and no fish, 10 fish and no coconuts, or again something in between. Put simply, these graphs show us the same information that we've been looking at in the tables, just in a slightly different format. Now, let's say that both countries want to consume both fish and coconuts, and so they'll have to choose something on their production possibilities frontier that divides their labor between the two items roughly equally. If Palau divides its labor between the two, it would produce 15 coconuts and 20 fish. And if Kiribati does the same thing, dividing its labor equally, it would produce 10 coconuts and 5 fish. In this situation, total global production would be 25 coconuts and 25 fish. But if each specializes and trades, it's possible for each to arrive at a level of production and consumption beyond their production possibility frontiers, reaching a point they wouldn't be able to reach without trade. Let's say that instead of focusing on self-sufficiency and dividing their labor, each country specializes in producing what they have a comparative advantage in. Kiribati produces only coconuts, for about 20 coconuts. And Palau produces let's say mostly fish for 32 fish but it produces a bit of coconut as well. Each then trades with the other for what they couldn't have produced themselves. And what happens? In Palau, total consumption increases from 15 coconuts and 20 fish to 16 coconuts and 25 fish. And in Kiribati, total consumption increases from 10 coconuts and five fish to 10 coconuts and seven fish. Both countries have experienced gains from trade, and importantly both countries are consuming beyond their production possibilities frontier, represented in the gold line. In other words, both countries are now consuming at levels beyond what domestic production alone based on self-sufficiency would otherwise allow. These are the gains from trade. And what's more, total global production is higher with trade than without it. Without trade, we produced a total of 25 coconuts and 25 fish-- a total of 50 units of food altogether. But with specialization and trade, we could produce 20 coconuts and 40 fish a total of 60 units if each country just specialized in one good. Or let's say we wanted to ensure the same amount of fish was produced and did not decrease. In that instance Palau would give up eight fish to produce six additional coconuts at their opportunity cost of three coconuts for four fish, giving a total production is reflected on this table. Global production still increased. In total, we're now producing 26 coconuts more one more than without trade and 32 fish seven more than without trade. The theory of comparative advantage rests on a number of assumptions about how domestic and international economies work. First, it assumes that there are constant returns to scale for the production of any good. This means that it takes four hours to produce one shirt for example, then producing two shirts would take eight hours, three twelve, and so on. In other words, there are no economies of scale. However in reality we know that economies of scale exist, that the per unit cost of production of any good tends to go down the more of that good is produced. Second, it assumes that there is perfect mobility between factors of production. That is to say, we can shift production between any two goods at any time with no cost. In reality we know that changing production has costs, that factories can't simply retool from producing cars to producing watches with no cost. Third, the model assumes that there are no transportation costs. In reality, shipping items around the world has a cost. However this is a relatively limited problem if we assume the difference in opportunity cost of production--that is that gains from trade and specialization-- outweigh the added cost of transportation. Fourth, the model assumes that free trade exists between the two countries--that there are no barriers to trade--while in reality we know that countries will often impose tariffs or non-tariff barriers on trade in an effort to shield domestic production from competition. Since it was first articulated by David Ricardo in the 18th century, the theory of comparative advantage has been refined and clarified in efforts to expand its utility and understand its limits. Nevertheless, it remains a powerful argument in favor of international trade. So that concludes our very brief introduction to the idea of comparative advantage. Be sure to check out the other videos in this series and thanks for watching. Bye!