In Day 2, we take the concept of opportunity cost a step further and define both absolute and comparative advantage.
If you think it through, it makes sense. Imagine I can earn $30 by, say writing and selling my lesson plans. Should I spend 5 hours of my life cleaning my house? If I do, I’ve lost 5 hours of time in which I could have earned $150. I’d be better off hiring a cleaner – they could get it done in just four hours at a cost of $20 an hour (or $80 total). I could spend $80 and free myself up to earn $150. Or.. I could do it myself and save $80 – but at the cost of $150 in lost income. Clearly, I’m better off hiring the cleaner. However, if my time goes down to $15 an hour, I’d be better off doing it myself (5 hours at $15 an hour is $75 in lost wages versus the cost of $80 I’d get for hiring the cleaner).
In my example, the cleaner has an absolute advantage over me in that they can clean the house faster than I can (4 hours versus five for me). But note, my decision to hire the cleaner occurred because the opportunity cost of cleaning the house myself ($150 in lost earnings) was better than the $80 cost of hiring the cleaner. It had nothing to do with whether or not the cleaner was faster than me – it had everything to do with opportunity cost.
The person with the lower opportunity cost is said to have the comparative advantage and in making economic decisions, we should use comparative advantage and opportunity cost to guide us, not absolute advantage.
We can change the scenario to give a new person (my wife in this example) the absolute advantage regarding housework (she is faster than the cleaner). But given my wife’s opportunity cost of her time, it still makes more sense to go with the cleaner and their comparative advantage.
The table demonstrates the overall cost of each option. Note that the cleaner results in the lowest cost. For the cleaner, we assume their opportunity cost must be less than $20 an hour or they wouldn’t be willing, as rational people, to work for $20 an hour if they had better-paying opportunities available.
Another example of comparative advantage. Even if Pam the lawyer was better at secretarial work than Ann, it would still make more sense for Pam to stick to lawyer work, as she gives up $150 an hour in earnings if she does anything else. Ann could be five times slower on secretarial work than Pam and it would still make sense for Pam to be the lawyer and Ann to be the secretary.
Here, we are going to introduce a very simple mode. Two men, Tom and Hank, share a desert island. The only two activities possible are fishing or gathering coconuts. For Tom, if he does nothing but fish, he can gather 40 fish a day. If he only gathers coconuts, he can get 30. Or, he can get any possible combination of fish and coconuts along the line that connects 30 coconuts to 40 fish. The line is called the “production possibility frontier”. Any point along that line represents Tom using all his time (it is “efficient”). Any point inside the line means that Tom isn’t working as hard as he could be working (it is inefficient). Any point outside the line, is simply not possible.
Here is Hank’s production possibility graph. Note that Tom has an absolute advantage over Hank in both coconuts (30 over Hank’s 20) and fish (40 over Hank’s ten).
Since there are only two resources on the island, we can express the price of each resource in terms of the other. For Tom, every time he gets an extra fish, he is giving up the chance to get three-fourths of a coconut. Every time Tom gets an extra coconut, he is giving up four-thirds of a fish. Note that Tom gives up fewer potential coconuts to get an extra fish compared to Hank. We could say that Tom has a lower opportunity cost for fish or that Tom has the comparative advantage over Hank in fishing. Hank, on the other hand, has a lower opportunity cost and thus the comparative advantage in gathering coconuts.
We should follow the principle of comparative advantage and let the person with the comparative advantage gather the resource for which they have the lowest opportunity cost. This means fishing for Tom and gathering coconuts for Hank.
Following their comparative advantage and specializing in one resource, Tom and Hank can trade their surplus. This results in Tom (pictured here) being able to achieve consumption that is outside (greater than) his production possibility frontier.
With Hank, the advantages are even bigger than were Tom’s. Both Tom and Hank are demonstrably better off through specializing through the principle of comparative advantage and then trading with each other. They achieve more through specialization and trading than they ever could alone.
Through specialization and trade, Tom and Hank gain access to 6 extra fish and 3 extra coconuts. We call this the “gains from trade”.
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