Comparative Advantage

Let me tell you about the island of Tasmania. It's about 130 miles off the coast of southeastern Australia. A long time ago when seas where low, Tasmania was part of Australia. During that time, the archaeological record documents that Tasmanians fished and they used bone tools. About ten thousand years ago, rising waters cut Tasmania off from Australia. On at least three of the smaller islands, the isolated human population died out completely. In Tasmania, the four thousand hunter-gatherers remained with no contact with the rest of humanity at all. They lost technologies they once had -- no more fishing, no more bone tools. They also missed new inventions, such as stone tools and fishing nets and fire, that were adopted in Australia.

When Europeans "discovered" the Tasmanians in 1642, they found that this extreme isolation had created the simplest material culture of any people in the modern world. Without access to other people, some island populations shrink -- others even vanish. Fortunately, for most of us, human cooperation has expanded over time. As we saw in the previous videos, we enjoy enormous benefits from specialization and trade. One reason for this beneficial cooperation is what economist call "Comparative Advantage."

Two things are surprising about Comparative Advantage. First, just by rearranging who does what, we can make more stuff through specialization in trade even if no one ever gets any better at doing any line of work. But the second insight's my favorite. If you get better at doing something, that obviously benefits you, but it also benefits me even though my abilities to produce haven't changed at all.

Let me show you how this works. It's best seen with a simple example -- just two people -- Bob and Ann -- who produce just two goods -- bananas and fish. Here's what Bob can do if he spends all of his time producing only one good. Bob can either gather 10 bananas or he can catch 10 fish. Ann can either gather 10 bananas or catch 30 fish. So let's say they each split their time between producing bananas and fishing. Bob and Ann each produce five bananas, Bob produces five fish, and Ann produces 15 fish. In total, they produce 10 bananas and 20 fish. You math wizards in the audience surely see an obvious way to increase this total. If Bob produces just bananas and Ann produces just fish, then the total rises to 10 bananas and 30 fish. So just by rearranging who does what, we get more total stuff.

Now you might think this outcome is simply the result of the division of labor that we covered previously, but you'd be wrong. The key insight from the division of labor is that workers individually get more productive when they specialize. Yet in this scenario, neither Bob nor Ann has gotten any better at producing bananas or fish. Just by rearranging what tasks each does is what made total production increase.

The key to understanding how this works is opportunity cost. Bob has to choose to gather bananas or catch fish. When he chooses to gather a banana, he gives up one fish. In essence, Bob trades with himself. He can use his time to gather bananas or trade that time to catch fish, and the cost of that trade is one fish per banana. That's Bob's opportunity cost. The same holds true for Ann, but her cost of producing one banana is three fish. In the amount of time that it takes Ann to gather one banana, she could have caught three fish. She trades with herself one banana for three fish. So Bob only has to give up one fish to produce one banana, but Ann must give up three fish to produce a banana. Ann's opportunity cost of gathering a banana is higher than Bob's.

She can improve her situation if she can get bananas for less than three fish, and Bob can improve his situation if he can get fish for less than one banana. Let's say Ann trades two fish to Bob for one banana. They each gain. If Ann wants a banana, she can either gather it herself and give up three fish, or she can catch only two fish and then trade them to Bob. She prefers the lower-cost option and so she trades. Bob prefers the lower cost option too. Instead of giving up a whole banana to catch a fish, he can trade that banana for two fish. Now he's only giving up a half a banana for a fish. You can see that even if Ann is better at everything, nothing in this story changes. She still benefits from trade because the number of fish Ann gives up to pick a banana herself is greater than the number of fish that she must catch and give to Bob in order to get a banana from Bob.

Now, for an insight that is really counter-intuitive. What happens if Ann gets better at fishing? Let's say that she can now catch 40 fish. Obviously that's good for Ann, but it also means that bananas just got more costly for Ann to produce herself. She now has to sacrifice four fish for each banana that she gathers. By becoming a better fisherman, Ann becomes a comparatively worse banana gatherer, and this fact helps Bob. The reason is that Ann is now willing to trade more fish for each banana that she gets from Bob. So, although Bob's ability to produce hasn't changed, he can now get more fish for his bananas. Comparative Advantage is a beautiful thing. No matter what my talents are, I can still help you even if you are better at everything. The more different we are from each other, the more we benefit from trading with each other.

Let's get back to the real world. What Comparative Advantage practically means for most people is that we each spend most of our working time at a job that utilizes each of our comparative talents. How do you know what you're comparatively good at? What you get paid for your job tells you that. Comparative Advantage is the main force driving us to use our talents in those jobs that we do best. It's why people who are good at math tend to become engineers, and those who have good graphic sense tend to go into the arts. Specialization and trade play key roles in the movement from poverty to prosperity. We would be desperately poor without them, but they alone do not explain the full extent of our prosperity.

Another feature of the modern world is important -- "Innovationism." Our society is an orgy of innovations. This Innovationism would be impossible without specialization and trading, yet specialization and trade do not guarantee Innovationism. This is a topic for a future video.