Comparative Advantage – Should we trade if you are more productive than me?
Question: If you can produce A better than
me and I can produce B better than you, then what should we do to maximize our
production?
Answer: Of course, you will specialize in
producing A and I will specialize in producing B. Then we will trade.
Question again:
If you can produce both A and B better than me, then what should we do?
Answer: This is the part many people
overlook and feel confusing in the CFA exam. Some may think that there are no
trading opportunities because you are better than me in producing both A and B.
Indeed, this is wrong!
Comparative advantage is all about
opportunity cost (OC) NOT the absolute cost! So, whoever has lower opportunity cost
(OC) in producing A should produce A and whoever has lower opportunity cost in
producing B, should producing B! For example,
|
|
# of A /
day |
# of B /
day |
Cost of A
(day) |
Cost of B
(day) |
OC of A
in terms of B |
OC of B
in terms of A |
|
You |
20 |
40 |
0.05 |
0.025 |
2 |
0.5 |
|
Me |
10 |
30 |
0.1 |
0.033 |
3 |
0.33 |
From the table, you see that,
although you are better than me in producing both A and B (thus, you have lower
costs in producing A and B than me), your OC of producing B is higher than me!
Because of this, you should specialize in producing A and I should specialize
in producing B. Then we will trade. And this will maximize our total
productions. Therefore, OC is what matters but not the absolute cost when we
determine the comparative advantages.
How is this possible? This is
because, for you, 1B = 0.5A and for me 1B = 0.33A (OC of B in terms of A). So,
I can sell B to you at 1B=0.4A. As a result, you get cheaper B than what you
can produce at and I can sell B at higher price than my opportunity cost. So,
we both benefit from the trade. This is also true from the point of view of A.
For you, 1A = 2B (your OC) and for me, 1A=3B (my OC). So, if I can buy A from
you at 1A=2.5B. You gain by selling A at higher than your OC and I can buy
cheaper A than my OC!
In summary, when you encounter
questions about comparative advantage, always think of opportunity cost (OC) of
each party but NOT the absolute cost!
beautiful, too often overlooked principle
how did you derive 0.4 (in 1B=0.4A)?
0.4 is just an arbitrary number between 0.5 and 0.33. It can be other numbers depends on actual situation. But in anyway, both “you” and “me” will be happy to trade.
Thanks and btw, this forum is awesome!