The Economics of Having an Edge

Saudi Arabia is a desert country. Yet it imports sand from Australia. What’s the reason behind this bizarre arrangement? The sand Saudi Arabia has is not the right kind to build concrete for its towering skyscrapers and fancy resorts. These are too small and too smooth to be much use for construction; you might as well make bricks out of icing sugar. Hence the irony of Gulf countries importing sand from Australia. In this case, Australia, which has lesser demand for sand within the country, exports it to Saudi Arabia, which has a greater demand for it. This facilitates international trade and makes both the nations better off. 

Now consider India’s numerous call centers. American companies hire their services because it is cheaper than setting up a call center in America. Indian call center workers may not always speak English very fluently but they provide the service cheaply enough to make the tradeoff worth it.

Another example is of an agrarian nation like Peru, which excels at producing products like rope or fish meal. Its success in doing so and exporting those goods to major trade partners like the U.S, Brazil and China provides the means to import goods and services like gas, oil and telecommunications equipment, which it is not good at producing. 

Why do countries trade? The reason behind this is the simple economic concept of Comparative Advantage: producing specific goods (like the U.S. manufacturing cars and trucks, or Saudi Arabia producing oil) and foregoing the development of other products, which they can import using the revenues from the products they export.

So how does a country decide what to specialize in and what to forego? The answer is simple, they use the age-old theory of comparative advantage where once a country or company develops a product or service in a more efficient and cost-prohibitive manner, that country or company should focus their efforts on producing that particular product or service over other ones. That gives them a comparative advantage.

In economic terms, a country is said to have a comparative advantage in producing a good when it has the lowest opportunity cost to produce that good. Opportunity cost is the cost of the next best option, or what you are letting go to do what you are currently doing. 

This can be illustrated with a simple example. Consider the situation where you and I are stranded in the wilderness. I can either pick 100 cherries or catch 5 fish and you can either pick 50 cherries or catch 10 fish. If I catch 5 fish, it will cost me 100 cherries. Therefore, the opportunity cost of each fish is 20 cherries. For me to pick 100 cherries, I have to let go 5 fish. Thus the opportunity cost of each cherry is 5 divided by 100 that is 1/20 fish.

Following the same logic, your opportunity cost of each fish is 5 cherries and of each cherry is 1/5 fish. My opportunity cost for cherries is 1/20 fish which is lower compared to your 1/5 fish; therefore, I have a comparative advantage in picking cherries and you have a comparative advantage in catching fish. Therefore, as shown in the table below, rather than handling both the tasks together, I only catch fish and you only pick cherries, thereby increasing the total output than when there was no trade-off. 

CherriesFishTotal
You01010
Me 1000100
Total10010110

This interesting concept can be applied to everyday situations too. Having a comparative advantage is not the same as being the best at something. This brings us to another concept called absolute advantage. A nation or company is said to have an absolute advantage if it requires fewer resources to produce a given item. For example, assume France and the United States both manufacture airplanes. In one month, France can produce 10 planes while the U.S can produce 25. This means it takes France 3 days to manufacture each plane versus the U.S. rate of 1.2 days. Therefore, the U.S. has the absolute advantage because its ability to produce high-quality products at a faster rate indicates a more efficient production model and more talented labor.

The above example required the United States to have an all-round superiority in manufacturing airplanes in order to have the absolute advantage. On the other hand, the beauty of comparative advantage lies in the fact that someone can be moderately skilled or even completely unskilled at doing something, yet still have a comparative advantage at doing it! How can that happen?

Michael Jordan has an absolute advantage at basketball. But, maybe he can also type the fastest, giving him an absolute advantage at typing, too. Since he’s better at typing, he can type more cheaply without relying on his secretary to do all his typing, can’t he? The answer is no. If Jordan takes time out from basketball to do all his typing, he sacrifices the huge income he earns from playing multiple matches. So instead, his secretary does the typing and gives up a lower paying alternative job. Therefore, the secretary, and not Michael Jordan, has the comparative advantage at typing while Jordan earns more by focusing on basketball.

Similarly, do you think Gordon Ramsay does all the cooking at home everyday? He might have top-notch cooking skills yet hires a cook to do all the cooking at home. What he possesses but the cook lacks is the ability to do shows, run restaurants and write cookbooks whereas the cook can only prepare a nice, homely meal for his family. Therefore, both of them use their respective comparative advantages to do what they get the most profits from and in turn, benefit massively. 

@juliagalef/twitter.com

This principle appeals to Harry Potter fans too. Here’s why: Hermione might be the best at everything, whereas Harry and Ron simply do things they are ‘less’ bad at.

The law of comparative advantage has its criticisms too. Models of comparative advantage are usually based on two countries and two commodities, but in reality, there are multiple commodities and countries. Exporting goods leads to an increase in pollution but such a model may not include environmental costs. Moreover, a developing economy may have a comparative advantage in producing primary goods but as these products have a low-income elasticity of demand, it can hold the economy back from exploring other profitable industries, such as manufacturing. Some workers in uncompetitive industries may struggle to gain employment in new industries. 

Although these shortcomings have to be considered in today’s ever-changing economy, comparative advantage forms the basis of free trade. Even though economists often disagree on questions of policy, they are united in their support of free trade. The field of economics has broadened its scope and refined its theories since the time of Adam Smith and David Ricardo,  but economists’ opposition to trade restrictions is still based largely on this principle. Globalization, connectivity, trade liberalization, and technological innovation have all had a lasting impact on international trade patterns over the last 20 years. Although the way we conduct business in general and world trade in particular has changed a great deal, the fundamental principle that determines the direction of trade—that is, which countries produce what, and who imports from whom—has not changed. The major force behind world trade integration today continues to be  Ricardo’s often cited but little understood idea of “comparative advantage”.

Given the surprising relevance of the principle of comparative advantage, the next time you feel stuck in Economics, call your friend and ask for help. She might have been waiting for your help in Statistics!

– Aditi Prakash (Writer, Econ Declassified)

Bibliography

Boudreaux, D. (2019, November 12). The Wonderful Surprises of Comparative Advantage. American Institute of Economic Research. https://www.aier.org/article/the-wonderful-surprises-of-comparative-advantage/

Lando, M. (2015, October 19). The Law of Comparative Advantage and How It Can Benefit Your Life. Recruiter.com. https://www.recruiter.com/i/the-law-of-comparative-advantage-and-how-it-can-benefit-your-life/

Landsburg, L. (2019, February 3). The theory of Comparative Advantage. Econlib. https://www.econlib.org/library/Topics/Details/comparativeadvantage.html

Mankiw, G. (2020). Principles of Economics (9th ed.). South-Western College Publishing.

O’Connell, B. (2018, July 19). What is Comparative Advantage? The Street. https://www.thestreet.com/politics/comparative-advantage-14651012

To subscribe to our monthly e-newsletter and updates related to Economics Declassified, click here.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s