The farmer’s explanation of the gains from trade, though correct, poses a puzzle:
if the farmer is better at both rearing cattle and growing potatoes, how can the gardener ever specialize in doing what he does best? The gardener doesn’t seem to do anything best. To solve this puzzle, we need to look at the principle of com- parative advantage.
As a first step in developing this principle, consider the following question: in our example, who can produce potatoes at lower cost – the gardener or the farmer? There are two possible answers, and in these two answers lie the solution to our puzzle and the key to understanding the gains from trade. The slope of the production possibilities frontier discussed above will help us to solve the puzzle.
Absolute Advantage
One way to answer the question about the cost of producing potatoes is to com- pare the inputs required by the two producers. Economists use the term absolute advantagewhen comparing the productivity of one person, firm or nation to that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.
In our example, the farmer has an absolute advantage both in producing meat and in producing potatoes, because she requires less time than the gardener to produce a unit of either good. The farmer needs to input only 2 hours in order to produce a kilogram of meat, whereas the gardener needs 6 hours. Similarly, the farmer needs only 1 hour to produce a kilogram of potatoes, whereas the gar- dener needs 1.5 hours. Based on this information, we can conclude that the farmer has the lower cost of producing potatoes, if we measure cost in terms of the quantity of inputs.
Opportunity Cost and Comparative Advantage
There is another way to look at the cost of producing potatoes. Rather than comparing inputs required, we can compare the opportunity costs. Recall from Chapter 1 that the opportunity cost of some item is what we give up to get that item. In our example, we assumed that the gardener and the farmer each spend 48 hours a week working. Time spent producing potatoes, therefore, takes away from time available for producing meat. As the farmer and gardener reallocate time between producing the two goods, they move along their production possi- bility frontiers; they give up units of one good to produce units of the other. The
absolute advantage
the comparison among producers of a good according to their productivity
opportunity cost measures the trade-off between the two goods that each pro- ducer faces.
Let’s first consider the farmer’s opportunity cost. The following analysis confirms our discussion about the slope of the production possibilities frontiers above. According to Table 3.1, producing 1 kilogram of potatoes takes her 1 hour of work. When the farmer spends that 1 hour producing potatoes, she spends 1 hour less producing meat. Because the farmer needs 2 hours to pro- duce 1 kilogram of meat, 1 hour of work would yield ẵ kilogram of meat. Hence, the farmer’s opportunity cost of producing 1 kilogram of potatoes is ẵ kilogram of meat.
Now consider the gardener’s opportunity cost. Producing 1 kilogram of pota- toes takes him 1ẵ hours. Because he needs 6 hours to produce 1 kilogram of meat, 1ẵ hours of work would yield ẳ kilogram of meat. Hence, the gardener’s opportunity cost of 1 kilogram of potatoes is ẳ kilogram of meat.
Table 3.3 shows the opportunity costs of meat and potatoes for the two produ- cers. Notice that the opportunity cost of meat is the inverse of the opportunity cost of potatoes. Because 1 kilogram of potatoes costs the farmer ẵ kilogram of meat, 1 kilogram of meat costs the farmer 2 kilograms of potatoes. Similarly, because 1 kilogram of potatoes costs the gardener ẳ kilogram of meat, 1 kilogram of meat costs the gardener 4 kilograms of potatoes.
Economists use the term comparative advantage when describing the oppor- tunity cost of two producers. The producer who gives up less of other goods to produce good X has the smaller opportunity cost of producing good X and is said to have a comparative advantage in producing it. In our example, the gar- dener has a lower opportunity cost of producing potatoes than does the farmer:
a kilogram of potatoes costs the gardener only ẳ kilogram of meat, while it costs the farmer ẵ kilogram of meat. Conversely, the farmer has a lower opportunity cost of producing meat than does the gardener: a kilogram of meat costs the farmer 2 kilograms of potatoes, while it costs the gardener 4 kilograms of potatoes. Thus, the gardener has a comparative advantage in growing potatoes, and the farmer has a comparative advantage in producing meat.
Although it is possible for one person to have an absolute advantage in both goods (as the farmer does in our example), it is impossible for one person to have a comparative advantage in both goods. Because the opportunity cost of one good is the inverse of the opportunity cost of the other, if a person’s opportunity cost of one good is relatively high, his opportunity cost of the other good must be relatively low. Comparative advantage reflects the relative opportunity cost.
Unless two people have exactly the same opportunity cost, one person will have a comparative advantage in one good, and the other person will have a compar- ative advantage in the other good.
TABLE 3.3
The Opportunity Cost of Meat and Potatoes
Opportunity cost of:
1 kilogram of meat 1 kilogram of potatoes
Gardener 4 kg potatoes 0.25 kg meat
Farmer 2 kg potatoes 0.5 kg meat
comparative advantage
the comparison among producers of a good according to their opportunity cost
C A S E S T U D Y
Afghanistan and the Opium Trade
In the first decade of the 21st century, troops from a number of nations have been in Afghanistan supporting the government, helping rebuild infrastruc- ture, training Afghan police and troops, and fighting Taliban and insurgent groups who pose a perceived threat to security in the country and beyond.
One of the regions where problems have been most acute is Helmand prov- ince in the south of the country. There have been considerable losses of civil- ian and military life in this region and the military struggle has been made all the more difficult by some very real economic issues that have militated against lasting peace in the region.
One of these economic issues relates to the growing of opium poppies.
Some 70 per cent of all the opium grown in Afghanistan comes from this province. With opium comes all manner of other problems that have a far reaching impact in many other countries. Opium is the raw material used for heroin and the poppy which produces opium represents a lucrative
F Y I
The Legacy of Adam Smith and David Ricardo
Economists have long understood the principle of comparative advantage.
Here is how the great economist Adam Smith put the argument:
It is a maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoe- maker does not attempt to make his own clothes but employs a tailor. The gar- dener attempts to make neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbours, and to purchase with a part of its pro- duce, or what is the same thing, with the price of part of it, whatever else they have occasion for.
This quotation is from Smith’s 1776 book An Inquiry into the Nature and
Causes of the Wealth of Nations,which was a landmark in the analysis of trade and economic interdependence.
Smith’s book inspired David Ricardo– an Englishman born of Dutch parents – to become an economist, having already made his fortune as a stockbroker in the City of London. In his 1817 bookPrinci- ples of Political Economy and Taxation, Ricardo developed the principle of com- parative advantage, originally put for- ward by Robert Torrens, a British Army officer and owner of theGlobenewspa- per in 1815, as we know it today. His defence of free trade was not a mere academic exercise. Ricardo put his eco- nomic beliefs to work as a member of the British parliament, where he opposed the Corn Laws, which restricted the import of grain.
The conclusions of Adam Smith and David Ricardo on the gains from trade have held up well over time. Although economists often disagree on questions of policy, they are united in their sup-
port of free trade. Moreover, the central argument for free trade has not chan- ged much in the past two centuries.
Even though the field of economics has broadened its scope and refined its theories since the time of Smith and Ricardo, economists’opposition to trade restrictions is still based largely on the principle of comparative advantage.
David Ricardo
©CLASSICIMAGE/ALAMY
business for many farmers in the region. There is a very good reason why farmers grow opium – it generates financial returns that are greater than any legal crop. Helmand has a comparative advantage in the production of opium; yields per acre are higher than in other parts of Afghanistan and there is a plentiful supply of relatively cheap labour to help produce and har- vest the crop – important given that this is a relatively labour intensive crop to grow.
For farmers in the region, decisions about how to use their land are deter- mined in part by the returns they expect to get from alternative crops that could be grown. Different crops will yield a different value of benefits. The opportunity cost of growing opium is relatively low in that the sacrifice of the value of the benefits foregone of alternatives is low. The sacrifice involved in terms of lost benefits from the movement of resources from producing a legal crop such as wheat, for example, is negligible and so there is a real incentive to produce opium which has high rewards. If the return per acre for growing opium is €150, for example, and that for growing wheat is €25, it does not take an economist to point out that the incentive for growing opium is strong.
It can be argued that growing an illegal crop such as opium also brings with it high risks which would increase the opportunity cost. However, in Helmand this is distorted by the fact that the problems enforcing the rule of law means that the power of the authorities to intervene and punish farmers for growing opium is extremely limited. The protection afforded to farmers by warlords and the network of gangs who stand to benefit from the lucrative trade in opium means that the chances of getting caught and punished are negligible. Only if the law can be enforced and there are real and visible risks to growing an illegal crop will the opportunity cost start to increase and incentives to grow a legal crop start to appear.
This means finding ways of encouraging the growth of legal crops and giv- ing farmers adequate returns that increase the opportunity cost of growing opium. This may be achieved through providing subsidies to farmers to pro- duce legal crops. Subsidies do have to be paid for and the Afghan govern- ment would need considerable help to be able to put in place such a solution. One other option that has been suggested involves direct interven- tion in the market for opium. Under such a scheme the US government, for example, could spend around $2.5 billion in purchasing the opium crop from farmers. Such a price might have to be paid each year but in comparison to the $1 billion it currently pays in trying to eradicate the crop and the
$200 billion it has paid out in military operations in Afghanistan, the cost may well be offset by the benefits. There is a trade-off and the trade-off might be worth making! In buying the crop those who rely on it to finance their activities through imposing protection money, taking ‘taxes’ and so on would be sidelined and the corruption in the Afghan government that has been blamed for being part of the problem would also be marginalized.
Comparative Advantage and Trade
Differences in opportunity cost and comparative advantage create the gains from trade. When each person specializes in producing the good for which he or she has a comparative advantage, total production in the economy rises, and this increase in the size of the economic cake can be used to make everyone better off. In other words, as long as two people have different opportunity costs, each can benefit from trade by obtaining a good at a price that is lower than his or her opportunity cost of that good.
Consider the proposed deal from the viewpoint of the gardener. The gardener gets 5 kilograms of meat in exchange for 15 kilograms of potatoes. In other words, the gardener buys each kilogram of meat for a price of 3 kilograms of potatoes. This price of meat is lower than his opportunity cost for 1 kilogram of meat, which is 4 kilograms of potatoes. Thus, the gardener benefits from the deal because he gets to buy meat at a good price.
Now consider the deal from the farmer’s viewpoint. The farmer buys 15 kilo- grams of potatoes for a price of 5 kilograms of meat. That is, the price of potatoes is⅓ kilogram of meat. This price of potatoes is lower than her opportunity cost of 1 kilogram of potatoes, which is ẵ kilogram of meat. The farmer benefits because she is able to buy potatoes at a good price.
These benefits arise because each person concentrates on the activity for which he or she has the lower opportunity cost: the gardener spends more time grow- ing potatoes, and the farmer spends more time producing meat. As a result, the total production of potatoes and the total production of meat both rise. In our example, potato production rises from 40 to 44 kilograms, and meat production rises from 16 to 18 kilograms. The gardener and farmer share the benefits of this increased production. The moral of the story of the gardener and the farmer should now be clear: trade can benefit everyone in society because it allows people to specialize in activities in which they have a comparative advantage.
Quick Quiz Hasani can gather 10 coconuts or catch 1 fish per hour. His new friend, Jacek, can gather 30 coconuts or catch 2 fish per hour. What is Hasani’s opportunity cost of catching one fish? What is Jacek’s? Who has an absolute advantage in catching fish? Who has a comparative advantage in catching fish?