Friday, 09/07/01
One of the questions asked during discussion was what the difference between absolute and comparative advantage was. I had written that a producer with absolute advantage could make some good X for less inputs. I also wrote that opportunity cost of an item involved what you could have instead made with the resources that were used to acquire the item. Both of these things involve the inputs - the resources - used in making the good X. I gave a rather clumsy answer to the question and had more time to think about it since then.
Absolute advantage asks "who is better at doing something?" Suppose we have the following setup:
| Producer | Units of X Produced | Units of L Spent |
|---|---|---|
| A | 5 | 1 |
| B | 2 | 1 |
Obviously, we'd think that A is better than B at making good X. Here, L (you can think of this like hours of Labor) is the resource A and B use to make good X. What's going on here? Each guy is taking some resource input (L) and converting it into output (X). This can be visualized as a machine that changes L into X:
There are two ways to get more X output:
When we talk about absolute advantage, we are talking about the second method of being able to make more outputs; we want to know who has the better machine.
Suppose we had the following information:
| Producer | Units of X Produced | Units of L Spent |
|---|---|---|
| A | 5 | 1 |
| B | 6 | 3 |
B is now making more X than A is. Does that mean he is better at making X? No - all he's doing is throwing in more inputs L. How can we check for only the quality of their machines? We can do this by holding the amount of inputs L each guy gets to use constant. In the first table at the top, both guys got to use 1L. What if we let both A and B use 3L?
| Producer | Units of X Produced | Units of L Spent |
|---|---|---|
| A | 15 | 3 |
| B | 6 | 3 |
By allowing each guy to use the same amount of inputs L, the difference in output must come from how "good" their machine is. A question will always tell you how many inputs were used by each producer to make their outputs. You can divide output by inputs used to get "output per input." This is a measure of how "good" their box is, and that's what you compare when you want to see who has absolute advantage. Whoever makes more of good X per input L used is better at making good X - that producer has absolute advantage in making good X.
If absolute advantage asks "who is better at doing something?" then comparative advantage asks "who gives up more when he actually does it?" We can go back to A and B, who have machines that make good X using input L. Now suppose we suddenly give these guys machines that make good Y using input L:
| Producer | Units of X Produced per L Spent | Units of Y Produced per L Spent |
|---|---|---|
| A | 5 | 4 |
| B | 2 | 1 |
We can see that A not only had the better X machine, but also got the better Y machine. Producer A has absolute advantage in both the production of good X and good Y. Suppose we look at what each guy could make using 1L: A would get 5X and B would get 2X.
If they spent 1L to make X, what did they give up? They gave up the opportunity to make Y. This is where the idea of opportunity cost comes in. A gave up the opportunity to make 4Y and B gave up the opportunity to make 1Y. Well, A gave up more Y but also got more X back. How can we compare the decisions for A and B? One way is to convert into per unit prices. We will look at how much Y was given up for each unit of X gained.
Who gave up more for each unit of X? A did. So B is the lower opportunity cost producer of X and we say that B has a comparative advantage in producing X. What about Y?
Who gave up more for each unit of Y? B did. So A is the lower opportunity cost producer of Y and we say that A has a comparative advantage in producing Y. Here are some facts to note:
Absolute advantage only considers A's X machine versus B's X machine. Comparative advantage involves both the X and Y machines. Also, from our four notes, we conclude that a producer with absolute advantage in producing a good will not necessarily have comparative advantage in producing that good. Finally, a producer that does not have absolute advantage in producing a good is not necessarily prevented from having comparative advantage in producing that good.
As an aside, notice that I never needed to give A or B endowments of L to figure out who had absolute and comparative advantage. This is a direct consequence of the fact that we don't care how much they are putting into their machine - we only care about the machines themselves.