Comparative Advantage

What is comparative advantage? And why is it important to trade? This video guides us through a specific example surrounding Tasmania — an island off the coast of Australia that experienced the miracle of growth in reverse. Through this example we show what can happen when a civilization is deprived of trade, and show why trade is essential to economic growth.
In an economy with a greater number of participants trading goods and services, there are more ways to find a comparative advantage and earn more by creating the most value for others. Let’s dive right in with an example from our new friends, Bob and Ann.
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- [Don] 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.

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