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 South-Eastern 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 10 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, you

get more total stuff, and 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 which 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 bananas 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 through 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, and if

Ann wants a banana, she can either gather
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 of 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 a banana
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 fishermen, Ann becomes a
comparatively worst 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 your
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. That'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 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.