Law of Comparative Advantage
Specialization leads to
increased output
WHY?
What do we mean by “division
of labor?”
Specialization
Adam Smith:
 The Division of Labor = increased productivity and
output
David Riccardo:
 Nations also can specialize in the production of goods
and services
 Nations benefit from producing goods and services
they are “better” at and freely trading with other
nations
Comparative and Absolute
Advantage
Absolute Advantage
- Implies that a product can be produced more
efficiently (i.e. with fewer inputs)
Comparative Advantage
- Means that a person/firm/nation can produce the
good with a lower opportunity cost
A Hypothetical Example
Labor Hours Needed to
Produce a Unit of:
Country
Portugal
England
Wheat
10
20
Cloth
20
60
Portugal has an ABSOLUTE ADVANTAGE in both products.
Comparative Advantage
How do we determine which country
should produce which product to
maximize production and trade?
You must first determine opportunity
costs for both producers and products!
Calculations of Opportunity Cost
Portugal
Opportunity Cost of wheat = 10/20 = ½ cloth
Opportunity Cost of cloth = 20/10 = 2 wheat
England
Opportunity Cost of wheat = 20/60 = 1/3 cloth
Opportunity Cost of cloth = 60/20 = 3 wheat
Which country has the comparative advantage in cloth?
Portugal
Which country has the comparative advantage in wheat?
England
Output vs. Input
 The previous example used the “input
method” to determine comparative
advantage
 The “input method” measures the amount
of resources needed to produce one unit of
output
 However, the “output method” measures
the amount of output that can be
produced with a given amount of an input
Input Method
Time Required to
Produce One Radio
Time Required to
Produce One Bushel
of Wheat
Ted
20 minutes
5 minutes
Nancy
30 minutes
15 minutes
Who has the comparative advantage in producing radios?
Ted (1 radio = 4 bushels of wheat)
Nancy (1 radio = 2 bushels of wheat)
Who has the comparative advantage in producing bushels of wheat?
Ted (1 bushel of wheat = ¼ radio)
Nancy (1 bushel of wheat = ½ radio)
Output Method
Radios produced per hour
Wheat produced per hour
Ted
3 radios
(60 mins./20 mins.)
12 bushels
(60 mins./5 mins.)
Nancy
2 radios
(60 mins./30 mins.)
4 bushels
(60 mins./15 mins)
Who has the comparative advantage in producing radios?
Ted (1 radio = 4 bushels of wheat)
Nancy (1 radio = 2 bushels of wheat)
Who has the comparative advantage in producing bushels of wheat?
Ted (1 bushel of wheat = ¼ radio)
Nancy (1 bushel of wheat = ½ radio)
Cross-Multiplication Method
 A “life-hack” to this is the cross-multiplication
method
 Take the numbers in the matrix and cross multiply
them
 For outputs – you want the combination of
numbers that gives you the greatest/biggest
product
 For inputs – you want the combination of numbers
that gives you the smallest product
Input Method
Time Required to
Produce One Radio
Time Required to
Produce One Bushel
of Wheat
Ted
20 minutes
5 minutes
Nancy
30 minutes
15 minutes
With Ted producing radios and Nancy producing wheat, the total amount
of time to produce = 300 minutes
With Ted producing wheat and Nancy producing radios, the total amount
of time to produce = 150 minutes
So Ted should produce wheat and Nancy should produce radios
Output Method
Radios produced per hour
Wheat produced per hour
Ted
3 radios
(60 mins./20 mins.)
12 bushels
(60 mins./5 mins.)
Nancy
2 radios
(60 mins./30 mins.)
4 bushels
(60 mins./15 mins)
With Ted producing radios and Nancy producing wheat, the total
production is 12 units of production.
With Ted producing wheat and Nancy producing radios, the total
production is 24 units of production.
So Ted should produce wheat and Nancy should produce radios.