Suppose that two people, Michelle and James each live alone in an isolated region. They each have the same resources available, and they grow potatoes and raise chickens. If Michelle devotes all her resources to growing potatoes, she can raise 200 pounds of potatoes per year. If she devotes all her resources to raising chickens, she can raise 50 chickens per year. (If she apportions some resources to each, then she can produce any linear combination of chickens and potatoes that lies between those extreme points. If James devotes all his resources to growing potatoes, he can raise 80 pounds of potatoes per year. If he devotes all his resources to raising chickens, he can raise 40 chickens per year. (If he apportions some resources to each, then he can produce any linear combination of chickens and potatoes that lies between those extreme points.)
The opportunity cost represents the amount of a certain good that one party is forced to forgo in favor of producing another good (Bowles, 2006). Accordingly, in this scenario Michelle’s opportunity cost for producing potatoes is 50 chickens because this is the precise number of chickens she would be giving up by growing only potatoes. Conversely, Michelle’s opportunity cost for growing chickens is 200 potatoes because this is the precise number of potatoes she would be forgoing by growing chickens. James’ opportunity cost for growing potatoes is 40 chickens because this is the precise number of chickens he would be giving up in order to grow only potatoes. Conversely, his opportunity cost for growing chickens is 80 potatoes because this is the precise number of potatoes he would be forgoing in order to grow only chickens.
The absolute advantage refers to the party with the greatest capacity to produce (Bowles, 2006). In other words, an entity with an absolute advantage can produce the greatest quantity. However, it is important to note that an absolute advantage does not take into account productive efficiency (Bowles, 2006). Thus, in this case, Michelle has the absolute advantage in producing both goods because she has the capacity to produce more of both chickens and potatoes.
Comparative advantage refers to one party’s ability to produce relative to another party’s ability to produce (Bowles, 2006). This concept aims to determine which producer is more efficient at producing a certain good. In the above example, Michelle would possess the comparative advantage in the production of potatoes because she is capable of producing more than two times the amount of potatoes that James is capable of producing, while only forgoing 50 chickens. Thus she would have a larger supply of potatoes and could sell them at a lower price than James and potentially realize an even greater profit. Conversely, James possesses the comparative advantage when it comes to chickens because while he is only capable of producing 40 chickens (which is less than the amount Michelle is capable of producing) he would only be forgoing profits attainable from 80 potatoes. Whereas if Michelle were to produce chickens she would be forgoing the profits attainable from 200 potatoes, thus it would be highly inefficient for her to only produce chickens.
Specialization and Exchange
If each party mentioned above were to specialize in producing the selected good in which they each possess a comparative advantage and then engage in exchange, they would certainly be better off (Crockett, Smith, & Wilson, 2010). By trading at a rate of 2.5 pounds of potatoes per 1 chicken both Michelle and James would ultimately benefit. If James were to trade all of the chickens he produced (40) for potatoes, he would have more potatoes than he would normally be capable of producing (100). The same would be the case if Michelle were to trade the maximum number of potatoes.
Many business, nations and economies engage in this type of activity. In fact, the entire foundation of modern world trade revolves around these principles (Crockett, Smith, & Wilson, 2010). Businesses trade resources, information, customers and capital with one another all the time. Nations with a comparative advantage in one economic field often specialize in that product or service and engage in trade with other economies (Bowles, 2006). The agriculture and manufacturing industries provide perfect examples of this type of specialization, whereby “producer” countries will specialize in production and exportation of specific items and import others (Bowles, 2006). While this is the basis of the current global system, it certainly has its shortcomings. For instance, producer countries that wish to serve the needs of major importers (like the United States) and constantly pressured to keep costs (like labor) down in order for their goods to remain fiscally attractive to foreign buyers. This reality has lead to quite a bit of human exploitation and neglect.
Bowles, S. (2006). Microeconomics: Behavior, Institutions, and Evolution. Princeton, NJ: Princeton University Press.
Crockett, S., Smith, V., & Wilson, B. (2010). Exchange and Specialization as a Discovery Process. Retrieved June 9, 2011, from http://ideas.repec.org/p/gms/wpaper/1001.html