Back in 1700s, Adam Smith was the first person to formalize a model of international trade. Smith figured out that if countries specialized in producing those items where they had absolute advantage, absolute advantage means that your country can produce the good at a lower resource cost than other countries, in production, and purchased items where they had an absolute disadvantage in production, they'd be better off. So if country A could produce food using less labor than country B, in country B could produce furniture using less labor than country A, then it would be mutually beneficial for the countries to trade with each other. About a hundred years later, David Ricardo pointed out a flaw in the model. He argued that while England, let's say, had absolute advantage in most types of products, that is, England could produce most items using fewer resources, it could still gain by specializing in production according to comparative advantage. Rather than absolute advantage, comparative advantage means that your country can produce at the lowest indirect or opportunity cost. I saw an example years ago in Todd Bush's book, From Here to Economy, that has become my absolute favorite for illustrating the different types of productive advantages and the resulting trade patterns. He uses Gilligan's Island. In his example, the world is like Gilligan's Island. On the island, the only two people who seem to produce anything are the Skipper and Gilligan. Because their group is marooned on an island, Gilligan and Skipper need to provide for the basic necessities for their five passengers. Food and shelter, inexplicably the passengers all seem to have enough clothing to last for years, even though it was supposed to be a three hour pleasure cruise. Since they're on an island, it's natural that they'll be eating a lot of fish dinners, and then they'll also need to build huts for shelter. To build a single hut, framing it, adding walls, thatching the roof, Skipper needs 20 hours. Gilligan, on the other hand, is not very competent. He dens to knock the hut over a timer tube before completion, and takes 45 hours to finish a hut. Skipper, can get down to the lagoon, catch enough fish for seven people, come back, clean the fish, and cook the fish dinner in 10 hours. Gilligan, he falls into the lagoon, loses his equipment, and initially burns the dinner, taking 15 hours total to produce an edible fish dinner. One more piece of information I'm going to need here. How many resources do each of our producers have to work with? Well, Skipper's a pretty average guy working 40 hours a week, 50 weeks a year, he takes the occasional week's vacation on the other side of the island to unwind, for a total of 2000 hours. Gilligan, on the other hand, isn't a skillless skipper at producing, but it's got a good heart and will work extra hard until he makes things right. In the end, Gilligan works 3600 hours per year. Think about it, isn't that the way things work in the real world? Which countries are more like the Skipper, skilled labor, but not as much of it? And which countries are more like Gilligan, with lots of unskilled labor? Okay, in terms of who should be producing which product? What would Adam Smith say? Remember, Smith thought that specialization should be dictated by who has absolute advantage, that is who can produce at the lowest resource cost. In this case, Skipper actually produces both items using less labor hours, so he has absolute advantage in both products. Smith would say that Skipper should produce both products. What should Gilligan do? Well, he can't really hurt anyone if he sits in his own little corner of the island and produces both as well. Let's say that the two producers each split their resources, time, evenly among the two products. Skipper will spend a thousand hours on hut building and a thousand hours on fish dinners. In the end, Skipper builds 50 huts and creates 100 fish dinners. In the meantime, Gilligan will spend 1800 hours on hut building and 1800 hours on fishing. Ultimately, he will build 40 huts and create 120 fish dinners. In total, the overall island production between the two producers is 90 huts and 220 fish dinners. Now, what would David Riccardo say? Remember, Riccardo thought that specialization should be dictated by who has the comparative advantage, that is who can produce at the lowest opportunity cost. You can go back to episode 8 if you need a refresher on opportunity cost. How do we know where the comparative advantage lies? Well, let's start by taking a look at Skipper. Every hut he builds takes 20 hours. Had he used the 20 hours on fishing, he could have produced two fish dinners. So Skipper's opportunity cost of producing one hut is that he sacrifices two fish dinners. What about Gilligan? He takes 45 hours to build a hut in which time he could have produced three fish dinners. This means that Skipper has comparative advantage in hut production. Now, some of you might be thinking, well, of course Skipper has comparative advantage, he's better at everything. This is not necessarily true. Let's look at fish dinners. To produce a fish dinner takes the Skipper 10 hours or he sacrifices one half of a hut. Gilligan takes 15 hours, but he sacrifices only one third of a hut. Gilligan actually has the comparative advantage in fishing because he sacrifices less or has the lowest opportunity cost. According to Riccardo, Skipper should devote himself and his resources solely to producing huts. If he uses all 2,000 hours on hut production, he can produce a total of 100 huts. Gilligan uses all of his resources for fishing and can produce 240 fish dinners. What do you notice about total island production? Specialization according to comparative advantage yields total output of 100 huts and 240 fish dinners compared to the 90 huts and 220 fish dinners that are produced when following specialization according to absolute advantage. What does this mean in the real world? Specialization according to comparative advantage leads to increased global production, which means better living standards for everyone. Next time, trade restrictions.