Comparative Advantage

The idea of “comparative advantage” is very counter-intuitive. Popularized by David Ricardo, it says that free trade can work to everyone’s advantage even when one participant is more efficient/cheaper than the other on every parameter.

I saw a very good explanation of how that’s possible in a TED talk by Matt Ridley. He showed this picture of two guys, Adam and Oz, and how long each takes to make a spear and an axe:

As you saw above, Oz is faster at making both spears and axes. So it would appear that Oz wouldn’t benefit through any interaction (trade) with Adam since he (Oz) is faster on both fronts: spears and axes. So there’s nothing to be gained through trade in such a scenario, right?
Wrong, says the comparative advantage theory. Here’s why. See the picture below to see what happens if Oz makes 2 spears and Adam makes 2 axes:

You have to look closely to see what each of them gained: Time! By splitting it this way and then swapping items, each still gets a spear and an ax but now each spent less time. And the time saved can be used to do whatever they like doing.

Substitute time with something else, say cost of production, in the above pictures and you find they’d both save money through trade.

The idea of comparative advantage is so counter-intuitive, and yet it’s a win-win situation.

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