Ernie Siciliano

English

Research Papers in Economics

6 Region Focus • Summer 2007
A
man decides to open a bakery. He figures that for
each hour he bakes, he can make 20 doughnuts,
which he will then sell for $2 each. Or he can make
10 loaves of bread that sell for $3 each every hour.
The first week he is in business he bakes both doughnuts
and bread and finds demand is so high he cannot possibly do
both. He decides to hire an assistant. As an entrepreneur,
the baker has limited capital and so he hires a local high
school student to help out. Because the youth has limited
baking experience, he can make only 15 doughnuts or five
loaves an hour. The baker realizes he should specialize 
in either doughnuts or bread, but because he is clearly adept
at producing both, he is not sure
which task to pick.
The baker would be wise to
heed the advice of David Ricardo,
who first theorized about compar-
ative advantage in the early 1800s.
The baker, Ricardo would say,
ought to specialize in bread 
making because that would be
cheaper.
Most often, comparative
advantage is used when discussing
trade between nations. A country
holds a comparative advantage
when it can produce a good at a
lower opportunity cost than
another country. 
Comparative advantage differs
from absolute advantage, which is
the ability of a country to produce
a good more efficiently. While it is
possible for a country to lack an
absolute advantage in producing goods,
every country has a comparative advantage.
For example, imagine if the United States and Mexico
both produced tacos and hot dogs. To produce each taco, 
the United States needs two workers while Mexico needs
three. For every hot dog produced, the United States 
needs one worker while Mexico needs two. The United
States holds an absolute advantage in producing both 
tacos and hot dogs because it can produce both goods with
fewer workers. However, Mexico holds a comparative 
advantage in producing tacos, because it can produce them
at a lower opportunity cost. In the United States, every taco
made costs two workers, and thus two hot dogs. For Mexico,
every taco made costs three workers, and only one and a 
half hot dogs. 
Comparative advantage is important in the macro-
economy because it explains the benefits of global trade. 
If each country specialized in the good for which it held a
comparative advantage and then traded among each other,
more goods would be produced and the efficiency of the
global economy would be maximized. 
In the Mexico-United States example, if Mexico 
produced one extra taco, the United States could produce
two extra hot dogs. In the global economy, there would be
the same number of tacos and one more hot dog, indicating
a slightly higher standard of living for both countries, 
assuming they could trade freely.
Comparative advantage is also
useful in analyses of firms and
industries. With no specialization,
it would be reasonable to assume
that both the baker and his 
assistant spend four hours on both
bread and doughnuts. If that 
were the case, the bakery would
produce 140 doughnuts and 60
loaves of bread. At that level of
production, there would be $460
in revenues. 
Not bad, but if the baker spent
all his time on bread while his 
assistant focused on doughnuts,
then the bakery would produce 
80 loaves of bread and 120 dough-
nuts — increasing production in
both bread and doughnuts.
Assuming demand exists for the
excess production, the bakery will
now have revenues of $480 dollars.
That’s also better, by the way, than the
$440 the bakery could earn if the owner specialized 
in doughnuts.
Looking at comparative advantage enables one to under-
stand how scarce resources are used in the microeconomy.
Often, the most talented individuals in our society are adept
at more than one task. For example, the baker was superior
in both bread-baking and doughnut-making. However, his
time was limited to eight hours a day, and therefore a scarce
resource. To get the most production in such a small 
time frame, the baker had to maximize productivity to
increase revenue. In the end, the consumer ultimately 
benefits because the increased number of doughnuts and
bread represents a rise in the standard of living, if not an
increase in waistlines. RF
JARGONALERT
Comparative Advantage
BY ERNIE SICILIANO
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REGION FOCUS REWORK SUMMER ISSUE  9/20/07  4:17 PM  Page 6

Jargon alert : Comparative advantage

http://www.richmondfed.org/publications/research/region_focus/2007/summer/pdf/jargon_alert.pdf

Jargon alert : Comparative advantage

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