Comparative advantage worked example | Basic economics concepts | AP Macroeconomics | Khan Academy

The countries of Kalos and Johto can produce two goods: shiny charms and berries. You got to love these worlds created in these economic questions. The table below describes the production possibilities of each country in a day.

So, here it tells us that Kalos, if it puts all of its energy behind charms, could produce 10 charms in a day. But if it put all of its energy behind berries, it could produce 20 berries in a day. And then Johto, if it puts all of its energy behind charms, could produce 25; if all of its energy is behind berries, then it could produce 75.

Given these numbers are based on both countries having the same labor and capital inputs, who has the absolute advantage in charms? So pause the video and see if you can figure this out.

All right, so let's just remind ourselves: absolute advantage is just who is more efficient. Who, given the same inputs, can produce more? They told us that these countries have the same labor and capital inputs, so this is really just a question of who can produce more charms in a day.

You can see very clearly that Johto can produce more charms in a day. So I would say Johto because they produce... let me write a little bit neater. They produce more charms per day, with the same inputs. So they are more efficient; they have the absolute advantage.

Now, this is an interesting thing because our intuition might say, "well, whoever has the absolute advantage, maybe they're the ones that should be producing charms." But this is what's interesting: when we study comparative advantage, that is not always the case. I suspect that this question will lead us there.

All right, next question. They say, "calculate the opportunity cost in Kalos of charms." So the opportunity cost in Kalos of charms is that when Kalos decides to produce 10 charms, they're trading off 20 berries. In another way of thinking about it, it costs them 20 berries to produce 10 charms.

So we could say it costs 20 berries for 10 charms, which is equal to two berries per charm in Kalos. So there you have it; the opportunity cost—they trade off two berries per charm. Actually, let me make a little column here for the opportunity cost, so this is two berries per charm.

And I have a feeling—but if you're taking an exam, say an AP exam, it's not a bad idea to just fill this thing out. So, what is the opportunity cost? They haven't asked us that yet, but I'm just going to do it really fast.

What is the opportunity cost of charms in Johto? Well, they are trading off to produce 25 charms; they trade off 75 berries. So this would be 75 divided by 25, which would be three berries per charm. 75 berries for 25 charms is three berries per charm.

And if you want to know the opportunity cost of berries, well, you could just take the reciprocal of each of these. So in Kalos, the opportunity cost is one-half charms per berry. In Johto, it is one-third charms per berry.

If they wanted to produce 25 berries—or if they wanted to produce 75 berries—they would trade off 25 charms. So it costs them 25 charms to produce 75 berries or one-third of a charm per berry.

So I'm just doing a little bit of extra, but then it's going to be useful because in the next question they actually are asking us: who—let me scroll up a little bit—they're saying who has the comparative advantage in berries? Explain.

Well, whoever has the lower opportunity cost has the comparative advantage. So we see here that Johto has the lower opportunity cost in berries. One-third is lower than one-half; it's a lower operating cost of producing a berry.

So Johto has one-third charms per berry opportunity cost, which is lower than Kalos's. Kalos's is one-half charms per berry opportunity cost. So Johto has a comparative advantage in berries.

I apologize a little bit for my penmanship; I'm trying to save time by writing a little bit fast. But hopefully, me saying it out loud at the same time is making it somewhat legible.

All right, so the next question: if these countries were to specialize in trade, who would produce which good? Explain.

Well, whoever has the comparative advantage, each will produce that one. So Kalos has a comparative advantage; Kalos has a lower opportunity cost for charms. Kalos has the advantage in charms.

And then we already said Johto has the advantage in berries. So Kalos produces charms, Johto produces berries. And once again, this goes back to something we touched on at the beginning of the video: even though Johto has the absolute advantage—in fact, they have the absolute advantage—Johto is not... even though they can produce charms way more efficiently than Kalos, Johto should actually produce the berries while Kalos should produce the charms because they have a lower opportunity cost in terms of berries.

Now, let's answer this last question right over here: what would be a trading price that Johto and Kalos would agree on to trade charms for?

Now you might be saying, "well, what's a price?" I'm used to saying that in terms of just, you know, maybe dollars or some type of currency. How do I answer a price right over here?

Well, the key is that we can give a price in terms of opportunity costs. So they want a price of charms, so it really could be in terms of berries.

Let's see; let's look at each of their costs of charms. So Kalos's opportunity cost of a charm is two berries per charm, and then Johto's opportunity cost of charms is three berries per charm.

And here we're going to appreciate why comparative advantage works. We said that Kalos would be the one that would focus on the charms. Notice, if they can sell the charms to Johto for something that is higher than their opportunity cost and lower than Johto's opportunity cost, then they both benefit.

So a good price—let's say you could go halfway between the two, but it really could be anything in between the two—let's say 2.5 berries per charm. They both benefit, so they would trade at 2.5 berries per charm.

Why does this make sense for Johto, even though they have the absolute advantage? Well, they produce nothing but... but if they produce nothing but charms, it would cost them three berries per charm. No matter what they do, it'll cost them three berries per charm.

But now they figured out a way, through trade, to get charms at two and a half berries per charm, and so this will be a better deal for Johto.

One thing to appreciate when we talk about comparative advantage: some people think that it's about one country benefiting more than the other. But if we assume all the assumptions about comparative advantage in our models, then it's actually about both countries that are trading benefiting. They will both be better off; they'll both get gains from trade and both will be better off.