August 29, 2009

Comparative Advantage

I don't want you to miss the forest for the trees. Comparative advantage is not a small part of economics, but it is at the heart of a market system. Like I have mentioned, I wish that economics would quit following the tradition of speaking of comparative advantage in terms of countries. I think we should start with discussing it in terms of individuals.

Wealth is created when we specialize. We spend a lot of time developing our special skill set. That is why most of you are here in this class. You have decided that you can make yourselves more valuable and personally better off by going to school and obtaining certain skills. We then trade what we can do well for the things we need and want. (Note the role of money and the efficiency that money brings to this process).

Adam Smith got this general point. He said we should all specialize. We should do what we do best and pay others for what they do best. Through such transactions we all end up better off. However, what Smith could not explain is why someone who had better skills than another in a particular field may still be better off trading with the person of lesser skills. This is where Ricardo filled in the blank.

While Smith was looking at the absolute value of a person's production, Ricardo looked at opportunity cost. Let me explain using an example.

Imagine that I am a busy person. I make $50 per hour using my specialized skills for teaching online classes. I am also great at mowing the lawn. I can mow the lawn and make it look great in one hour. It is Saturday morning and I am busy teaching my class. The lawn needs to be mowed. If I leave my task and go mow the lawn, my opportunity cost will be $50.

Imagine that I have a teenage son. He is not as good at mowing the lawn as I am. It takes him two hours to do the job well. He works a part-time job at $8 per hour. He could go to work and get in an extra 2 hours. But, the lawn needs to be mowed. I offer his $20 to mow the lawn.

Even though I am better at mowing the lawn than my son, I am better off working on my class and paying my son to do the job. My opportunity cost is $50 to mow the lawn (one hour). My son's opportunity cost to mow the lawn is $16 (two hours). If I pay him $20 to mow the lawn, I am $30 ahead. My son is $4 ahead if he mows the lawn. Thus, even though in absolute terms I am better at mowing the lawn, we both win if my son mows the lawn and I pay him for the job. This is comparative advantage.