August 20th, 2015
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Sometimes in economics, we can mix up some key concepts. One of the most common areas of confusion revolves around the concept of “comparative advantage.” Even Adam Smith did not develop this concept in his works. We have established that specialization has economic benefits. However, how should we specialize when we are not necessarily “The Best” at any particular thing?
I am better at cooking than my wife; but my wife is better at cleaning than I am. Our household is better off if I cook and my wife cleans. In this case, we each have an absolute advantage between cooking and cleaning. However, what if my wife was better at both things? Should she just do all the work? I know there is a lot more that goes into household management (believe me! I get an earful at home either way!), but bear with me. The concept of comparative advantage provides an answer in the case where there is no absolute advantage. If my wife is five-times more productive at cleaning than I am, but only two-times as productive at cooking, then the answer is that she should clean and I should cook.
The theory of comparative advantage is essentially the idea that even though one entity may be better at producing all goods than a second entity, it still may be beneficial to trade with the second entity, if they have lower opportunity costs (between goods). Opportunity cost (if you remember) is a key concept in economics and has been described as expressing “the basic relationship between scarcity and choice.” Opportunity Cost is “a benefit, profit or value of something that must be given up to acquire or achieve something else.”
Since every resource (land, money, time, etc.) can be put to alternative uses, every action, choice or decision has an associated opportunity cost. The opportunity cost of any choice is the value of the benefits one could have received by taking an alternative action (which has been forgone). Using this concept, value can be observed even without money or prices (in terms of money).
Let’s say the U.S., using its available resources, could produce five-Million cars or 15-billion bushels of corn. With its resources, say China can produce four-million cars or eight-billion bushels of corn. If the U.S. did not trade with China, it could produce combinations of between 0 to five-million cars and 0 to 15-billion bushels of corn. Likewise, China could choose to use its resources to produce between 0 to four-million cars and 0 to eight-million bushels of corn.
For simplicity, let’s say each country splits their resources between cars and corn. The U.S. could produce 2.5-million cars and 7.5-billion bushels of corn. China could produce two-million cars and four-billion bushels of corn. Total production of cars would be 4.5-billion cars and 11.5-billion bushels of corn.
In this case, the U.S. has an absolute advantage in the production of both goods. However, because it has different comparative advantages than China, the U.S. could still benefit from specialization and trade with China (and vise versa).
In the U.S., the opportunity cost for cars is three wheat. In China, the opportunity cost of cars is only two wheat. China has a comparative advantage in cars. The opportunity cost of wheat in the U.S. is ⅓ cars. The opportunity cost of wheat in China is ½ cars. The U.S. has a comparative advantage in wheat. The U.S. could produce just wheat and trade some of that for cars from China and be better off. Likewise, China could make cars and trade some of them for wheat from the U.S. There would be a greater supply of total goods and prices would be lower.
It is the ability to produce goods with fewer resources, at a lower opportunity cost, which gives countries a comparative advantage.
Critics of the advantages of “comparative advantage” point out some important real-world conditions:
Nonetheless, evaluating comparative advantages provides insight into the advantages of specialization, even when you are not “the best” at any particular thing. This applies to individuals, businesses and countries. You can certainly improve your day-to-day life (and wealth) by applying the “comparative advantage” concept. For instance, it may cost you less to do your own laundry, rather than sending it to the cleaners. However, if you were really good at your primary profession (and could earn more income than it costs you to have your closed laundered), you would be better off spending time working instead of doing your own laundry. In this case, the opportunity cost of doing your own laundry (the income you could have earned by spending that additional time working) is higher than the actual cost of paying someone else to wash your cloths.
When you stop to think about it, if you apply this concept in in every aspect of your life, you can get really good at leveraging your talent and time for higher gains.
Time is money. What you do with that time determines the value of it. Is that time costing you or earning you money?
So, consider your comparative advantages (in terms of your opportunity costs)! It is important to The Future of Your Wealth!