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Comparative Advantage

Definition

An entity’s capacity to deliver a service or product at a lower opportunity cost than other people, organizations, or nations. As a result, the entity can sell a good or service for less than its competition.

Why Use It

Whenever you consider a good or service, each has advantages and disadvantages.

The opportunity cost reveals the potential benefits an entity misses out on when picking one option over another.

The principle informs choosing the best option while contemplating trade-offs. The option with the best overall value is the one with the comparative advantage.

When to Use It

In society, the more variety in people and skills, the wider the gap in opportunity cost. So, a specialized person will often find it helpful to trade or buy something they require rather than it themselves.

Say you’re a fashion designer and you recently purchased a fixer-upper. The newly purchased home needs to be gutted. You have a choice to complete the renovation or find a contractor to do it. If your opportunity cost is less than the contractor, hiring them to complete the renovation is worth it.

In some cases, folks discover their comparative advantage by negotiating their salary. For example, suppose an extraordinary doctor earns more money in surgery than teaching a class on the subject. In that case, the doctor will likely choose the higher-paying position and perform what they are comparatively best at doing.

One distinction is in the concept of comparative advantage versus absolute advantage. In the latter’s case, an entity can produce more or better goods and services than someone else, but just because they can create more or higher quality products does not mean they have a comparative advantage. As long as a person or organization can hold a lower opportunity cost, they’ll be able to find others who are willing to trade.

How to Use It

Determining the opportunity cost of goods or services will inform decision-making and ultimately, free you to choose the best route forward each time.

As an outlandish example, we’ll look at Jeff Bezos, who owns Amazon, one of the most profitable companies globally, and who personally makes 3,715 dollars every second.

Should Jeff Bezos cook his meals?

Jeff is a great businessman. One of the most successful the world has ever seen. He’s likely good at doing all kinds of things. Jeff is quick on his feet, understands directions, works harder than most, and can complete activities quickly. Jeff can probably make himself a great dinner. But just because he can cook a delicious meal, does it mean that he should?

Let’s say that Jeff can prepare dinner in 60 minutes. He can have a productive call that nets him an additional $1M revenue in that same amount of time. An in-house chef, on the other hand, might take several hours to cook Jeff’s dinner. The chef could have worked at a lauded restaurant instead and earned $150 for three hours of work.

Jeff’s opportunity cost is $1M, and the chef’s opportunity cost is $150. Jeff has an absolute advantage in cooking dinner in less time. Yet, the in-house chef has a comparative advantage because he has a lower opportunity cost. The trade-offs are immense in Jeff’s case. He should pay for an in-house chef without question and take the phone call. If Jeff is willing to pay the chef more than $150 and less than $1M, the deal works out well for them both.

How to Misuse It

There are plenty of restrictions on free trade in the real world, even though comparative advantage would indicate those are precisely the deals that should be made. One of the main reasons is rent-seeking which happens when an organization coordinates and lobbies the government to protect its interests.

In these cases, the organization protecting itself from competition makes purchasing these goods or services more expensive for consumers.

Being aware of these limitations is essential when looking at a decision holistically.

Next Step

When thinking about your next choice, take a moment to consider the opportunity cost and make the best decision.

If you’re looking at the big picture, notice where comparative advantage eats absolute advantage’s lunch.

Where it Came From

Political economist David Ricardo wrote about the concept of comparative advantage in his 1817 book, “On the Principles of Political Economy and Taxation.” Previous to that, the idea was mentioned in Adam Smith’s 1776 work, “The Wealth of Nations.”

What Are Mental Models?

Mental models are thinking tools that help guide and shape our perceptions of the world. They simplify complexity so we can understand life better, make decisions confidently, and solve problems.

Deep Dive Into Mental Models

Deep Dive Into Mental Models

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