Comparative Advantage for Everyone

May 12, 2008 by
Filed under: Business, Finance and Investment 

One very interesting topic in economics is the principle of comparative advantage. This topic is traditionally taught in the context of teaching the justifications and benefits for International Trade between countries, even if one trading country could produce all of its desired goods at a cheaper price than its trading partners.

When I have asked economics students to explain it, I have found it to be poorly understood. I have come up with my own analogy to explain the principle. Furthermore, it also explains how this principle applies to individuals in everyday life. Here is my example:

Let’s say I have a day job as contract web developer for which I get paid $50/hr. After work, I can either eat out for dinner or buy ingredients and cook at home.

When I go out to eat, my favourite meal is a Thai stir fry which has meat, vegetables and rice, which I can buy for $10. The restaurant takes care of all the preparation and cleaning. All I do it eat and leave.

When I eat at home, I might prepare something in the kitchen with frozen vegetables, beef and potatoes, and the ingredients for that will average out to $5/day over the course of a week.

On the surface, it seems that I am saving $5/day when I eat at home, but this is not the whole story.

In addition to the time spent shopping, I will also have to spend time to unpack and prepare the ingredients, wait for them to cook and clean up afterwards. Let’s say that the total time from preparing to washing up takes 1 hour.

What If instead of doing that, I worked for an additional hour per day and decided to always eat out?

I would earn an extra $50, spend $10 on the Thai meal, leaving me up $40 from my starting balance, and $45 ahead of cooking at home. Amazing.

I can extend this further to the Thai restaurant itself. Let’s say the owner/head chef wants to promote the restaurant by creating a website. She could either close the shop, read web design books and learn how to use HTML editing software, or she could hire me. The website the chef wants is simple – it just has the restaurant’s name, phone, address, a street map and the current menu.

I could hammer this out within 2 hours, for which I would charge $100. The chef is also clever, but she might take 5 hours as she has to perform software installation, read documentation and debug common beginner mistakes.

What should the chef do? Let’s say the restaurant serves 20 people per hour, and makes an average margin of $5 on each meal, the restaurant’s hourly income is $100/hr.

If the chef builds her website herself during restaurant hours, she would forego $500 in earnings. If she hires me, her total out of pocket expense is $100. Hence, she is $400 better off by hiring me to build her website.

For this example, we would conclude that my comparative advantage is in web development, and the restaurant’s comparative advantage is in preparing food.

This principle can be used to justify why a multi-talented business owner may be justified in hiring a graduate fresh out of university for clerical tasks, or why one would hire an accountant to do a simple tax return.

Of course this example makes a few assumptions. If I were in a permanent job, perhaps I would not have the ability to work an extra hour. Also, some people might in fact like cooking at home or spending time with family. Also, some Thai restaurants use excessive amounts of oil which could lead to weight gain.


2 Comments on Comparative Advantage for Everyone

  1. curve on Mon, 12th May 2008 11:43 pm
  2. Great article, it is simple when put in those terms. I have gotten the feeling in the past that certain economists can deliberately explain a concept in a way that is designed to obfuscate it.

  3. on Mon, 17th Nov 2008 1:03 pm
  4. Comparative Advantage for Everyone…

    This article demystifies the economic concept of ‘comparative advantage’, often used to justify the benefits of international trade and globalization.

    It uses the analogy of an IT professional who can choose to either cook dinner at home, or eat out…

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