The principle of comparative advantage is a fundamental concept in trade theory, and entrepreneurs would do well to understand it.
(article continues below)
The concept of comparative advantage shows us that trade can benefit all parties involved as long as the relative costs are different. Let me explain this concept in detail with two examples.
Example 1: Comparative and Absolute Advantage
There is an island with two people in it. The economy only has two goods: food and cloth. In this economy, one bundle of food trades for one bundle of cloth and each person needs at least 6 bundles of each. Let's say that the first person, Bob, is particularly good at making food and the second person, Joe, is particularly good at making cloth.
In a day, Bob can either make 3 bundles of food or 1 bundle of cloth and Joe can either make 1 bundle of food or 3 bundles of cloth. In this case, we say that Bob has an absolute and comparative advantage in making food and Joe has an absolute and comparative advantage in making cloth. (Absolute advantage simply means that the person is more productive in producing a good. We will get to comparative advantage later.)
If Bob and Joe refuse to trade with each other, they would have to make everything themselves. Assuming that the two starts out with 0 bundles of each good, it would take Joe and Bob at least 8 days to make six bundles of each goods. (6 days to make 6 bundles of goods that they have an absolute disadvantage in and 2 days to make 6 bundles of goods that they have an absolute advantage in.)
Now, let's assume that Bob and Joe cooperated. In this case, Bob and Joe would only produce what they have an absolute advantage in. Bob will spend 4 days to make 12 bundles of food and Joe will spend 4 days to make 12 bundles of cloth. By trading, it would only take the island economy 4 days to achieve the desired result instead of 8 days.
In this example, it is easy to see why the two decided to trade. Now, let's move on to something trickier.
Example 2: Comparative Advantage without Absolute Advantage
Let's say that Joe suffered an injury and as a result, became less productive than he used to be. Instead of making 1 bundle of food or 3 bundles of cloth in a day, now poor Joe can only produce 1/2 bundle of food and 1 bundle of cloth a day. Now, Bob has an absolute advantage in producing both goods. Should Bob and Joe still trade with each other?
If they do not, how many days will it take them to achieve the desired results (assuming that they start out with 0 of each good)? Again, it would take Bob 8 days to achieve the desired result but it would take 18 days for Joe to achieve the desired result (12 days to make 6 bundles of food and 6 days to make 6 bundles of cloth).
Will trade benefit both parties? Now that Joe has no absolute advantage, we need to look at comparative advantage. We determine comparative advantage by looking at the opportunity cost of producing a good:
The opportunity cost for Bob to produce 1 bundle of food is 1/3 bundle of cloth and the opportunity cost for Joe is 2 bundles of cloth. Since a bundle of food trades exactly for one bundle of food, we see that Bob has the comparative advantage in producing food and Joe has the comparative advantage in producing cloth.
First, Bob will spend 4 days to make 12 bundles of food and Joe will spend 4 days to make 4 bunches of cloth. Now that they have sufficient food, both will spend the next 4 days to make 8 bundles of cloth. In this scenario, both parties will achieve what they want in a total of 16 days of labor instead of 26 days of labor. For helping Joe save 10 days of labor, Joe can compensate Bob in a number of ways.
Entrepreneurs should use the concept of comparative advantage in their decision making. For example, the founder/CEO of a business has an absolute advantage in both making executive, macro decisions and in secretarial work. However, the founder/CEO still hires a secretary so he or she can concentrate on making the big decisions.
Although this might seem obvious, however, there are times when founders fail to delegate enough work because he or she has an absolute advantage in many areas and as result, gets bogged down in work where he or she has a comparative disadvantage.