Sep 18, 2015

Specialize and focus on what you're best at doing, relative to others, and trade for the rest, because of opportunity cost.

#### Explanation:

Here is a great explanation of economist David Ricardo's 1817 theory of comparative advantage, using the classic example of Portugal and England trading wine for cotton.

I'll try to paraphrase and simplify that example even further:

Dave and Richie are both makers of 2 products: widgets and doodads.

Dave can make:

• 10 widgets/hour

Richie can make:

• 9 widgets/hour

Dave is more productive than Richie at making both widgets and doodads; he enjoys an absolute productivity advantage over Richie on making both products.

If Dave and Richie work 12 hours per day, splitting their time 5/7 between making widgets and doodads, here's what they would make independently:

Dave (in 12 hour, split 5/7):

• 5 hours x 10 widgets/hour = 50 widgets

Richie (in 12 hours, split 5/7):

• 5 hours x 9 widgets/hour = 45 widgets

If Dave and Richie had to make widgets and doodads by themselves and never trade with each other (autarky may ring a bell in the macroecon sense), then they could adjust the  of hours of they spend making widgets or doodads but they'd be trading off every extra hour making widgets for one less hour making doodads, and vice versa, with time being the limited resource (opportunity cost).

However, what if Dave and Richie could just focus on making what they're each relatively best at and trade with each other for the other product? Looking back at their productivity, Dave can make +4 more doodads than Richie, compared to just +1 more widget, per hour. Dave is better than Richie at making both, but he's much better at making doodads. Dave has a comparative advantage over Richie in making doodads.

Dave focuses on only making doodads and Richie focuses on only making widgets:

Dave (in 12 hour, all doodads):

• 0 hours x 10 widgets/hour = 0 widgets

Richie (in 12 hours, all widgets):

• 12 hours x 9 widgets/hour = 108 widgets

Dave then trades 45 of his doodads for 60 of Richie's widgets and they end up with the following:

• 0 widgets + 60 widgets from Richie = 60 widgets

Richie, after trading 60 widgets to Dave:

• 108 widgets - 60 widgets to Dave = 48 widgets

Compare this to the  of doodads and widgets Dave and Richie would have if they worked solo without trading (autarky).

Dave:

60 widgets with trade > 50 widgets with autarky

Richie:

48 widgets with trade > 45 widgets with autarky