Trade and exchange

To illustrate the concept of comparative advantage we will look at a very simplified example.

The scenario - the accountant and the motor mechanic

Comparative advantage

Background

Jane is an accountant by profession and, in her spare time likes to work on her 'classic' 1955 Ford Thunderbird. Ted lives close by and is a professional car mechanic. He needs to complete his annual accounts, and often does this himself.

Jane's normal fee for her accounting services is £100 per hour, and most of her work is on site at clients' premises. Ted charges £25 per hour, and has a small garage behind his house.

Jane is a more efficient motor mechanic than Ted, especially in fixing problems with classic cars - if it takes Ted 2 hours to complete a particular job, Jane would take only 1 hour.

Jane is also, as expected, a more efficient book-keeper and accountant than Ted. To complete his set of annual accounts, Ted will take 5 hours, whereas Jane will only take 1 hour to do the same work.

The average cost of a taxi journey in town is £20.

Jane's car breaks down

One Friday morning, just before she goes to her first appointment, her car fails to start. She estimates that it will take her 1 hour to fix the car. However, if she chooses to fix her car she cannot got to her first hourly appointment.

By coincidence, Ted needs to complete his accounts that very same day, and might be forced to close the garage early, and spend the afternoon finishing them, which he estimates will take 5 hours.

What should they do?

On the surface, Jane is the most efficient worker, both in terms of accountancy skills and car mechanic skills. It might appear sensible for Jane to fix her car on Friday morning, and for Ted to complete his accounts on Friday afternoon. But is this rational?

A quick calculation will reveal that it is better for both of them to carry on with there usual work, and then hire each other to complete the work that needs to be done.

Comparative advantage answer

Comparative advantage

What this simple example reveals is that it is a more efficient use of scarce resources when resources are used in a specialised way, and used according to the principle of comparative advantage. In terms of Jane and Ted, Jane is twice as efficient in terms of time taken to complete work on her car (2 hours versus 1 hour), and five times more efficient at accounting (1 hour versus 5 hours). In this simple case, Jane has an absolute advantage in terms of both, but a comparative advantage in terms of accountancy. If they specialise, and trade, they are both better off.

Applications

Specialising according to the principle of comparative advantage, and then trading, is at the centre of how market economies work. The idea of comparative advantage can be traced back to the work of 19th century British economist, David Ricardo. This principle can be found in terms of how individuals, firms and whole nations specialise.


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