In this article, I want to give an overview of two of the most fundamental concepts of modern microeconomics: opportunity cost and comparative advantage. These two concepts are so fundamental that they are the foundation of every other concept in the field. They also lead to the concept of trade, which underpins every individual, business and government decision. Let’s get started!
Economics is the study of how society chooses to allocate scarce resources. That’s all it is. If you want to understand society, the economy and how it works, all you have to do is find out how society chooses to allocate scarce resources. By scarce resources, I mean resources that are limited in terms of how much of it there is, what is available to use and what is available to consume. In a capitalist society, the allocation of limited resources is done through the price mechanism – the mechanism that affects the allocation of resources known as supply and demand.
Every human action involves the allocation of scarce resources. For example, let’s say we are trying to decide what to eat for dinner. We have limited resources and we have to allocate them to dinner. So we have to decide how much money we have, how much time we have, how much food we have and how much effort it will take to cook dinner. Each of these resources is scarce. Maybe we have $10, five hours, five meals and five minutes. We have to choose how to allocate these scarce resources to decide what to eat for dinner. That is a microeconomic decision.
It is the same with every choice we make. Whether we’re choosing where to spend our next vacation, or which penny stocks to watch, we are making a decision about the allocation of resources.
But how do we decide? How do we make the best decision given the limited resources we have? That is the fundamental question that economics tries to answer. We can only make the best decision based on our limited resources if we make the comparison between the two choices we are presented with. For example, we have limited resources – we are only able to eat one dinner. If we have to choose between steak, chicken and pasta, we have to make a decision based on the limited resources we have. First, we have to evaluate what we have. Then, we have to decide the best way to allocate those scarce resources.
So how do we evaluate what we have, and make the optimal decision? The answers to this question are found in the concepts of opportunity cost and comparative advantage.
Opportunity cost is simply a way of describing the most valuable alternative that we give up by making a certain decision. For example, let’s say you are trying to decide whether to go out to dinner tonight or stay in and cook dinner. You have limited resources – you only have so much money, time and energy. You have to decide how to allocate these resources to the two options. You could allocate them to go out to dinner, or you could allocate them to cook dinner.
By making a certain decision, you are necessarily sacrificing something. If you go out to dinner and spend $50, you are sacrificing the next best thing you could do with that $50. If you stay in and cook, you are sacrificing the most valuable thing you could have done with the time you spent cooking. The point is that no matter which choice you make, there is a sacrifice, and this sacrifice is the opportunity cost of the decision.
Opportunity cost tells us about the sacrifice we make by making a certain decision. Comparative advantage tells us how to make the best decision. It is the most important concept in economics because it tells us the best way to allocate your limited resources. In other words, it tells us how to make the best decision given our limited resources.
Comparative advantage tells us that the best way to allocate our resources is to focus on our comparative advantage. But what is comparative advantage? It is our ability to produce something more efficiently than other things. It is the ability to produce something using fewer resources. For example, let’s say we are trying to decide what to make for dinner. Let’s say you are a good cook and I am not. You are able to make a better steak than I will make. That is called your comparative advantage.
The underlying principle of comparative advantage is that every person, every business and every country should specialize in the activity in which they have comparative advantage.
If we specialize in the activity in which we have comparative advantage, the economy as a whole benefits. It’s almost like magic – specialization gives us something for nothing. This works because each person’s comparative advantage is different. For example, you have a comparative advantage in cooking, so you should cook. I have a comparative advantage in writing, so I should write. I have a comparative advantage in writing, so I write while you cook. We are both better off.
Trade is the consequence of comparative advantage. If we specialize in the activity in which we have comparative advantage, we can both be better off if we choose to trade. Rather than making dinner myself, I should (in an ideal world) sell my writing, and buy my dinner. Specialization, in this sense, leads to trade and therefore economic activity.
In other words, optimizing for opportunity cost leads to acting for comparative advantage, which leads to trade. And trade is the fundamental property of a healthy and active economy.
The next time you are trying to figure out what to do with your resources, make sure you think through your opportunity cost and your comparative advantage. The best decision, economically speaking, is to use your resources to maximize your comparative advantage. If you can do something better than others, spend your time doing that and don’t be afraid to buy products and services from others that can do things more efficiently than you!