Economics and incentives
Comparative advantage
Even if you are worse at everything, you gain by doing what you are relatively least bad at and trading for the rest.
David Ricardo, On the Principles of Political Economy and Taxation (1817), chapter 7, using England's cloth and Portugal's wine.
Ricardo's numbers: England needs 100 men working a year to make its cloth and 120 to make its wine; Portugal needs 90 for the cloth and 80 for the wine. Portugal is better at both, so on absolute advantage it should make everything. But in Portugal a unit of wine costs 80/90, about 0.89, of a unit of cloth, while in England it costs 120/100, or 1.2. Wine is relatively cheap in Portugal and cloth relatively cheap in England. If each country makes one unit of each, 390 men produce two units of cloth and two of wine. Put England's 220 men all on cloth and Portugal's 170 all on wine and the same workers produce 2.2 units of cloth and 2.125 of wine. Both goods go up, and trade lets both countries share the surplus.
It holds because cost is what you give up, and opportunity costs differ even when one side is uniformly more productive. Nobody can have the lower opportunity cost in everything, because an opportunity cost is a ratio: being cheaper at wine in terms of cloth means being dearer at cloth in terms of wine. That is why a senior engineer who codes faster than a junior still hands over the routine tickets, why a surgeon does not do her own filing, and why countries specialise. The gain is not hypothetical. When Japan went from near-autarky to open trade after 1859, the measurable gain was several percent of national income, as the example shows.
The model assumes the people released from one activity really move to the other. If they cannot, because skills, towns or capital do not transfer, the national gain is smaller and the losses land on a few people while the gains are spread thinly. It is silent about who inside a country captures the surplus. It is also static: specialising in what you are relatively good at today can lock you out of learning what you would be good at tomorrow, which is the argument behind protecting infant industries and behind taking a stretch role. For a person, it pairs with circle of competence: being the best at a task is not a reason to do it if someone else's time costs less.
Example
Japan's shift from autarky to open trade after 1859 is as close to a controlled experiment as trade economics gets. Daniel Bernhofen and John Brown used detailed data on trade flows, prices in the final autarky years of 1851 to 1853, and Japan's real income to ask how much income would have had to rise in those years to afford the consumption bundle that trade later made possible. Their estimate, published in the American Economic Review in March 2005, put the upper bound on the gains from comparative advantage at about 8 to 9 percent of Japan's gross domestic product (GDP).
Where it applies
On a team, assign work where each person's opportunity cost is lowest, not where they are best in absolute terms: the strongest engineer who reviews everything is wasting the advantage. In an AI system the same rule decides what the language model does and what plain code does; the model is not the right tool for parsing dates even when it can.
Think about it
What task do you keep because you are better at it than a colleague, even though it costs you more than it would cost them?
Applied it to something real? Log it.
Test yourselfPortugal makes both wine and cloth with fewer workers than England. Why does Ricardo still have Portugal import cloth?
Because cost is what you give up. In Portugal a unit of wine costs 80/90 of a unit of cloth; in England it costs 120/100. Portugal gives up less cloth per unit of wine, so it should make wine and buy cloth.
Related models
- Opportunity costThe cost of any choice is the net value of the best alternative you gave up, whether or not money changed hands.
- Circle of competenceKnow where your real understanding ends, and keep your big bets inside that line.
- The opportunity cost of timeThe real price of an hour is the best thing you could have done with it instead.
- Supply and demandPrice settles where what sellers will offer meets what buyers will take; hold it anywhere else and a shortage or a glut does the adjusting instead.
Sources and further reading
- David Ricardo, On the Principles of Political Economy and Taxation, chapter 7, On Foreign Trade (1817; 3rd edition 1821, Library of Economics and Liberty)
- Daniel M. Bernhofen and John C. Brown, An Empirical Assessment of the Comparative Advantage Gains from Trade: Evidence from Japan, American Economic Review 95(1) (2005)