Ricardo's Law of Comparative Advantage
Ricardo is perhaps best known for his theory of comparative advantage of nations, which postulated that specialization leads to wealth, and self-sufficiency leads to poverty. Such a proposition was initially regarded as preposterous—and often still is by those who do not truly understand the principle. Through his research, Ricardo demonstrated that trade between two countries can be mutually profitable, even when one country is more productive than the other in every commodity that is being exchanged.
England and Portugal
Ricardo used trade between England and Portugal as a prime example. Portugal could produce both wheat and wine more cheaply than England, giving Portugal an absolute cost advantage in both commodities. Delving deeper into the economics of these two countries, Ricardo found that one unit of wine in England cost the same amount to produce as two units of wheat, while in Portugal, the production cost of one unit of wine was the same as 1.5 units of wheat. Lost OpportunityEven though Portugal could produce wheat more cheaply than England, every unit of wheat it produced cost the country the opportunity to make a higher profit by producing one unit of wine. This is known as a lost opportunity cost. From this perspective, Portugal had a comparative cost advantage in the production of wheat. Ricardo went onto show how both countries could benefit by trading these two products with each other, with Portugal focusing on the production of wine and England focusing on the production of wheat.
Application in Your Life
At the personal level, this is why, in our coaching program we stress the importance of determining your highest-value tasks—the 20 percent of things you do that yield 80 percent of your desired results—and then focusing on these high value tasks while delegating (or even eliminating) the rest. A second lens through which you have learned to view this principle is that of your hourly rate. Anything you do, for which you could not pay someone your desired hourly rate leads to a lost opportunity cost.
Application in Your Business
Ricardo's Law of Comparative Advantage is equally relevant in the management of your business. To the extent that you invest any of your business's resources—the money, time, and energy of your employees, your physical plant and equipment, your intellectual capital and the like—in activities where another company has a comparative advantage, you incur a loss-of-opportunity cost. In some cases, the loss can be significant.
Action Exercise
Which of your products or services represent the highest return on investment of your business's resources? These represent your business's areas of comparative advantage.
If you would like to know more about how what your Comparative Advantage is in your business, please contact one of my business coaches at www.tafastrack.com.au
