Applying the economics of Comparative Advantage to Business and Product Decisions

 

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Unless you’re an economics major or studied it in college, there’s a good chance that you haven’t heard of the law of Comparative Advantage. Even if you have, this post may still either serve as a good refresher if it’s been a while, or offer a different perspective and/or application of the concept as it relates to either: managing your time as a busy entrepreneur, or deciding what to focus on as a product owner so as to maximize your chances of product success.

It’s no secret that the laws of economics can be applied to problems spanning a range of topics, sectors and even industries, in many different ways. They can be applied to business, to management, managing/growing your personal finances, and to yes, even relationships. For the record though, I can’t say I agree with all of the applications of economics, in particular this one, where the author argues that as a woman, marrying for money is “the smart thing to do”, and goes so far as to say: “After all, passion fades, but mutual funds are forever.” Heh, whatever.

So, let’s see how we can apply one economic concept, called Comparative Advantage, to either of the following problems:

  1. An entrepreneur skilled in several areas with a limited amount of time and resources, and faced with the problem: “I have too much to do and too little time. Do I focus on product, hiring, marketing, investor relations, or split my time between them? How do I decide how much time to spend on each?” (after all, founders are, typically, gifted, multi-talented, versatile professionals)
  2. A product owner faced with the question: “I’m planning on launching a product that does x, y and z. I know of at least 3 competing companies that do x, y and z. Should I focus my product to do one of either x, y or z? Or all of the above? How do I decide what to do first, and how much time to spend doing that?”

But first let’s take a look at what the law of Competitive Advantage is, before we see how it can be applied to answer these two (rather common) questions.

According to Wikipedia, David Ricardo (1772–1823), was one of the most influential classical economists that ever was. He was also a member of Parliament, businessman, financier and speculator, who amassed a considerable personal fortune. His most important contribution was the law of Comparative Advantage, which states:

Two countries (or other kinds of parties, such as individuals or firms) can both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods. Even if one country is more efficient in the production of all goods (absolute advantage), it can still gain by trading with a less-efficient country, as long as they have different relative efficiencies.

 

Let’s look at some examples (courtesy of Wikipedia) that demonstrate the immense utility of this economic law in simpler terms:

 

Example 1

Two men live alone on an isolated island. To survive they must undertake a few basic economic activities like water carrying, fishing, cooking and shelter construction and maintenance. The first man is young, strong, and educated. He is also faster, better, and more productive at everything. He has an absolute advantage in all activities. The second man is old, weak, and uneducated. He has an absolute disadvantage in all economic activities. In some activities the difference between the two is great; in others it is small.

Despite the fact that the younger man has absolute advantage in all activities, it is not in the interest of either of them to work in isolation since they both can benefit from specialization and exchange. If the two men divide the work according to comparative advantage then the young man will specialize in tasks at which he is most productive, while the older man will concentrate on tasks where his productivity is only a little less than that of the young man. Such an arrangement will increase total production for a given amount of labor supplied by both men and it will benefit both of them.

Example 2

Suppose there are two countries of equal size, Northland and Southland, that both produce and consume two goods, food and clothes. The productive capacities and efficiencies of the countries are such that if both countries devoted all their resources to food production, output would be as follows:
Northland: 100 tonnes, Southland: 400 tonnes

If all the resources of the countries were allocated to the production of clothes, output would be:
Northland: 100 tonnes, Southland: 200 tonnes

Assuming each has constant opportunity costs of production between the two products and both economies have full employment at all times. All factors of production are mobile within the countries between clothes and food industries, but are immobile between the countries. The price mechanism must be working to provide perfect competition.

 

Southland has an absolute advantage over Northland in the production of food and clothes. There seems to be no mutual benefit in trade between the economies, as Southland is more efficient at producing both products. The opportunity costs shows otherwise. Northland’s opportunity cost of producing one tonne of food is one tonne of clothes and vice versa. Southland’s opportunity cost of one tonne of food is 0.5 tonne of clothes, and its opportunity cost of one tonne of clothes is 2 tonnes of food. Southland has a comparative advantage in food production, because of its lower opportunity cost of production with respect to Northland, while Northland has a comparative advantage in clothes production, because of its lower opportunity cost of production with respect to Southland.

To show these different opportunity costs lead to mutual benefit if the countries specialize production and trade, consider the countries produce and consume only domestically, dividing production capabilities equally between food and clothes. The volumes are:

PRODUCTION AND CONSUMPTION BEFORE TRADE
Country Food Clothes
Northland 50 50
Southland 200 100
TOTAL 250 150

This example includes no formulation of the preferences of consumers in the two economies which would allow the determination of the international exchange rate of clothes and food. Given the production capabilities of each country, in order for trade to be worthwhile Northland requires a price of at least one tonne of food in exchange for one tonne of clothes; and Southland requires at least one tonne of clothes for two tonnes of food. The exchange price will be somewhere between the two. The remainder of the example works with an international trading price of one tonne of food for 2/3 tonne of clothes.

If both specialize in the goods in which they have comparative advantage, their outputs will be:

PRODUCTION AFTER TRADE
Country Food Clothes
Northland 0 100
Southland 300 50
TOTAL 300 150

World production of food increased. clothes production remained the same. Using the exchange rate of one tonne of food for 2/3 tonne of clothes, Northland and Southland are able to trade to yield the following level of consumption:

CONSUMPTION AFTER TRADE
Country Food Clothes
Northland 75 50
Southland 225 100
World total 300 150

Northland traded 50 tonnes of clothes for 75 tonnes of food. Both benefited, and now consume at points outside their production possibility frontiers.

Now how would we apply this concept to the 2 problems we looked at earlier?
For an entrepreneur with more things to do than there are hours in the day, it makes little sense to focus on anything other than the things he is best suited for. Now that might be sales, or product (but whatever that something is, it’s best if the entrepreneur didn’t stray too far from that job function, otherwise he wouldn’t be able to spend time on the things that only he uniquely can do relative to his teammates. This is especially true for the entrepreneur that is so experienced / talented that he is capable of doing the job of each of his direct reports better than they can). Of course, this ties in closely with delegating the right tasks to the right people, and hiring people that are smarter than you are.

Similarly, for a product owner looking to make a decision on whether to focus on product X, Y or Z (or all of the above), he must again, take a close look at what the team’s / company’s comparative advantages are (time to market, cost of development/production, man hours that would be required) in relation to its competitors. If the company projects that it could realize the lowest opportunity cost with product X in relation to products Y or Z and its competitors building out the same products, it should focus on building product X first. This is not to say that product Y and product Z don’t present sufficient incentives to be pursued. If the company possesses a clear comparative advantage if it were to build out product X, that’s what they should do first.

This argument does assume a number of things:
1. The team or company has a limited amount of resources, and doesn’t have the funds/manpower to proceed with developing X, Y and Z in parallel.
2. The product owner has already done his/her due diligence – run focus groups, analyzed the competitive landscape and done the requisite customer research before arriving at the conclusion that either one of product X, Y, or Z is the best path for the company to take at this point in time.
3. Neither of the companies already has a product X, Y, or Z, and these are possible products they are each considering.

Of course, the concept of Comparative Advantage has several applications, and we’ve only looked at a few examples, specifically how they relate to making business and product decisions. Needless to say, if you adopt this line of thinking into your everyday actions, it’s not hard to imagine how this could have a positive disruptive effect on the way you make most of your decisions.

 

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by Kunal Punjabi
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