Adam Smith, David Ricardo, Comparative Advantage, and You

Today, let’s learn a bit about economics. As I mentioned a few days ago, recently I’ve been reading a great deal about economics in an effort to get a better grasp on how money works on a larger scale than in my own wallet. In this effort, I started at the beginning, reading a pile of classic books on economics and working forward, and recently I reached David Ricardo’s 1817 classic The Principles of Political Economy and Taxation. It made me consider some of the implications of frugality – and whether it’s cheaper to hire someone to clean your house.

But let’s back up a bit. Before I read Ricardo’s book, I read Adam Smith’s slightly older book, The Wealth of Nations (at the same time as P.J. O’Rourke’s hilarious reader’s guide to it, On the Wealth of Nations). In that book, Adam Smith talks about absolute advantage, a concept that’s easy to understand. Absolute advantage merely refers to the advantage that someone has when they can produce more output per unit of effort than someone else. For example, if your next door neighbor Jim makes $25 per hour of work and you only make $18, Jim has an absolute advantage over you – he invests less time for every dollar earned than you do.

Comparative advantage, which is the idea that Ricardo talks about, is a bit more slippery, and it’s best explained in an example. Let’s say that Annie and Bonnie both have small gift shops in a small town where they both sell their homemade soaps and their homemade candles. Annie can make a homemade candle for fifty cents, but making a bar of soap costs her a dollar. Meanwhile, Bonnie can make homemade soap for a quarter, but a candle costs her a dollar to make. In other words, Annie is much more efficient at making candles and Bonnie is much more efficient at making soap. If they’re willing to trade – Annie gives candles to Bonnie in exchange for soap – they’ll both make substantially more profit that way. That’s comparative advantage in a nutshell.

This idea of comparative advantage works in everyone’s life. Let’s say, for example, that I can make $20 an hour working at my own business – each hour of time I invest in it earns me $20. It takes me an hour to mow my lawn, but it’s a chore I know I have to do. Now, a teenage neighbor kid has a killer mower and is in excellent shape – he can bust through my lawn in a half an hour. He comes up to me and says “I’ll mow your yard for you for $10.”

Now, the cheapskate choice is to say no and do it myself, but it’s not the most financially sensible choice. If I tell the kid no, I spend an hour mowing my own lawn to save myself the $10 I would have to pay him – but I lose the $20 I would make if I spent that hour working on my business. Instead, what I should do is pay the kid $10, then spend the next hour (that I would have been mowing) working on my business, earning $20. Net profit – $10.

You can carry this forward to all sorts of cases. There’s a woman on our block who does housecleaning at a rate of $54 for four hours of cleaning (remember, folks, this is Iowa). If I’m working on my businesses while she’s doing that, does it make sense to hire her to clean the house one afternoon a week? I’d earn $80 and spend $54 – that still leaves $26 for me for four hours’ work, a net profit.

There are just a couple important caveats. First, do you know exactly what you earn for each hour of your work? I find that long term calculations work best here – let’s say, over three months, I spend 200 hours on a side business and I bring in $4,300 after taxes and expenses. It’s probably fair to believe that I earn $21.50 an hour for the time invested.

Second, would contributing more hours directly lead to more income? If I added an extra twenty hours to that business time, would I bring in another $430? Probably not directly – but I could spend that extra time building up more business for later or improving the infrastructure to increase my efficiency.

Here’s my frugal advice: use comparative advantage where it’s obvious. If I can get the neighbor kid to mow the grass for $10 while I can directly earn $20 working at my side business in that same timeframe, I should hop on board. This is the same logic that convinces people to use daycare, for example.

Of course, one should be careful if the value isn’t as obvious. If I were to hire that housecleaner, would I really be able to utilize those extra four hours enough to earn more than $54? It’s possible that over the long term I will, but it’s not a guarantee. These situations are judgment calls based on what’s going on with your life and activities, but it’s worth considering. For me, I may just hire that housecleaner.

Who says that economics texts from the early 1800s aren’t valuable and relevant to our lives today?

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37 thoughts on “Adam Smith, David Ricardo, Comparative Advantage, and You

  1. RC says:

    Another thing to be careful of is making sure, if the advantage is no longer there, to stop paying for a service, e.g., lawn care,if you no longer are using the time to increase your income in some way. After a period of time people become comfortable with having someone mow their lawn, clean their house, etc., when in fact their situation may have changed (no longer working OT at work, or on a side business)and they should probably start doing those things themselves again.

  2. Good point, RC!
    This is really interesting. Is “The Wealth and Poverty of Nations” by David S Landers on your list? I’ve read about half of it before I got a bit burned out, but the half I did read was *really* interesting :)

  3. Tyler says:

    I agree with RC –
    Make certain that you are actually using that extra time to build more wealth and not for non-wealth building activites.
    ~Tyler

  4. Kathy says:

    Good theory, good theory.
    Unless, of course, the teenage boy leaves your yard looking like it was done by a ten year old, and the cleaning lady helps herself to some of the wife’s jewelry, LOL.

  5. VJ says:

    So the ads from adsense are back on your site.

  6. Ryan says:

    When I was younger, I thought about getting a second job for extra money. But I used this same principle to realize that the second job at $8/hour would take away opportunities to work for $30/hour overtime at my first job (although these hours were intermittan). Not to mention the career opportunities that presented themselves at my first job due to looking dedicated by staying late.

  7. Parth says:

    This is really interesting stuff. But I can only subscribe in a reader. I don’t want to get emails. Any solutions? Do you have a link?

  8. Sarah says:

    Also this sort of thinking only really works when the hired help’s basic costs of living are lower than yours. Otherwise, you may find that ‘a change is as good as a rest’, and you’re better off financially mowing your own lawn.

  9. Sharon says:

    I also work at home and make my own hours, so I read your post with interest, but I would still mow the lawn myself in those circumstances because you have left out the advantage of getting some good exercise at the same time that you are doing necessary task. I would look at that chore as my unpaid lunch break that saves me $10 and adds to my overall health. That is also how I look at housework. I turn it into an exercise session since my job involves me sitting at a computer for several hours a dsy. Just a thought.

  10. MS says:

    @VJ
    There was a posting a couple of weeks ago regarding the adsense return. As a compromise, Trent has resumed using adsense and added a “report an unethical ad” link to help weed out the bad ads.

  11. !wanda says:

    @Parth: http://feeds.feedburner.com/thesimpledollar
    The link is in the text blurb on the top right corner of each page.
    I have an issue with the text on that page. It says the blog is for “people struggling to escape from the many-tentacled debt monster (in other words, everyone).” I’ve never been in debt and take umbrage at the implication that everyone is.

    @Sarah: The hired help’s basic costs of living should be included in what they charge, particularly if they work for themselves, like a lot of housecleaners. So, you can decide based on price.

  12. mouse says:

    keep your blue-collar chores – the mowing, housekeeping. you need the exercise! do it in a way that gets your heartrate up. exchange it for your gym membership.
    outsource your white-collar jobs. i think what i pay my accountant and takes him no time at all equals what i would waste if i gave up work to do the same taxes myself, but theres a good chance that he can do it a lot better. and because doing them cause me a lot of stress – its another step towards my well-being and your health is priceless. my philosophy is frugality should not cause you TOO much stress – if you shave off years of your like to save a few bucks, you won’t be alive to enjoy your retirement/freedom.

  13. Michael says:

    Trent enjoys synoptic reading, so I am surprised he hasn’t made the connection between these books and high demand for personal finance writing.

  14. Brad says:

    But don’t forget taxation in your cost analysis. If you’re making $20 per hour and in the 25% tax bracket, you’re take-home pay is roughly $15 per hour. Your $80 in additional income is not too far in value from your $54 payment to your cleaning lady.

  15. Stephan F- says:

    Then there are things you can do to change the equation. I mow my own lawn for the exercise and with noise-canceling headphones I can listen to audiobooks on my iPod. I tend to take longer then absolutely necessary to do the mowing as I stop and write down notes and ideas about what I am listening too.

    A question you might want to address is how much to spend on improving yourself? Lots of people say spend an hour a day but what about money. I’ve only found Brian Tracy saying you should spend 3% of your income on continuing education.
    How much do/would you spend upgrading yourself?

  16. Courtney says:

    Sarah, I disagree with you, and I’ll tell you why. I earn $20 an hour. I hire Bob the Builder to do a job that would normally take me an hour. I give him $10. It looks like Bob the Builder makes half of what I make.

    But WAIT! Bob has practice, skills, and specialized tools that may enable him to do the job in just half an hour. If he gets two jobs in an hour, his pay is the same as mine, $20 per hour.

    True, Bob has to drive from job to job, but sometimes the difference in time is even more stark. I locked my keys in my car last week. If I found a wire coathanger and tried to open it myself, I estimate I would have tried for a half hour with no guarantee of success. I called a mechanic a few minutes away. Once he got here, it took him all of 15 seconds to slide his specialized tool into the window and unlatch the door.

    Even manual labor like cleaning homes is much faster when maids have lots of practice and effective cleaning tools (I found this when I cleaned homes in college).

    The equation doesn’t work if you’re paid by the hour, but in my experience most workers of the type you’re talking about are paid by the job, not by the hour.

  17. The problem with the theory is that you actually have to USE the time the housekeeper or yard person is working to do your own paying work. And you have to earn, for each hour the serviceperson works, significantly more than she or her makes: enough to pay your worker, pay yourself extra, and pay the taxes on the full amount earned.

    Ever try to write when a housecleaner is banging around? :-)

  18. Marcus Murphy says:

    Excellent post! I look at this stuff all the time, and there are a million different ways you can approach it.

    On the topic of economic books, Alan Greenspan’s book The Age of Turbulence: Adventures in a New World is up there with the best I’ve read. I think you would find it a very worthy read.

    Cheers.

  19. Chris Thompson says:

    There’s a very succinct way to put this. I once had a conversation with someone about how installing MythTV was cheaper than buying a Tivo.

    He said “It’s only cheaper if your time is free.”

    True enough.

  20. TubaMan-Z says:

    As a salaried employee, the more hours I work just serves to bring down my hourly wage (admittedly in the short-term. There is the potential for a higher salary long-term). Doing things myself is clearly a cost-savings. And if I use a vacation day to do it, I am making pretty good money mowing my lawn.

  21. Sue says:

    Hi Trent

    This is a serious question – how many of you are there? I’ve been reading your blog for months now, and if I were able to do half as many things as you, I’d be a happy gal!

    You know what would make a great post? A description of how you spend an average weekday/weekend. Would be great for those of us who would love to get ideas from how you manage to fit all these zillions of activities into your schedule!

  22. Micki says:

    This is the same idea that Charles Givens wrote about in his book Superself. He recommended hiring help for any household chore if it enabled one to spend that time making more money. See also The Power of Focus by Canfield, Hansen, and Hewitt, which directs people to focus on what they do best and let other people handle the rest.

  23. The sad part of it is many people hire out and end up spending the freed-up time doing something non-productive like watching TV.

    Best Wishes,
    D4L

  24. Jeff C. says:

    I fight this battle constantly in driving an older vehicle. It runs great, but needs work occasionally. I can do a good bit of work on the car, but it takes me longer because I don’t have the experience or tools. However, the cost for having it fixed is high. I weigh that time vs money issue.

    Then of course, I fight the battle of newer (not new) vehicle cost vs. time/repair cost of the older one, but that is a discussion for another time.

  25. Julie says:

    @ Sue: I have determined that Trent doesn’t need sleep. That’s the only way to explain it. ;-)

    Trent, it’s very exciting to hear that you’re reading about economics – and primary sources too, not just a textbook. It would be so nice for the economically inclined people (such as myself) if everyone was like you!

  26. trb says:

    @D4L – I think the really sad part is that people end out hiring out things that aren’t easily evaluated with dollars, like child care. What’s the value of spending a day teaching your kids? As Kathy noted, there’s more to this equation than what you can make and what the hired help charges – the quality of the product is a big, big deal, and intangible benefits for you are hard to capture.

  27. brent says:

    My take on applying the time value of money in your private life is that you should also look at it the other way: making the decision to NOT spend money based on time.

    For instance, driving home late in the afternoon when you’re tired and don’t want to cook but everyone’s hungry… you COULD just take the family through the drivethrough for $30. Problem solved in 5 minutes. You get a crap meal, but you get it quickly.

    OR, you could go home and put some sausages on a frypan, cut and steam some vegies, and be eating 30 minutes after you walk in the door. Again, a boring meal, but probably about $5-7.

    So: is $25 worth 25 minutes of your life? I don’t about you, but it would take me, after tax, about an hour and a half to earn that money. My time’s worth more than that. I’m not going to waste an hour of my time at work, slaving away, time that I COULD have been spending doing ANYTHING else.

    When the time it takes to EARN the money, is longer than the time that you SAVE by spending now, it’s not worth it. You shouldn’t go drivethrough: it’s a waste of time.

  28. lorax says:

    @Sue The Wealth of Nations is 1264 pages. It can take quite a while to read parts of it – the phrasing is sometimes quite different from modern language it takes some time to understand paragraphs.

    I’m guessing Trent plugs into the book like the people in the matrix.

  29. Charlene says:

    You made my day. I love The Wealth of Nations! It was one of my favorite books from school. Made so much sense. Ironically, my other favorite econ author was Karl Marx, who also made sense to me (on cause, not solution). A strange combination, I know. Anyway, just wanted to say thanks for the trip down academic memory lane.

  30. John says:

    I agree wholeheartedly with the mathematics of the analysis, but I also reiterate the realities that several commenters above have raised.

    I probably spent eight hours last weekend raking my leaves. I did it the old-fashioned way- with an old rake and some garbage bags. I could have spent $150 on a leaf vacuum, or paid some guy money to do it, but I chose to do it myself instead. I work in a legal setting, and sometimes I think some of the guys in suits would benefit from four hours of pushing a lawn mower- would probably bring them down to earth a little bit.

    I raked because I had nothing better to do, and I enjoyed working in the yard on such a beautiful day. I don’t know if this makes any sense, but a lot of times I’d rather drive on roads without traffic for fifteen minutes than sit in traffic for ten. That’s probably not a good analog, but I’ll use it anyway.

  31. mark says:

    You are forgetting one thing. Doing your own laundry, mowing your own lawn, growing your own food, etc. connects you to basic essentials of being alive. It’s a different thing if you buy your food at a store or grow it in your back yard… Would you be wiling to pay someone to play with your kids while you work? Or take out your wife for dinner? No, because you want to be connected to these people and paying someone else to be there instead of you, will only increase your disconnection from them. It’s the same thing with food, clothing, lawn mowing… it’s one thing to pay people to provide you these things so you can spend more time working on things you enjoy, but at the same time you loose the opportunity to learn new things, to hone your skills, to connect with the larger realities of life, your community, your environment. It’s not all about the buck.

  32. mark says:

    And here’s a great (not too long) blog entry on this. It’s from the “Markets and Man” chapter of Polanyi’s The Great Transformation. A great explanation:
    http://cumberlandbooks.com/blog/?p=1318

  33. Nicholas Link says:

    The incometaxrate is quite important for determining how effect the coparative advantage is. Our economics teacher used a pretty good example, in Denmark the incometax can be pretty high for high incomes (66%). His reasoning was that because of the taxes he has to work for 3 hours to pay a bricklayer for one hour. Then he considered doing it himself, he is not a very good bricklayer but on the other hand he has three times as long time to do.
    So high incomestaxes reduces comparitive advantage.

  34. I found this paper very instructive, and a great read: The Adam Smith Myth, by Murray N. Rothbard.

    http://www.mises.org/story/2012

    Rothbard destroys Smith with utmost precision… quite shocking!

    A personal Rothbard favorite of mine is “What has government done to our money?”. A small but very clear and precise book about the origins of money, inflation and the banking system.

    You can read it online here: http://www.mises.org/money.asp

    …thanks for this blog btw – it’s very good.

  35. Jeremy says:

    I second the Murray Rothbard articles and books. If you really want to understand economics http://mises.org is the place to be. I’ve learned far more from that resource than all the college econ classes and other financial reading I’ve done.

  36. Boomer55 says:

    I spent many hours contemplating David Ricardo’s theory of comparative advantage after being introduced to it in a L.LM curriculum (Masters Degree in Law)several years ago. As with many over the years (I want to say late 1700′s or learly 1800′s if memory serves me correctly), I was initially intrigued because this theory appeared to be “clever”. However, when I was introduced to it, it was presented on a national scale. I really cannot recall the specific countries, but I think it was wine production in Portugal and cotton or wool production in Britain? In any event, the more I thought about this concept, the more it did not make sense. Then, one day – it hit me.

    Back when David Ricardo formulated his theory, Portugal was capable of producing only a limited amount of wine and Britain a limited amount of cotton (or wool? I do not remember). Given the preconception that neither country could saturate a market with their product, due to their crude production and distribution methods, this theory made solid economic sense. However, in today’s world, if the nation of Portugal truly desired to create the infrastructure, it may be possible to actually “capture” a market by producing so much of a given product so as to constitute a virtual monopoly. I believe that if California and Australia truly wanted to dominate the market in wine, they conceivable would be able to do so. However, if they should do so, then they would be sounding the death knell to David Ricardo’s theory of comparative advantage, since this theory does not recognize the possibility that oversupply of a product will result in a decrease in its value. The basic “supply and demand model” at work.

    Therefore, we must recognize an inherent limitation to Ricardo’s theory of comparative advantage. It only works if the element of “oversupply” is not factored in. Otherwise, the introduction of “oversupply” will distort the “supply and demand” equation and the costs to Portugal of producing wine may be optimum considering that Portugal can obtain maximum price for its product in a market that can assume it production capabilities. However, when a market is subjected to “oversupply” of a given product, it reacts counter-intuitive and the price is thus driven lower, notwithstanding the fact that Portugal is more “efficient” in producing wine as compared to Britain in producing cotton (or wool). The same can be said of Britain if they attain the capacity of saturating the market with cotton or wool.

    In the final analysis, I propose that while David Ricardo’s theory of comparative advantage may have been relevant during it’s time, that in this age when a nation is capable of oversupply and market saturation, it is no longer a useful economic model. That is why OPEC nations have instituted quotas on crude oil production so as to maximize the price per barrel. Without such coordinated effort (aka cartel), each nation would compete by maximizing production while at the same time depressing the price per barrel – maximum contribution for minimal return.

    We really need to stop subscribing to economic models solely because they are “clever” and fully rationalize them.

    If a nation state wants to maximize the efficiency of production of a given product, they should do so with the idea that maximum expenditure of labor payments is beneficial to the local economy and that foreign trade with other nations in this product should be made with the understanding that the product cost premium they pay by purchasing this product from this given nation is in the purchasing nation’s best interests because trading with another nation in this product would be detrimental to the purchasing nation’s interests in the grander scheme of things – with the particular price of this product being relative to the purchasing nation’s overall needs and desires.

    And lastly, the purchasing nation should be made to realize that any resulting trade deficit will dealt with decisively. In simple terms, you will purchase our product, regardless of the fact that it may be more expensive, because the purchasing nation does not want to incur the economic penalty of refusing to do so. Perhaps we should call this the theory of “desirable coexistency”?

  37. Boomer55 says:

    For serious debate, please contact me at wrhufflaw@msn.com. Intelligence, but not personalities, invited at onset. If you can show flaws in my logic, I invite you to do so. But, please keep it professional.

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