Tuesday, May 19, 2009

The First Theorem - Comparative Advantage

If self-interest is axiomatic, the first theorem we can derive from it is the law of comparative advantage. The only reason that anyone finds it in their self-interest to pay someone to do something is that each has a comparative advantage: the doer has one in the thing to be done, and the payer has one in doing something else instead.

Comparative advantage is usually explained as David Ricardo explained it in 1817 by reference to the trade of Portuguese wine for English cloth. That trade made sense for both countries even though Portugal could actually make cloth more cheaply than England. The trade benefited Portugal because Portuguese cloth merchants could, in effect, pay for English cloth with Portuguese wine, because the wine cost the cloth merchant less money than the same amount of Portuguese cloth would have cost him.

To put some hypothetical numbers on it, assuming that one pound sterling was worth 2 Portuguese escudos ($), a wine merchant who wanted a bolt of cloth could either (i) pay $100 for it, or (ii) pay $90 for Portuguese wine that he could sell in England for ₤50, which he could then use to buy a bolt of English cloth. The English were willing to pay a bolt’s worth for the Portuguese wine because, well, have you ever heard of English wine? The trade worked because Portugal had a “comparative advantage” in wine and England had one in cloth.

But international trade is just a special case of comparative advantage. Indeed, it’s hard to imagine any aspect of our lives in which comparative advantage doesn’t come into play. All specialization is based on comparative advantage properly understood. Take the simple case of a lawyer and a typist. If the lawyer can keep busy billing hours at ten times the hourly cost of a typist, his opportunity cost for typing is greater than the cost of hiring a competent typist, even if the latter were only half as fast as the lawyer.

The lawyer also pays someone to clean his office, press his suits, build his automobiles, fight his wars, and teach his children. (We’ll get to bearing and rearing those children later.) It turns out that our lawyer has a comparative advantage in lawyering vis a vis almost any other non-hobby activity he can name. And each of the people whose services he directly or indirectly consumes has a comparative advantage in providing those services.

Note that comparative advantage is not about barter. When a lawyer hires a typist, the typist does not have to hire the lawyer for the trade to make sense. The lawyer pays the typist in cash, and the typist can use the cash to buy whatever anyone with a comparative advantage in anything has to sell that the typist needs. We each do that one thing that has the greatest net pay-off for us, the thing in which we have a comparative advantage. People pay us to do that thing so that they are free to do the thing they do best. We don’t have to do it for each other so long as we can do it for someone.

Of course, measuring what we’re “best at,” in the sense that it gives us the greatest pay-off, isn’t easy. “Pay-off” is like net profit, considering all costs, including not only benefits, out-of-pocket costs, and opportunity costs traditionally understood, but psychic income and costs as well. Indeed, I think a case can be made that only psychic “net income” matters, and that material net income correlates with psychic net income because natural selection has seen to it that it does. After all, we value what we value because we have come by genes, training, or experience to value it, not because its extrinsic worth exists outside our perception of it.

What economic calculus could have led Pat Tillman to leave the metaphoric battlefield of the gridiron for the real thing? We know what opportunity cost attended his enlistment – the risk of life, limb and a very well-paid football career. But what was the opportunity cost of playing football? Motivation is always about values – we can always say in retrospect that we did what we did because we valued its probable outcome more than anything else we were aware we could do. Obviously, we don’t always do the best thing for us, even from among the options we know we have, but that does not mean that we acted without motivation or that our motivation was not the product of values.

The path from the international trade to more generalized opportunity cost, to all decision making is part of my reductionist project. At the end of the day, we all do what makes us feel about ourselves as close to what we want to feel about ourselves as circumstances permit. In the simple world of economic security, that means taking profitable action, which means specializing in the thing in which we have a comparative advantage in economic terms. But in all things, the inner calculus is the same: there is a way we want to feel, and the opportunity cost of not feeling that way is greater than that of any choice we might make with respect to a decision at hand. To some extent, the correlation between material self-interest and psychic satisfaction is innate. In other cases, and to varying extents, it’s cultural. And, of course, in any given person or group of similarly afflicted individuals, that link can simply be pathologically broken.

Examples to follow…

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