How are opportunity cost and comparative advantage interlinked? What is mean by opportunity cost? How does opportunity cost influence decisions? Why are they important for free trade? If you think that these questions are worthwhile, then, let’s do it.
“Scarcity = >choices => opportunity cost => comparative advantage => specializations => economies of scale => free trade system “
Definition of opportunity cost
“Actually, It is a potential cost that a person sacrifices. He does so due to scarce resources and multiple choices. So, he cannot purchase everything”
Examples of opportunity cost
Suppose, David is a 10th class student. On holiday, he does part time job to distribute newspapers. By doing so, he earns $50 per week.
One day, he instead job, goes to watch a circus. As he reach there, he notices many children enjoying. Today, he has $100 and he has to manage ticket, fare, and snacks. Ticket is of $65 and he needs some $30 for fare. Finally, it remains only $5 for snacks.
Generally, he loves to have sea food. But, now, he has only $5 for snacks and so, can’t afford. At last, after some brainstorming, he goes for simple one to enjoy circus show.
In this way, he sacrifices the desire to have sea food, and prefers to watch show. If he had more money, David would have definitely enjoyed his favorite sea food on special occasion.
In another one possibility, had he thought to watch movie, instead of circus, he might have enjoyed his favorite snacks.
“So, to watch circus, David pays much more than the actual cost of ticket. He pays cost of ticket + cost of fare + cost of satisfaction that he would have experienced, if he had more dollars”
This is what I am describing about “Opportunity cost”. In simple terms, it is the potential cost that a person gives up to purchase something else.
Relation between opportunity cost and comparative advantage
Unequivocally, opportunity cost act as a determinant or basis for comparative advantage. More the opportunity cost, lesser the advantage, and vice versa.
For more clarity, a firm used to produce a goods in which that firm has greater advantage means lower opportunity cost compare to trading competitor. Then only, the product of that firm could capture better market access, and so the more market share.
Hence, to have a great comparative advantage, firm need to have better factors of production or expertise.
Comparative advantage and free trade
As I discussed in the previous blog, that comparative advantage paves the way for more specializations. Consequently, mass production and economies of scale affect bring down prices much lower.
“Lower prices => easier market access =>more market share =>greater consumer saving => higher standards of living and investment for production”
Finally, the above shown cycle goes on until the firm has comparative advantage over competitor.