Opportunity Cost, Profit, and Comparative Advantage

Josh is going to mow 800 lawns and get \$20,000 in revenue. He can lease his capital equipment for \$3300. Suppose that fuel and other expenses (marketing, billing, bookkeeping, and so on) come to \$1700. That means that he has cash income of \$15,000. Is that profit?

Suppose that Josh puts 8 hours a day into his business, for a total of 800 hours for the season. In that case, on average, Josh is getting just under \$20 an hour. He should not consider all of this to be profit.

Suppose that Josh could earn \$22 an hour working in an office. If you include the value of his time, (\$22)(800) = \$17,600, the lawn mowing business loses \$2600. In other words, he would be better off working in an office than starting his lawn-mowing business.

On the other hand, suppose that Josh's best alternative is to make \$12 an hour. Now, the lawn mowing business is a better choice. But to calculate his true profit he should subtract \$12 an hour from his proceeds. Multiplying \$12 an hour by 800 hours gives \$9600 in salary. Subtracting this from \$15,000 gives \$5400 in economic profit.

Even if Josh does not call the \$9600 salary, economists would call it his opportunity cost. Opportunity cost is what you have to give up in order to get something. In his textbook Hidden Order, David Friedman writes (p. 32),

The cost of an A on a midterm for one of my students may be three parties, a night's sleep, and breaking up with his current significant other. The cost of living in my house is not only taxes, maintenance, and the like; it also includes the interest I could collect on the money I would have if I sold the house to someone else...

Different people would realize different profits from the lawn mowing business, because of differences in opportunity cost. A surgeon would have a high opportunity cost, which translates into a loss if the surgeon were to mow lawns. An unskilled worker whose alternative is flipping burgers would have a low opportunity cost. For the unskilled worker, mowing lawns would be profitable.

An entrepreneur like Josh may be able to earn much more from his business than he could get working for someone else. This additional income is economic profit. A fancy term for it is Ricardian rent. A company's Ricardian rent is its income minus all of the opportunity costs, including the rental cost of capital and the value of the owners' time. A company's accounting profits, on the other hand, do not net out all opportunity costs. For example, if Josh does not pay himself a salary, then his reported profits will be \$15,000 even though his Ricardian rent is only \$5400.

Suppose that there is a surgeon who is more skilled at mowing lawns than Josh. In fact, the surgeon can mow a lawn in half the time that it takes Josh to mow a lawn. Should the surgeon mow the lawn herself, or should she pay Josh to mow her lawn?

The surgeon definitely should pay Josh to mow her lawn. He will charge her \$25. Even if it only takes her half an hour to mow her lawn, had she spent that time doing surgery she probably would have earned about \$1000.

The surgeon can mow her lawn in half the time that it takes Josh to mow her lawn. We say that she has an absolute advantage in lawn mowing. However, her comparative advantage is in doing surgery. She is better off spending her time doing surgery, and then trading some of her income earned as a surgeon to someone else to mow her lawn.

There is a sense in which all market activity reflects comparative advantage. If there were no such thing as comparative advantage, you would do everything for yourself. However, because there is comparative advantage, people tend to specialize in their work and trade for the goods and services that they consume.

Your parents may be better than you at both folding laundry and loading the dishwasher. But that does not mean that the best way to handle the chores is for them to do all the work while you watch TV! If you are a lot worse at folding laundry but only a little worse at loading the dishwasher, then you have a comparative advantage in taking care of the dishes.

1. Suppose that one player on a basketball team is the best rebounder, ball-handler, and shooter. How can the coach use the principle of comparative advantage to decide how to use this player?

2. Using the concept of opportunity cost, would you say that the value of an hour of leisure time is the same for everyone?

3. "I love my job," Andrew says. "I would do it even if I were paid half the salary." Is Andrew earning Ricardian rent?