Challenging Economics – Theory Of Comparative Advantage

There are few debates that economists take only one side in and trade is one of them. Textbooks argue that trade creates prosperity always and everywhere. Students are required to answer questions on the benefits of trade and the costs of protectionism. There is a strong attempt to give the impression that all economists support free trade and the debate is only between those who understand economics and those who don’t. What is strange about all of this is how shaky the foundations for this belief are. It is mostly reliant on the “Law” of Comparative Advantage, which as I shall discuss, has some very significant flaws.

The theory of comparative advantage was first devised by David Ricardo in 1817 and is so popular it is often considered a law (even though economics as a social science has no laws). The beauty and appeal of it, is its sheer simplicity. It’s an easy and straight forward example of how trade benefits everyone and why countries should specialise in what they’re relatively best at. However its simplicity is also its greatest flaw. International trade is far more complex than it was 200 years ago and there is a case to be made that comparative advantage is too simple to truly understand how the world works.

Imagine there are two countries and two goods. Let’s say its China and USA and the two goods are Clothes and Computers (this is the example used in my lectures and textbooks). Both countries could produce both goods and USA may even be better than China at producing both Computers and Clothes. Let’s say an American worker can produce 5 units of Computers in an hour while a Chinese worker can only produce 1. An American worker can produce 4 units of Clothes in an hour while a Chinese worker can produce 3 units.  Both countries could each produce independently or they could trade. Ricardo argued that even though China is less efficient in both goods, it should focus on the one that it is comparatively better at, i.e. clothes.

Efficiency per worker per hour

 

USA

China

Computers

5

1

Clothes

4

3

Let’s say each country has 100 workers in each industry.

Total Production

 

USA

China

Computers

500

100

Clothes

400

300

Total

900

400

So let’s now imagine that China stops making computers and only focuses on clothes, while America stops making clothes and only focuses on computers. We assume factor mobility (workers can easily transfer from clothes making to computer making) and constant returns to scale (if you double the workers, you’ll double the output).

Production After Specialisation

 

USA

China

Computers

1000

0

Clothes

0

600

Total

1000

600

As can be seen by specialising with each other and then trading between themselves, total production has increased and both countries are better off. That might have taken a while to explain and get your head around, but if you do, you know understand why economists favour free trade. However, as I will now discuss, there are many problems with this simplified story.

_______________________________________________________________________________

First of all it assumes that people can easily move between industries. However, the simple fact is that when a clothes mill closes down, the workers will not easily become IT experts. Likewise factories and machinery used to make clothes cannot be used to make computers and so will be wasted. If there are significant costs in re-adjusting the economy, then specialisation could leave countries worse off than before. The economy does not instantly and smoothly move from one production to another, there is the problematic transition phase. It is also assumed that the economy is at full employment, if not then the fired workers may just remain unemployed.

Secondly, the whole argument for free trade is based on the assumption that doubling the number of workers will double production. If this is not true and production increases by less than double, then free trade would harm the economy. This is certainly the case with agriculture where doubling the number of acres under cultivation does not double output as the new land is of poorer quality. So a country that specialises in agricultural products (most of the Third World) is as Reinhert said, “specialising in poverty”. On the other hand, most manufacturing industries benefit from economies of scale where doubling the number of workers, increases production by more than double. Thus you could have the situation where an industrialised country gets richer by specialising in industry with economies of scale (this is the case for the First World) while another country grows poorer by specialising in agriculture with diseconomies of scale (this is the case for the Third World).

Thirdly, there is the issue of technology. If a country specialises in an area that has little room for technology advancement, then they will face stagnation. This is the case for agriculture; after all it is hard to invent a new way to grow coffee or potatoes. On the other if a country specialises in an area that has lots of room for technological advancement then they would benefit hugely and even over take their trading partner even if they started off behind. This is true for manufacturing and IT in particular. By just focusing on a static unchanging world, the theory of comparative advantage misses the importance of a dynamic and innovative industry.

This leads onto the fourth point, that efficiency is not fixed, rather it changes over time. So a country that is inefficient at the moment in the production computers could become more efficient over time. An industry could be given protection and subsides until it is set up, whereupon it can then benefit from economies of scale and compete internationally. This is known as the infant industry argument. After all, should a country specialise forever in being an agricultural nation? Where is the future in that? Adam Smith argued that America should specialise in agriculture where it had a comparative advantage and not try to compete with Europe in industrial goods. Similar advice was given to East Asian countries like South Korea. They ignored it and specialised where they wanted to be good at, not where they were at the moment and as a result became industrial powerhouses.

Fifthly, the theory treats both countries as equals who can fairly bargain to achieve a mutually beneficial outcome. However, anyone who has studied international trade knows that this does not reflect reality. America and the European Union have enormous power over poverty stricken Third World countries and can effectively dictate the terms of trade. This is because exports (usually from raw materials) are so crucial for poor Third World economies that rich countries have power over them. So while world production may increase from trade, rich countries may capture of these gains. The World Trade Organisation (WTO) is dominated by rich countries and large corporations and can draw the rules of trade to suit themselves.

Sixthly, the theory of comparative advantage implies that trade occurs between countries producing different items not available at home. However, in reality the vast majority of US trade is in manufacturing goods with other rich developed economies. In contrast to the theory, in practice countries trade with other countries that are remarkably similar to themselves.

Seventhly, the above example was a barter economy with no mention of money. In reality, any trade between China and America would be dependent on exchange rates. These are not set primarily by trade, but by capital flows and speculation. Thus a country could become more productive through specialisation but be worse off due to an unfavourable exchange rate.

So that leaves the theory of comparative advantage in tatters. There are many benefits to specialisation but they should not be overstated. There are many problems with a country becoming over dependent on one sector, especially if it is agricultural. Free trade does not always make people better off and can make many people worse off. We should not rely on catch-all “laws” but rather examine each case to find if people really will benefit.

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6 thoughts on “Challenging Economics – Theory Of Comparative Advantage”

  1. Well done again! I do not think the theory is in taters quite yet. It is certainly not a description of a foregone conclusion, but is a simplistic look at one way countries might benefit from trade. The other flaw you touched upon but didn’t fully explore is the power of being a lone supplier. This shows up in the minerals market where certain minerals are only available from just a few localities. Leaving deliberate economic action aside, what happens if civil war breaks out in your “supplier” country. If you have vested all of the production of some kind of widget in the most efficient country manufacturing them, all of a sudden your supply is cut off. Giving such power back and forth makes for a mutual dependency which may make us safer, but it does make us more dependent.

  2. And when China achieves that competitive advantage by destroying it’s environment, abusing it’s workers and manipulating it’s currency… what then? Race to the bottom?

  3. It’s funny,because once upon a time American economic thought emphasized tariffs and infrastructure and, to be honest, it wasn’t a stupid decision at that. Interestingly, the capitalist demigod who was the important thinker of that school continues to be quite fondly remembered as a founder. And yet…?

  4. Well-thought post—again. In “23 Things They Don’t Tell You About Capitalism,” Ha-Joon Chang cites Korea as having grown into an industrial country instead of an agrarian one simply because it did not accept this doctrine. It’s an easy read. I assign it to my undergrad students in a policy course I teach.

    1. I love that book, its one of my favourites. I’m a big fan of Ha-Joon Chang. I came across “Kicking Away The Ladder” while doing a development essay and found it really good. He makes the best case for the infant industry argument I’ve heard.

  5. Well done. Just as an aside,Ricardo’s theory was designed at the height of colonization and supports it. When a country has the markets for the raw materials there is no reason for a country (read as independent) to specialize in agriculture.

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