Economics #3: Comparative Advantage

In 1776, Adam Smith popularized the idea of specialization:

If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.

For example, if we are good at brain surgery and bad at making shoes, it makes sense to focus on brain surgery and trade for shoes. Same goes for legal work, accounting work, landscaping work, etc. If they guy down the street can do my taxes better than I can, I should ask him to do them. But what happens if we are better at everything? We can perform brain surgery, make shoes, practice law, file tax returns, and mow our lawn better than anyone else could. Do we just do everything ourselves?

In 1817, David Ricardo sought an answer to this question in the context of international trade. Why would a country that was better at producing everything, trade with a country that was worse at producing everything?

Comparative Advantage

To answer this, Ricardo used the example of two countries, Portugal and England, producing two products, Cloth and Wine. To update this a bit, let’s imagine two countries, the United States and China, and two products, airplanes and shoes.

Let’s say that if the US concentrated 100% of its resources on producing planes, they could produce 10 planes per day. If those resources were 100% concentrated on producing shoes, they could produce 20 tons of shoes per day. In China’s case, they could produce 2 planes or 15 tons of shoes per day.

Country Planes Shoes
USA 10 20
China 2 15

It’s clear that the US is better at producing both planes (10>2) and shoes (20>15) than China (an absolute advantage). An intuitive conclusion may be that it’s better for the US to produce their own goods and not trade with China. But remember that resources are limited, for every 20 tons of shoes the US produces, they are giving up 10 planes that they could have produced (opportunity cost). In our opening example with the brain surgeon, every hour he spends making shoes is an hour he could have spent performing brain surgery.

Let’s chart the opportunity costs for the two countries.

Country Cost of one plane Cost of one ton of shoes
USA 2 tons of shoes 0.5 planes
China 7.5 tons of shoes 0.13 planes

Every ton of shoes that the US produces costs them half a plane. Every ton of shoes that China produces only costs them one tenth of a plane. In terms of opportunity cost, China produces shoes at a lower cost than the US does (comparative advantage). Similarly, a plane costs china 7.5 tons of shoes and only costs the US 2 tons of shoes. The US has a comparative advantage in making planes.

This is a counter-intuitive insight. Even though the US is clearly better at producing both products, the opportunity cost of producing shoes is higher than for China. For this reason, both countries would be better off specializing in the good that they have a comparative advantage in and trading for the other.

The brain surgeon would be better off specializing in brain surgery even if he could make shoes better than everyone else.

But how does the world really work?

The theory of comparative advantage has been used to argue in favor of free trade. Just remove tariffs and quotas and everyone will be better off. Of course, the real world is a lot more complicated than our airplane and shoe example.

For one, countries differ in their mix of labor, land, capital, skill, etc. In the 1930, Heckscher and Ohlin popularized a model of trade where countries specialized in the industries that utilized their relatively abundant resource. For example, the US could concentrate on capital-intensive activities like making planes, while China could concentrate on labor intensive activities like making shoes.

This was good for the countries as a whole, but was it good for workers? If scarce labor in the United states bid up wages, surely opening trade with a country that had an abundant supply of labor would reduce wages. Heckscher-Ohlin argued that even though their wages decreased, shoes would now be cheaper for them to buy and the national income would increase more than their wages would fell. They would still be better off.

In 1941, Stopler and Samuelson showed that, in fact, workers could be made worse off as a whole. To show this, let’s look back at the plane and shoe example one more time. If free trade is suddenly opened up between the two countries, what happens for the US? Well, shoe makers go out of business and the land and labor they were using is freed up. What happens to wages and land rents? Since there is more available labor in the economy, wages should go down. There is also more available land in the economy, so rent should go down as well. But this ignores the plane industry. Since land and labor is now cheaper for plane makers as well, their profits will go up and they will expand. Let’s assume they use more land(capital, but land makes the example easier) relative to labor. So, they bid land prices up faster than labor prices.

The result? Workers make less money across the economy, yet rent prices stay the same or increase. Are shoes cheaper tho? Yes, but their price may have fallen less relative to how much wages fell. In this world, the returns to trade fall directly to the land (capital) owners and workers were worse off.

Even the Stopler-Samuelson theorm didn’t fully capture the complexities of trade. In reality, free trade is a trade off like everything else. Some will be worse off, some will be better off. On average more people will be better off, but that is no comfort to those made worse off.

Conclusion

The idea of specialization and comparative advantage changed the world. Before Adam Smith and David Ricardo popularized the idea, countries assumed that trade was a zero-sum game. The countries who exported won, and the countries who imported lost. In order to win, countries would establish colonies to buy their goods and establish tariffs to hinder imports.

This led to war, subjugation, monopolies, monarchies, and eventually revolution. The theory of comparative advantage showed that trade could be mutually beneficial. This ushered in a period of trade liberalization and cooperation that has increased the standard of living around the world.

References:
https://en.wikipedia.org/wiki/Comparative_advantage
https://en.wikipedia.org/wiki/Heckscher-Ohlin_model
https://en.wikipedia.org/wiki/Stolper-Samuelson_theorem

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Author: David Shahrestani

"I have the strength of a bear, that has the strength of TWO bears."

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