If market economics had to be distilled into two key articles of faith they would be as follows: firstly, the invisible hand will mean that even self-interested acts will, en masse, be beneficial for society (see The invisible hand); secondly, economic growth is not a zero-sum game, where for every winner there is a loser. These credos are counterintuitive—the latter in particular. It is human nature to assume that when someone gets richer or fatter or healthier it is at the expense of someone else in the world getting poorer, thinner or sicker.
Take two countries, for example Portugal and England. Say they trade two goods with each other—wine and cloth—and it so happens Portugal is more efficient than England at making both. It can produce cloth for half the price that England can and wine for a fifth of the price.
Portugal has what economists call an absolute advantage in producing both kinds of goods. On the face of it, the rule of division of labor—that one should specialize in what one is good at—doesn’t seem to provide a solution. You might assume there is little England can do to compete, and it must resign itself to slowly losing its wealth. Not so.
In this case, if England devoted all its resources to producing cloth and Portugal likewise concentrated on wine, they would, together, end up producing more cloth and wine. Portugal could then trade its excess wine in exchange for English cloth. This is because, in our example, England has a comparative advantage in making cloth, as opposed to wine, where it is so much less efficient than the Portuguese. The father of comparative advantage, economist David Ricardo, used this example in his groundbreaking 1817 book On the Principles of Political Economy and Taxation. It seems illogical at first because we are used to the idea that there can only be winners and losers when people are competing with each other. However, the law of comparative advantage shows that when countries trade with each other it can lead to a win-win result.
Comparative advantage at work
Let’s take two equal-sized countries, A and B. They trade shoes and corn, and country A is more efficient at making both. However, while country A can produce 80 bushels of corn per man hour compared with B’s 30, it can only produce 25 shoes per man hour compared with B’s 20. Country B therefore has a comparative advantage in shoe manufacture. This is what would happen if each country tried to produce both products:
| Corn | Shoes | |
| Country A man hours | 600 | 400 |
| A output | 48,000 (600x80) | 10,000 (400x25) |
| Country B man hours | 600 | 400 |
| B output | 18,000 | 8,000 |
Combined output = 66,000 bushels of corn and 18,000 shoes
However, if country A concentrated on producing corn and B on producing shoes, this is what would happen:
| Corn | Shoes | |
| Country A man hours | 1,000 | 0 |
| A output | 80,000 | |
| Country B man hours | 0 | 1,000 |
| B output | 20,000 |
Combined output = 80,000 bushels of corn and 20,000 shoes
Neither country is working any extra hours, but by concentrating on their comparative advantage, the two countries can, together, produce significantly more, and each will become better off.
The only circumstance under which comparative advantage would not work is if one country is not only more efficient than another at producing two types of goods but also more efficient in exactly the same proportion for each. In practice, this is so unlikely as to be effectively impossible.
The reason is that each country only has a finite number of people, who can devote only a finite number of hours to a particular task. Even if Portugal could in theory produce something more cheaply than England it could not produce everything more cheaply since the time it spends making cloth, for example, comes at the expense of the time that could have been devoted to producing wine, or anything else for that matter.
Although comparative advantage is most often applied to international economics, it is just as important on a smaller scale. In the chapter on division of labor (see Division of labor) we imagined a businessman who was more talented than his staff at everything from management to keeping the building clean. We can use comparative advantage to explain why he is better off devoting his time to what generates the most cash (management) and leaving the other, less profitable tasks to his employees.
“Name me one proposition in all of the social sciences which is both true and nontrivial.”
Stanislaw Ulam, mathematician
Always free trade? Ricardo’s theory of comparative advantage is typically used as the backbone of arguments in favor of free trade—in other words abolishing tariffs and quotas on goods imported from foreign countries. It is claimed that, by trading freely with other countries—even those that, on paper, are more efficient at producing goods and services—one can become more prosperous than by closing one’s borders.
However, some—including Hillary Clinton and prominent economist Paul Samuelson—have warned that, elegant as they are, Ricardo’s ideas are no longer strictly applicable to today’s rather more sophisticated economic world. In particular, they point out that when Ricardo set out his theory in the early 19th century there were effective restrictions on people moving their capital (their cash and assets) overseas. This is not the case today, when with one tap of a keyboard a businessman can transfer billions of dollars’ worth of assets electronically from one side of the world to another.
Former General Electric chief executive Jack Welch used to talk about having “every plant you own on a barge”—indicating that, ideally, factories should be able to float to wherever the costs of people, materials and taxation are lowest. Today such a scenario is arguably a reality, as companies, no longer tied to particular nations as they tended to be in Ricardo’s day, shift their workers and cash to wherever they prefer. In effect, say some economists, this causes wages to fall rapidly and the citizens of some countries to end up worse off than others. The counter-argument is that, in return, the country which has hived off jobs overseas benefits from the higher profits of that company, which are redistributed to its investors, and from lower prices in the shops.
“Comparative advantage. That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.”
Paul Samuelson, US economist, in response to mathematician Stanislaw Ulam
Others argue that comparative advantage is too simplistic a theory, assuming, among other things, that each market is perfectly competitive (in reality, internal protectionism and monopolies ensure that markets are not), that there is full employment, and that displaced workers can easily move to other jobs at which they can be just as productive. Some complain that were economies to specialize in particular industries, as the theory of comparative advantage suggests, this would reduce their economic diversity significantly, leaving them highly vulnerable to a change in circumstances—for instance a sudden fall in consumers’ appetite for their products. In Ethiopia, where coffee constitutes 60 percent of exports, a change in demand from overseas, or a poor harvest, would leave the country in a weaker economic position.
Nevertheless, most economists argue that comparative advantage is still one of the most important and fundamental economic ideas of all, for it underlies world trade and globalization, proving that nations can prosper even more by looking outward rather than inwards.
the condensed idea
Specialization + free trade = win-win
| timeline | |
|---|---|
| 1776 | The Wealth of Nations by Adam Smith is published |
| 1798 | Essay on the Principle of Population by Thomas Robert Malthus is published |
| 1817 | David Ricardo sets out comparative advantage in On the Principles of Political Economy and Taxation |
| 1945 | Push for freer trade begins after the Second World War |