Absolute advantage and comparative advantage

The common-sense notion of when trade between countries should occur is this:

if I make something you want more cheaply than you can, you should buy it from me rather than make it yourself; and if you make something more cheaply than I can, again it makes sense to trade.  This is called absolute advantage.

David Ricardo is credited with advancing our understanding of when trade makes sense in his 1817 book, On the Principles of Political Economy and Taxation, which promotes the idea of comparative advantage.

Comparative advantage, in its simplest sense, says that even if you’re a high-cost producer of everything, you’ll very probably be better off if you concentrate on making for export the stuff you’re least bad at, and trading it.  This is a counter-intuitive result.

a (bare-bones) example

Let’s say there are two countries, A and B, and that they make two products, wine and cheese.  Each country has 30,000 units of resources.

Country A needs 100 units to make wine and 300 to make cheese.  Country B needs 200 units to make wine and 400 to make cheese.

At one extreme, country A can make 300 wine and 0 cheese; at the other it can make 100 cheese and 0 wine.  Assuming no benefits/losses from scale differences, it can substitute wine for cheese at the rate of two to one.  Put another way, production possibilities are described by the line, wine = 300 -3(cheese).

Country A can make 150 wine instead of 300 and put the resources into cheese-making–yielding cheese output of 50.  It can choose any point along the line for actual production, but will always have the tradeoff of gaining 2 wine by making 1 cheese fewer, and gaining 1 cheese at the expense of 3 wine fewer.

Similarly, Country B can devote all its resources to winemaking and have output of 150, or all its efforts to cheesemaking, with output of 75.  Or it can make anything in the middle, with a tradeoff of 2 to one.  Its production possibilities are described by the line, wine = 200 – 2 (cheese).

Where does this get us?

The important thing to notice is the wine/cheese tradeoff in each country.  In country A, the cost of 1 extra cheese is 3 wine.  In country B, the cost of 1 extra cheese is 2 wine.

So, both sides would be better off if Country A would trade its wine for Country B’s cheese at a ratio of 2.5 to one.

Ricardo’s insight was that all that’s needed for profitable trade between countries is a differing internal tradeoff, or opportunity cost, or comparative advantage in the production of tradable goods between the two nations.

Lots of caveats in this simple world:  Factors of production must be completely mobile between industries in a given country, but not mobile at all between countries.  Employment should be full.  The market must set prices.

specialization

More than just some trade, assume the two countries began to specialize their production according to where their comparative advantage lay–wine for Country A and cheese for Country B.  Let’s go crazy and assume that Country A produces only wine and Country B produces only cheese and they trade with each other for the other product.

Country A makes 300 wine.  Country B makes 75 cheese.  A trades 100 wine for 40 cheese.

Country A now has 200 wine and 40 cheese.  B has 100 wine and 35 cheese.

Could either country have achieved this outcome by itself?  No!

To make 200 wine, A would need 20,000 in resources; to make 40 cheese it would require 12,000.  The total exceeds available resources by 2000, which is Country A’s gain from trade.

To make 100 wine, B would need 20,000 resources; for 35 cheese, it would need 14,000.  Again, this is more than the total available internally.

Neither country has the production capability to achieve this outcome without trade.

Therefore, one would conclude, open yourself to trade and specialize in the things you do best, even if your best is not as good as someone else’s efforts in the same area.  Trade will lift your living standards anyway.

What’s wrong with this picture–if anything?

1.  There are the “usual” kind of observations that point out the simplifications made in trying to illustrate the point.  For example, employment isn’t always full, so relative prices may change if one country has a glut of labor.  Great vintners may make poor cheese makers, and vice versa.   Production equipment may not shift frictionlessly from one industry to another.  Climate may be conducive to some products but not others.  These are not necessarily such a big deal.

2.  Mobility of the factors of production is a much bigger issue today than two centuries ago.  Yes, every country has identified strategic industries–typical cases would be telecommunication or transport–where local ownership is mandated by law.  But otherwise, most nations actively woo foreigners to set up shop locally, especially in areas where they think technology transfer is possible.  Global-oriented firms who believe they have a technological or business-practice advantage also seek to make maximum use of their edge by expanding abroad.  The internet makes this much easier.

3.  The world is changing a lot faster today that it has been in the past.  Putting a lot of your eggs in a single basket requires an enormous level of confidence in a country’s ability to find specializations that won’t quickly become obsolete.

4.  Developing nations consider the short-term rewards of specialization at what they do best at the moment as a trap that will make it much more difficult to advance technologically.  Some might say the entire idea of comparative advantage is a ploy by colonial powers among industrialized nations to keep their technological edge and effectively force developing nations to remain colonies.

They can point to instances of “lucky” countries like Argentina or, until relatively recently, Australia, which have enormous natural resource endowments but have been economically weak  because they’ve focused on farming or mining and have never developed higher value-added industrial or scientific skills.

Is the idea still useful?

Developing nations have gone on to adopt the currency-peg, technology transfer model perfected by Japan after WWII for dealing with developed countries whose markets they are targeting.  So the Ricardo model has been resoundingly rejected there.

On the other hand, two countries at roughly the same level of development still use the idea in their dealings with one another.  But even in this relatively safe arena, emerging countries like China are beginning to raise questions its viability.