Comparative advantage

Comparative advantage

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In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, the law of comparative advantage says that two countries (or other kinds of parties, such as individuals or firms thereas) will both gain from trade if, in the absence of trade, they have different relative costs
Opportunity cost
Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...

 for producing the same goods. Even if one country is more efficient in the production of all goods (absolute advantage) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies.

For example, if, using machinery, a worker in one country can produce both shoes and shirts at 6 per hour, and a worker in a country with less machinery can produce either 2 shoes or 4 shirts in an hour, each country can gain from trade because their internal trade-offs between shoes and shirts are different. The less-efficient country has a comparative advantage in shirts, so it finds it more efficient to produce shirts and trade them to the more-efficient country for shoes. Without trade, its opportunity cost
Opportunity cost
Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...

 per shoe was 2 shirts; by trading, its cost per shoe can reduce to as low as 1 shirt depending on how much trade occurs (since the more-efficient country has a 1:1 trade-off). The more-efficient country has a comparative advantage in shoes, so it can gain in efficiency by moving some workers from shirt-production to shoe-production and trading some shoes for shirts. Without trade, its cost to make a shirt was 1 shoe; by trading, its cost per shirt can go as low as 1/2 shoe depending on how much trade occurs.

The net benefits to each country are called the gains from trade
Gains from trade
Gains from trade in economics refers to net benefits to agents from allowing an increase in voluntary trading with each other. In technical terms, it is the increase of consumer surplus plus producer surplus from lower tariffs or otherwise liberalizing trade...

.

Origins of the theory


Comparative advantage was first described by David Ricardo
David Ricardo
David Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...

 who explained it in his 1817 book On the Principles of Political Economy and Taxation
On the Principles of Political Economy and Taxation
On the Principles of Political Economy and Taxation is a book by David Ricardo on economics. The book concludes that land rent grows as population increases...

in an example involving England and Portugal. In Portugal it is possible to produce both wine
Wine
Wine is an alcoholic beverage, made of fermented fruit juice, usually from grapes. The natural chemical balance of grapes lets them ferment without the addition of sugars, acids, enzymes, or other nutrients. Grape wine is produced by fermenting crushed grapes using various types of yeast. Yeast...

 and cloth with less labor than it would take to produce the same quantities in England. However the relative costs of producing those two goods are different in the two countries. In England it is very hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore while it is cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth. Conversely England benefits from this trade because its cost for producing cloth has not changed but it can now get wine at a lower price, closer to the cost of cloth. The conclusion drawn is that each country can gain by specializing in the good where it has comparative advantage, and trading that good for the other.

Examples


The following hypothetical examples explain the reasoning behind the theory. In Example 2 all assumptions are italicized for easy reference, and some are explained at the end of the example.

Example 1


Two men live alone on an isolated island. To survive they must undertake a few basic economic activities like water carrying, fishing, cooking and shelter construction and maintenance. The first man is young, strong, and educated. He is also faster, better, and more productive at everything. He has an absolute advantage in all activities. The second man is old, weak, and uneducated. He has an absolute disadvantage in all economic activities. In some activities the difference between the two is great; in others it is small.

Despite the fact that the younger man has absolute advantage in all activities, it is not in the interest of either of them to work in isolation since they both can benefit from specialization and exchange. If the two men divide the work according to comparative advantage then the young man will specialize in tasks at which he is most productive, while the older man will concentrate on tasks where his productivity is only a little less than that of the young man. Such an arrangement will increase total production for a given amount of labor supplied by both men and it will benefit both of them.

Example 2


Suppose there are two countries of equal size, Northland and Southland, that both produce and consume two goods, food and clothes. The productive capacities and efficiencies of the countries are such that if both countries devoted all their resources to food production, output would be as follows:
  • Northland: 100 tonnes
  • Southland: 400 tonnes


If all the resources of the countries were allocated to the production of clothes, output would be:
  • Northland: 100 tonnes
  • Southland: 200 tonnes


Assuming each has constant opportunity costs of production between the two products and both economies have full employment
Full employment
In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....

 at all times. All factors of production
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...

 are mobile within the countries between clothes and food industries, but are immobile between the countries. The price mechanism must be working to provide perfect competition
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...

.

Southland has an absolute advantage over Northland in the production of food and clothes. There seems to be no mutual benefit in trade between the economies, as Southland is more efficient at producing both products. The opportunity cost
Opportunity cost
Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...

s shows otherwise. Northland's opportunity cost of producing one tonne of food is one tonne of clothes and vice versa. Southland's opportunity cost of one tonne of food is 0.5 tonne of clothes, and its opportunity cost of one tonne of clothes is 2 tonnes of food. Southland has a comparative advantage in food production, because of its lower opportunity cost of production with respect to Northland, while Northland has a comparative advantage in clothes production, because of its lower opportunity cost of production with respect to Southland.

To show these different opportunity costs lead to mutual benefit if the countries specialize production and trade, consider the countries produce and consume only domestically, dividing production capabilities equally between food and clothes. The volumes are:
Production and consumption before trade
Country Food Clothes
Northland 50 50
Southland 200 100
TOTAL 250 150


This example includes no formulation of the preferences of consumers in the two economies which would allow the determination of the international exchange rate of clothes and food. Given the production capabilities of each country, in order for trade to be worthwhile Northland requires a price of at least one tonne of food in exchange for one tonne of clothes; and Southland requires at least one tonne of clothes for two tonnes of food. The exchange price will be somewhere between the two. The remainder of the example works with an international trading price of one tonne of food for 2/3 tonne of clothes.

If both specialize in the goods in which they have comparative advantage, their outputs will be:
Production after trade
Country Food Clothes
Northland 0 100
Southland 300 50
TOTAL 300 150


World production of food increased. clothes production remained the same. Using the exchange rate of one tonne of food for 2/3 tonne of clothes, Northland and Southland are able to trade to yield the following level of consumption:
Consumption after trade
Country Food Clothes
Northland 75 50
Southland 225 100
World total 300 150


Northland traded 50 tonnes of clothes for 75 tonnes of food. Both benefited, and now consume at points outside their production possibility frontier
Production possibility frontier
In economics, a production–possibility frontier , sometimes called a production–possibility curve or product transformation curve, is a graph that compares the production rates of two commodities that use the same fixed total of the factors of production...

s.

Assumptions in Example 2:
  • Two countries, two goods - the theory is no different for larger numbers of countries and goods, but the principles are clearer and the argument easier to follow in this simpler case.
  • Equal size economies - again, this is a simplification to produce a clearer example.
  • Full employment - if one or other of the economies has less than full employment of factors of production, then this excess capacity must usually be used up before the comparative advantage reasoning can be applied.
  • Constant opportunity costs - a more realistic treatment of opportunity costs the reasoning is broadly the same, but specialization of production can only be taken to the point at which the opportunity costs in the two countries become equal. This does not invalidate the principles of comparative advantage, but it does limit the magnitude of the benefit.
  • Perfect mobility of factors of production within countries - this is necessary to allow production to be switched without cost. In real economies this cost will be incurred: capital will be tied up in plant (sewing machines are not sowing machines) and labour will need to be retrained and relocated. This is why it is sometimes argued that 'nascent industries' should be protected from fully liberalised international trade during the period in which a high cost of entry into the market (capital equipment, training) is being paid for.
  • Immobility of factors of production between countries - why are there different rates of productivity? The modern version of comparative advantage (developed in the early twentieth century by the Swedish economists Eli Heckscher and Bertil Ohlin) attributes these differences to differences in nations' factor endowments. A nation will have comparative advantage in producing the good that uses intensively the factor it produces abundantly. For example: suppose the US has a relative abundance of capital and India has a relative abundance of labor. Suppose further that cars are capital intensive to produce, while cloth is labor intensive. Then the US will have a comparative advantage in making cars, and India will have a comparative advantage in making cloth. If there is international factor mobility this can change nations' relative factor abundance. The principle of comparative advantage still applies, but who has the advantage in what can change.
  • Negligible transport cost - Cost is not a cause of concern when countries decided to trade. It is ignored and not factored in.
  • Before specialization, half of each country's available resources are used to produce each good.
  • Perfect competition - this is a standard assumption that allows perfectly efficient allocation of productive resources in an idealized free market.

Example 3


The economist Paul Samuelson
Paul Samuelson
Paul Anthony Samuelson was an American economist, and the first American to win the Nobel Memorial Prize in Economic Sciences. The Swedish Royal Academies stated, when awarding the prize, that he "has done more than any other contemporary economist to raise the level of scientific analysis in...

 provided another well known example in his Economics
Economics (textbook)
Economics is an influential introductory textbook by American economists Paul Samuelson and William Nordhaus. It was first published in 1948, and has appeared in nineteen different editions, the most recent in 2010. It was the best selling economics textbook for many decades and still remains...

. Suppose that in a particular city the best lawyer happens also to be the best secretary, that is he would be the most productive lawyer and he would also be the best secretary in town. However, if this lawyer focused on the task of being a lawyer and, instead of pursuing both occupations at once, employed a secretary, both the output of the lawyer and the secretary would increase, as it is more difficult to be a lawyer than a secretary.

Effect of trade costs


Trade costs, particularly transportation, reduce and may eliminate the benefits from trade, including comparative advantage. Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

 gives the following example.

Using Ricardo's classic example:
Unit labor costs
Cloth Wine
Britain 100 110
Portugal 90 80

In the absence of transportation costs, it is efficient for Britain to produce cloth, and Portugal to produce wine, as, assuming that these trade at equal price (1 unit of cloth for 1 unit of wine) Britain can then obtain wine at a cost of 100 labor units by producing cloth and trading, rather than 110 units by producing the wine itself, and Portugal can obtain cloth at a cost of 80 units by trade rather than 90 by production.

However, in the presence of trade costs of 15 units of labor to import a good (alternatively a mix of export labor costs and import labor costs, such as 5 units to export and 10 units to import), it then costs Britain 115 units of labor to obtain wine by trade – 100 units for producing the cloth, 15 units for importing the wine, which is more expensive than producing the wine locally, and likewise for Portugal. Thus, if trade costs exceed the production advantage, it is not advantageous to trade.

Krugman proceeds to argue more speculatively that changes in the cost of trade (particularly transportation) relative to the cost of production may be a factor in changes in global patterns of trade: if trade costs decrease, such as on the advent of steam-powered shipping, trade should be expected to increase, as more comparative advantages in production can be realized. Conversely, if trade costs increase, or if production costs decrease faster than trade costs (such as via electrification of factories), then trade should be expected to decrease, as trade costs become a more significant barrier.

Effects on the economy


Conditions that maximize comparative advantage do not automatically resolve trade deficits. In fact, many real world examples where comparative advantage is attainable may require a trade deficit. For example, the amount of goods produced can be maximized, yet it may involve a net transfer of wealth from one country to the other, often because economic agents have widely different rates of saving.

As the markets change over time, the ratio of goods produced by one country versus another variously changes while maintaining the benefits of comparative advantage. This can cause national currencies to accumulate into bank deposits in foreign countries where a separate currency is used.

Macroeconomic monetary policy is often adapted to address the depletion of a nation's currency from domestic hands by the issuance of more money, leading to a wide range of historical successes and failures.

Development economics


The theory of comparative advantage, and the corollary that nations should specialize, is criticized on pragmatic grounds within the import substitution industrialization theory of development economics
Development economics
Development Economics is a branch of economics which deals with economic aspects of the development process in low-income countries. Its focus is not only on methods of promoting economic growth and structural change but also on improving the potential for the mass of the population, for example,...

, on empirical grounds by the Singer–Prebisch thesis which states that terms of trade between primary producers and manufactured goods deteriorate over time, and on theoretical grounds of infant industry
Infant industry
In economics, an infant industry is a new industry, which in its early stages is unable to compete with established competitors abroad.Governments are sometimes urged to support the development of infant industries, usually through subsidies or tariffs...

 and Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

. In older economic terms, comparative advantage has been opposed by mercantilism
Mercantilism
Mercantilism is the economic doctrine in which government control of foreign trade is of paramount importance for ensuring the prosperity and security of the state. In particular, it demands a positive balance of trade. Mercantilism dominated Western European economic policy and discourse from...

 and economic nationalism
Economic nationalism
Economic nationalism is a term used to describe policies which emphasize domestic control of the economy, labor and capital formation, even if this requires the imposition of tariffs and other restrictions on the movement of labor, goods and capital. It opposes globalization in many cases, or at...

. These argue instead that while a country may initially be comparatively disadvantaged in a given industry (such as Japanese cars in the 1950s), countries should shelter and invest in industries until they become globally competitive. Further, they argue that comparative advantage, as stated, is a static theory – it does not account for the possibility of advantage changing through investment or economic development, and thus does not provide guidance for long-term economic development.

Much has been written since Ricardo as commerce has evolved and cross-border trade has become more complicated. Today trade policy tends to focus more on "competitive advantage" as opposed to "comparative advantage". One of the most indepth research undertakings on "competitive advantage" was conducted in the 1980s as part of the Reagan administration
Reagan Administration
The United States presidency of Ronald Reagan, also known as the Reagan administration, was a Republican administration headed by Ronald Reagan from January 20, 1981, to January 20, 1989....

's Project Socrates
Project Socrates
Project Socrates was a US Defense Intelligence Agency program established in 1983 within the Reagan administration. This classified program, founded and directed by physicist Michael Sekora, was designed for the purpose of identifying the root cause of the United States' declining ability to...

 to establish the foundation for a technology-based competitive strategy development system that could be used for guiding international trade policy.

Free mobility of capital in a globalized world


Ricardo explicitly bases his argument on an assumed immobility of capital:
" ... if capital freely flowed towards those countries where it could be most profitably employed, there could be no difference in the rate of profit, and no other difference in the real or labour price of commodities, than the additional quantity of labour required to convey them to the various markets where they were to be sold."


He explains why, from his point of view, (anno 1817) this is a reasonable assumption:
"Experience, however, shows, that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connexions, and entrust himself with all his habits fixed, to a strange government and new laws, checks the emigration of capital."

Some scholars, notably Herman Daly
Herman Daly
Herman Daly is an American ecological economist and professor at the School of Public Policy of University of Maryland, College Park in the United States....

, an American ecological economist and professor at the School of Public Policy of the University of Maryland, have voiced concern over the applicability of Ricardo's theory of comparative advantage in light of a perceived increase in the mobility of capital:
"International trade (governed by comparative advantage) becomes, with the introduction of free capital mobility, interregional trade (governed by Absolute advantage
Absolute advantage
In economics, principle of absolute advantage refers to the ability of a party to produce more of a good or service than competitors, using the same amount of resources...

)."

Adam Smith
Adam Smith
Adam Smith was a Scottish social philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Smith is the author of The Theory of Moral Sentiments and An Inquiry into the Nature and Causes of the Wealth of Nations...

 developed the principle of absolute advantage
Absolute advantage
In economics, principle of absolute advantage refers to the ability of a party to produce more of a good or service than competitors, using the same amount of resources...

. The economist Paul Craig Roberts
Paul Craig Roberts
Paul Craig Roberts is an American economist and a columnist for Creators Syndicate. He served as an Assistant Secretary of the Treasury in the Reagan Administration earning fame as a co-founder of Reaganomics. He is a former editor and columnist for the Wall Street Journal, Business Week, and...

 notes that the comparative advantage principles developed by David Ricardo
David Ricardo
David Ricardo was an English political economist, often credited with systematising economics, and was one of the most influential of the classical economists, along with Thomas Malthus, Adam Smith, and John Stuart Mill. He was also a member of Parliament, businessman, financier and speculator,...

 do not hold where the factors of production are internationally mobile. Limitations to the theory may exist if there is a single kind of utility. Yet the human need for food and shelter already indicates that multiple utilities are present in human desire. The moment the model expands from one good to multiple goods, the absolute may turn to a comparative advantage. The opportunity cost
Opportunity cost
Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...

 of a forgone tax base may outweigh perceived gains, especially where the presence of artificial currency pegs and manipulations distort trade. Global labor arbitrage
Global labor arbitrage
Global labor arbitrage is an economic phenomenon where, as a result of the removal of or disintegration of barriers to international trade, jobs move to nations where labor and the cost of doing business is inexpensive and/or impoverished labor moves to nations with higher paying jobs...

, where one country exploits the cheap labor of another, would be a case of absolute advantage that is not mutually beneficial.

Economist Ha-Joon Chang
Ha-Joon Chang
Ha-Joon Chang is one of the leading heterodox economists and institutional economists specialising in development economics...

 criticized the comparative advantage principle, contending that it may have helped developed countries maintain relatively advanced technology and industry compared to developing countries. In his book Kicking Away the Ladder, Chang argued that all major developed countries, including the United States and United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...

, used interventionist, protectionist economic policies in order to get rich and then tried to forbid other countries from doing the same. For example, according to the comparative advantage principle, developing countries with a comparative advantage in agriculture should continue to specialize in agriculture and import high-technology widgits from developed countries with a comparative advantage in high technology. In the long run, developing countries would lag behind developed countries, and polarization of wealth would set in. Chang asserts that premature free trade has been one of the fundamental obstacles to the alleviation of poverty in the developing world. Recently, Asian countries such as South Korea
South Korea
The Republic of Korea , , is a sovereign state in East Asia, located on the southern portion of the Korean Peninsula. It is neighbored by the People's Republic of China to the west, Japan to the east, North Korea to the north, and the East China Sea and Republic of China to the south...

, Japan
Japan
Japan is an island nation in East Asia. Located in the Pacific Ocean, it lies to the east of the Sea of Japan, China, North Korea, South Korea and Russia, stretching from the Sea of Okhotsk in the north to the East China Sea and Taiwan in the south...

 and China
China
Chinese civilization may refer to:* China for more general discussion of the country.* Chinese culture* Greater China, the transnational community of ethnic Chinese.* History of China* Sinosphere, the area historically affected by Chinese culture...

 have utilized protectionist economic policies in their economic development.

See also


  • Competitive advantage
  • Revealed comparative advantage
    Revealed comparative advantage
    The revealed comparative advantage is an index used in international economics for calculating the relative advantage or disadvantage of a certain country in a certain class of goods or services as evidenced by trade flows...

  • Heckscher-Ohlin model
    Heckscher-Ohlin model
    The Heckscher–Ohlin model is a general equilibrium mathematical model of international trade, developed by Eli Heckscher and Bertil Ohlin at the Stockholm School of Economics. It builds on David Ricardo's theory of comparative advantage by predicting patterns of commerce and production based...

  • Bureau of Labor Statistics
    Bureau of Labor Statistics
    The Bureau of Labor Statistics is a unit of the United States Department of Labor. It is the principal fact-finding agency for the U.S. government in the broad field of labor economics and statistics. The BLS is a governmental statistical agency that collects, processes, analyzes, and...


External links

  • Comparative advantage in glossary, U.S. Bureau of Labor Statistics Division of Information Services
  • David Ricardo's The Principles of Trade and Taxation (original source text)
  • Ricardo's Difficult Idea, Paul Krugman
    Paul Krugman
    Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

    's exploration of why non-economists don't understand the idea of comparative advantage
  • The Ricardian Model of Comparative Advantage
  • J.G. Hülsmann's Capital Exports and Free Trade explanation of why the immobility of capital is not an essential condition.
  • Matt Ridley
    Matt Ridley
    Matthew White Ridley, FRSL, FMedSci is an English journalist, writer, biologist, and businessman.-Career:...

    , 'When Ideas Have Sex', a video at the TED
    TED (conference)
    TED is a global set of conferences owned by the private non-profit Sapling Foundation, formed to disseminate "ideas worth spreading"....

    talk where he explain the Comparative advantage for a general audience (5:05 out in the video).