June 12, 2002
Comparative Advantage

Question: What do you think is the most misunderstood concept in your discipline?

Answer: For Economics this question has a stock answer. The most misunderstood concept in Economics is the concept of "comparative advantage." First developed early in the nineteenth century by David Ricardo, "comparative advantage" holds that we should export not those commodities that we can make more efficiently than people in other countries can make them, but those commodities that we can make most efficiently relative to the efficiency with which we make the average good or service. This principle has a corollary: we should import not those goods and services that we make less efficiently than other people make them, but those goods and services that we make less efficiently than we make goods and services in general.

A country that allows its trade to be shaped by this principle of comparative advantage will find that its workers find employment in those industries in which they are most productive. It will find that its profitable firms grow and its unprofitable firms shrink. And it will find that those goods that used to be produced domestically at relatively high prices--because the country was unable to produce them efficiently--will have their prices drop as domestic demand is satisfied by cheaper imports.

It is important in assessing comparative advantage that "efficiency" be defined in its broadest possible sense. A commodity that we can make cheaply but that generates a lot of pollution is in all likelihood one that we cannot make "efficiently." A commodity that is expensive in resources to produce, but that as a by product teaches valuable skills to workers or provides valuable ideas to other businesses and sectors, is in all likelihood one that we can make "efficiently."

Yet, somehow, a huge number of people think not in terms of "comparative" but of "absolute" advantage: they think that if American businesses can produce goods using less worker time than other countries, that we have no business importing such goods. But they are wrong. The true source of long-run wealth is for us to specialize in what we are best at--not for us to distribute traded goods-sector workers around all sectors and make everything in which we are more productive than other countries.

Posted by DeLong at June 12, 2002 12:37 PM

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I would have to look high and low for a clearer explanation of comparative advantage. And since my personal comparative advantage lies elesewhere, I will prowl on.

Regards

Posted by: Tom Maguire on June 13, 2002 06:07 AM

This was written by Mark Lutz, of the University of Maine, in a book called "21st century economics", edited by William Halal (professor of management science) en Kenneth Taylor (professor of economics), with a foreword by Robert Solow:

"The problem is that comparative advantage ceases to be relevant even when put in the context of two types of domestic labor, because skills, understood as embodied knowledge, are no longer internationally immobile. With the new information technology, not only unskilled but also many highly skilled jobs can be, and are being moved abroad. (...) The only skilled occupations that can be expected to succesfully resist being shifted where labor is the cheapist are those where physical contact is an essential element, as in many domains of the service sector. Here again, as with capital mobility, it is the transnational corporations that lubricates the wheels by serving as 'global knowledge brokers.' Without multinational firms, we might still live in a world resembling that of comparative advantage based on a country's relative endowment of skills, but it is no longer the world we live in. As a result, international trade behaves according to the principle of absolute advantage. Unles this basic fact is recognized, we cannot be expected to explain the comtemporary malaise."

I guess the people who misunderstand the principle of comparative advantage are getting more and more sophisticated.

Posted by: Ivan janssens, Belgium on June 13, 2002 11:36 AM

Hmmm... Seems incoherent to me. If international trade works according to the principal of absolute advantage, the U.S. should be exporting everything except for auto parts and precision instruments. The U.S. has an incredibly productive economy in almost all sectors.

Posted by: Brad DeLong on June 13, 2002 07:55 PM

Your description would be better if it stressed that this economic law is universal and works for the mutual benefit of all parties -- instead of describing it from the point of view of one party only (which is usually how people manage to misinterpret it... what is seen and what is not seen... as usual) -- anyway, nice reminder that not everyone knows or understands this law.

Posted by: Magnus on June 13, 2002 11:49 PM

Further, an essential aspect of this law is that it applies to individual producers, not merely to aggregates of people (e.g. countries). See my weblog http://radio.weblogs.com/0103811/ for additional comments. --Magnus

Posted by: Jinn of Quality and Risk on June 14, 2002 02:34 AM

One way that the principle of comparative
advantage is misunderstood is by thinking it
applies straightforwardly to individual
transactions. But these are generally mediated
by money, which can introduce a distortion.
While "honest" money, fully serving the purposes
of helping exchange, does not do this, there
are serious and cumulative exceptions.

The worst possibility I know of is where
"investment" overseas is achieved by
deficit finance with a reserve currency.
When that happens, instead of cash going
overseas as a proxy for goods and services
that will be applied to raise productivity
and/or productive capacity, you get something
else. You get bits of paper going overseas,
mobilising and deploying purely local resources
but then doing a wealth transfer, placing
ownership of a revenue stream in the hands
of those that only did deficit financing.

At the end of the day, there isn't an
exchange of goods and services at all,
just a wealth transfer with continuing
consequences. It only looks like something
that comparative advantage applies to; there
is nothing wrong with the theory at all, only
with the attempt to apply it in the wrong
place. Luckily, this isn't a common
situation these days (though something
very like it did happen in setting up the
19th century Dutch East Indies' "Cultivation
System"). P.M.Lawrence.

Posted by: P.M.Lawrence on June 19, 2002 07:37 PM

But I wonder if regionality applies such as if it is "more efficient" to locate repetitive assembly work in Sorthern states than in Brooklyn then companies where assembly is a big part of the cost of would do so. In a different vein, what are the real advantages that the exporeter in the compartaive advantage model has? It would seem cheaper labor or access to resources. And then these advantages have to negate transportation costs and curreny issues. So does comparative advantage reasoning stop short of showing the actual out come in trade where a CA decision made by both parties?

S H

Posted by: on June 23, 2002 02:35 PM

But I wonder if regionality applies such as if it is "more efficient" to locate repetitive assembly work in Sorthern states than in Brooklyn then companies where assembly is a big part of the cost of would do so. In a different vein, what are the real advantages that the exporeter in the compartaive advantage model has? It would seem cheaper labor or access to resources. And then these advantages have to negate transportation costs and curreny issues. So does comparative advantage reasoning stop short of showing the actual out come in trade where a CA decision made by both parties?

S H

Posted by: on June 23, 2002 02:35 PM

So, resource allocation by comparative advantage means according to return in this country regardless of the rest. Allocation by absolute advantage means according to the relative return in this country vs. the others.
Given limited total amount and free flow of goods and resources they cannot possibly differ in the results.

Posted by: Leopold on June 26, 2002 05:50 PM

The most misunderstood concept in Economics is the concept of "comparative advantage." First developed early in the nineteenth century by David Ricardo, "comparative advantage" holds that we should export not those commodities that we can make more efficiently than people in other countries can make them, BUT THOSE COMMODITIES THAT WE CAN MAKE MOST EFFICIENTLY RELATIVE TO THE EFFICIENCY WITH WHICH WE MAKE THE AVERAGE GOOD OR SERVICE. This principle has a corollary: we should import not those goods and services that we make less efficiently than other people make them, but those goods and services that we make less efficiently than we make goods and services in general.


I believe that definition is incorrect because a country can have a comparative advantage in something that is less efficient than the average efficiency level of its own country, just because other country is relatively more efficient in the things we are best doing.
Example: Country A takes 1 cost unit to do 10 apples and 8 potatoes, country B does with that 20 apples and 10 potatoes.(potatoes price=apples price). Country A will specialize on potatoes not because is efficient in relation to the average efficiency of its own country but in relation to the whole world.
And the corollary for me of it is that no matter how inefficient you are doing things you will always have a comparative advantage in something, and every country can benefit from trade. But also this theory has a great restriction only works when resources can not move. Because if we could move resources from A to B all production will locate on B.(because has an absolute advantage on both products)
Also I would like to add that I don't think this theory is normative, that is, I don't think Ricardo thought this is what we should do, but a positive theory that tries to describe what actually happens when free trade occurs.

Posted by: Rafael Loring on July 4, 2002 02:53 AM

!!!!!!!"Hmmm... Seems incoherent to me. If international trade works according to the principal of absolute advantage, the U.S. should be exporting everything except for auto parts and precision instruments. The U.S. has an incredibly productive economy in almost all sectors."
Posted by: Brad DeLong on June 13, 2002 07:55 PM
This strikes me Mr De Long, this fact you mention is exactly why is suspected that the economy works by absolute advantage and not by comparative advantage.

Posted by: Rafael Loring on July 4, 2002 03:03 AM

Then should we export a good if we've got absolute advantage?

Posted by: on August 9, 2002 07:55 AM
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