The Theory of Comparative Advantage

The International Economics Study Center ^ | Unknown | Steven Suranovic

[Luis Gonzalez]

Got a couple of hours to kill?

[annyokie]

Invisable Hand, indeed.

[Texasforever]

LOL. I don't think so.

[Luis Gonzalez]

This article details explicitly why outsourcing works.

[Texasforever]

I take a fairly simple but time tested stance on competitive advantage. It is a 3 legged stool, labor cost, quality, schedule=final customer price and profit. If any source of labor can provide all 3 attributes that is where the work should be done. If a labor source can only provide low labor costs but not quality or schedule(efficiency), then that source of labor is not viable. If a labor source is costly but high quality and highly efficient, in other words, on time the first time then that is usually where the work should be done.

[expatpat]

Good post.

[CrucifiedTruth]

Although the results follow logically from the assumptions, the assumptions are easily assailed as unrealistic.

Yeah, unrealistic is the polite way to put it. Some old division of labor stuff with a few fancy new words. The problem is that international relations must be competitive. Otherwise we'll get a regulated, planned, world economy where the One-Worlders sit in the middle controlling everyone else. Their advantage really doesn't compare. The rest will simply struggle to be "more efficient", longer working, less eating and most importantly less thinking serfs.

The usual way of stating the Ricardian model results is to say that countries will specialize in their comparative advantage good and trade them to the other country such that everyone in both countries benefit.

Big problem. Country by country specialization means dependence. Dependence means lost sovereignty. In todays high-tech world, flexibility is easy to achieve and there is no much need for specialization. But many governments are falling all over themselves to regulate and litigate the independent small producers out of existence. That's what the special interest wants, that's what they do. Silly economic theories are just the cover - bought and paid for.

[SedVictaCatoni]

Here's a good way to summarize the whole thing succinctly:

Bob is a brain surgeon. He can stuff envelopes, if you want him to, and can quickly work out a procedure to do this simple task very efficiently. More to the point, though, he can perform brain surgery.

Ted is a high school dropout. You could give him a copy of Neurosurgery for Dummies, and he could perform a lobotomy, eventually. He can also stuff envelopes, though he's not as quick as Bob at that, either.

There is some brain surgery to be done, and some envelope-stuffing to be done. Bob's better at both, so should we just have Bob spend half his time on each, and tell Ted to take a hike?

Of course not. Even though Ted isn't as good as Bob at envelope stuffing, Bob is so much better at brain surgery that it makes sense to put Ted to work stuffing envelopes and let Bob get on with practicing his trade. This is intuitively obvious.

Same thing in world trade. Sure, America can make tennis shoes. It might even be better at making tennis shoes than Malaysia. But Malaysia can make tennis shoes pretty well, and it's terrible at making bulldozers. So it makes the most sense for America to stick to making bulldozers, and Malaysia to stick to making shoes, rather than both countries trying to make both goods.

[Willie Green]

Comparative Advantage and Competition
William R. Hawkins
Thursday, March 04, 2004

Gregory Mankiw, Chairman of the Council of Economic Advisers, triggered a political firestorm when he told the Joint Economic Committee of Congress (JEC) on February 10 that outsourcing jobs is “just a new way of doing international trade.” Yet, he was correct in his assessment. It was his total lack of concern about the consequences that provoked even the Republican Speaker of the U.S. House, Dennis Hastert of Illinois, to respond, “I understand that Mr. Mankiw is a brilliant economic theorist, but his theory fails a basic test of real economics.”

It is this conflict between theory and reality that has always driven debates over international trade. This discussion has often been sliced between economists on the one hand, and historians and political scientists on the other. Economics is a social science, not a hard science, despite all the attempts to disguise this fact with graphs, equations, and computer models. Economics is filled with contrasting philosophical views of how the world should work.

Mankiw´s idealism is evident from other things he said during his JEC testimony. Consider the following: “International cooperation is essential to realizing the potential gains from trade. Trade agreements have reduced barriers to international commerce, and contributed to the gains from trade. A system through which countries can resolve disputes can play an important role in realizing these gains.”

This statement reflects the theory of comparative advantage in its most simplistic form. Countries are to specialize in particular fields and then trade with those who have specialized in complementary fields. The emphasis is on cooperation, not competition. Each trading state recognizes and accepts its place in the integrated global economy. Indeed, the increasing use of the terms “integration” and “global” in place of “competition” and “international” reflect the philosophical bent of 19th century classical liberalism for harmony over rivalry.

There is, however, very little in the history of international trade to support this concept. David Ricardo conceived his comparative advantage model at a time when even his native England was not yet a fully industrial nation. He thus drew heavily on pre-industrial concepts based on a “natural” division of labor and specialization based on climate, raw materials and local artisan skills. One of the more famous examples of this approach is Adam Smith=s observation about the difficulty of growing bananas in Scotland.

Today, it is possible to manufacture products almost anywhere because technology is not limited by soil or climate like agriculture; transportation costs have dropped; capital is fluid; and there are smart, skilled people everywhere. Related to this “unnatural” state is another critical fact that free trade theory does not take into account: In a large and complex world, multiple nations can have a comparative advantage in the same field. They thus become rivals in the attempt to gain as large a share of world markets as possible.

The United Nations Conference on Trade and Development (UNCTAD) puts out measurements of “revealed” comparative advantage based on an index that compares the share of a given sector in national exports to the share of the sector in world exports (known as the Balassa formula). According to this measurement, the United States, China, Germany and Japan all have a comparative advantage in miscellaneous manufacturing; the U.S., China, Japan and Singapore have comparative advantages in electronic components; the U.S., Germany and Japan have advantages in transportation equipment (mainly cars and trucks) and in non-electrical machinery; the United States and Germany have an edge in chemicals; China and Germany both have comparative advantages in basic manufacturing, while Japan has just lost it advantage. In information technology and consumer electronics, China, Japan, and Singapore are rivals, with the United States having lost ground but still close enough to recover its advantage with a little effort. Comparative advantage is a dynamic function, subject to change over time as rivals actively compete, trying to better their position and knock out the others.

Ambitious nations are never satisfied with their “assigned” place in the system. The American colonies revolted against a British Empire that did not want them to develop industry but simply maintain their comparative advantage in the production of raw materials. Ricardo=s own classic “wine and cloth” example was meant to show that Portugal should accept its role as a traditional supplier of wine and let England move ahead with the new industrial process of cloth production. This example was denounced as “free trade imperialism” by all nations which understood that developing new technology and manufacturing capacity was the path to both prosperity and power. The current impasse at the Doha Round trade talks reflects this historic rivalry between developed and developing nations.

China is not going to accept the U.S.-Japanese-German edge in automobile production and import vehicles. It will build its own auto industry, along with industries in aerospace, chemicals and steel. Beijing will use American transnational corporations to aid in its development efforts, since these firms do not care where they produce. China will also push forward with its shipbuilding industry, even though South Korea, Japan and the European Union are currently more advanced. What moves international commerce is the same motive that moves business in general: cutthroat competition and a relentless desire to expand into new fields. The key difference between domestic and international competition is that the latter also affects national capabilities, which in turn can shift the world balance of power and with consequences far greater than those experienced by domestic companies in their more circumscribed competition.

The term “trade war” is far more applicable to the world trading system than most people want to admit. Political science professor William R. Thompson, from a career spent looking at the international system, has reached this conclusion: “Unlike the pattern in warfare in which ascending states fight their way up through their regional neighborhoods before taking on the system=s most powerful state, commercial challenges are aimed immediately at the leading commercial power.” Today, that target is the United States.

In this global competition, the United States is losing. There is no field in which its domestic producers are without rivals, which means that if national leaders adopt the attitude that it doesn´t matter who wins, America will be defeated by those who do care about winning. A $549 billion trade deficit in goods, and increasing penetration of foreign firms into key sectors of the domestic American economy, indicate how rivals are running up the score.

Professor Mankiw does not apparently think in these terms. The critical question is whether the man who appointed Mankiw, President George W. Bush, understands the larger issues at stake. So far, there is no evidence that he does.

William R. Hawkins is Senior Fellow for National Security Studies at the U.S. Business and Industry Council.

[AZLiberty]

I trust that the theory is mathematically correct -- in the aggregate. Today's problem becomes apparent when you take it down to the level of individuals.

Suppose, in the England/cloth/Portugal/wine example, that England "decides" to make only cloth and Portugal "decides" to make only wine. (I put the word in quotes because it isn't up to countries to make such decisions.) Then we have the potential of a lot of unemployed English winemakers and a lot of unemployed Portuguese clothmakers. Over time the employment market will adjust, with the people concerned finding other jobs or leaving the job market.

The speed of business and markets has been increasing for some time now, probably more than the speed of individual adjustment. This increases the likelihood that individuals will be left in the lurch as markets adjust. Furthermore, if markets adjust quickly enough, it's conceivable that a slow-moving individual could be caught out-of-step multiple times before he finds a niche or gives up.

[cinFLA]

Bob's better at both, so should we just have Bob spend half his time on each, and tell Ted to take a hike?

Nobody is going to pay Bob's rate to stuff envelopes (or, Bob will not work at the pay that stuffing envelopes will pay).

[BrucefromMtVernon]

"Law" of comparative advantage? None of the experts cited in the article are true economists. This so-called "law" is based on empirical, deductive reasoning. It's one big nothing.

[Texasforever]

It is a lot of words to explain something that is actually fairly simple. Outsoursing of High tech jobs has been made viable by those in the High Tech sector doing what they are paid for. Manufacturing outsourcing was also made viable by the High Tech sector doing what they were paid for by automating previously high skilled manufacturing tasks to the point of allowing a low skilled worker to accomplish.

[Luis Gonzalez]

Or why should America be engaged in competing for the tennis shoe market, when it can own the bulldozer market?

[Luis Gonzalez]

First a Unionist, now a protectionist.

You want another Great Depression, don't you Willie?

Thinking About Protection: The Hawkins Prescription for Trouble

       Suppose the mercantilist model--that centuries-old paradigm of planned, coordinated, "balanced" protectionism now resurrected by William R. Hawkins to create a stronger America--were a viable policy alternative in August 1945, at the end of World War II. And let us take this supposition as an opportunity to assess the U.S. trade record, to see where it has been, economically and politically, and perhaps to see where it is heading. After all this, we may better see just what Hawkins has in mind.
       
        With the end of the Second World War, America, then by far the greatest military and economic power on earth, faced an extraordinary challenge: What kind of postwar world should America nurture? Broadly it had two options.
       
        First, should the United States retreat to its mercantilist, isolationist, divisive, protectionist, and inadvertently contentious stance of the twenties and thirties?
       
        Consider the history behind this question. Congress, which refused to ratify the Treaty of Versailles, rejected U.S. membership in the League of Nations. In 1922, Congress adopted the Fordney-McCumber Tariff, which led to a 44 percent average tariff on dutiable imports. That percentage was boosted to nearly 60 percent by the more widely imposed Smoot-Hawley Tariff of 1930, a record tariff that touched off retaliatory protectionism and divisiveness around the world. It also exacerbated the Great Depression (economist Jude Wanniski says Smoot-Hawley caused it) and contributed to the frictions that led to the Second World War.
       
        Under newly installed President Harry S. Truman, America in 1945 carried forward the flag of leadership earned by military victories in war-ravaged Europe and Asia. Therefore, should America seek a united, not a divided, globe, an international fraternity of nations predicated on, to borrow the slogan of IBM, "World Peace through World Trade," an international fraternity wherein nations are free to exchange goods and services, ideas and technology, capital and tourists, for the benefit of all concerned?
       
        Wisely, I think, America chose the second option, though it still clung to a number of mercantilistic ideas advocated in the accompanying article by William Hawkins. America fostered the United Nations, headquartered in New York, and the General Agreement on Tariffs and Trade (GATT), headquartered in Geneva.
       
        GATT, which celebrated its fortieth anniversary in 1987, seeks to promote free trade by requiring member nations signatory to any tariff ... (3100 of 19478 Characters) Read Full Article

[Luis Gonzalez]

Willie, you're a Unionist...you ARE the vast majority of the problem, and the primary reason why America's ability to compete has been stiffled.

[Luis Gonzalez]

Try reading...the word used is "theory", not law.

[Texasforever]

Nobody is going to pay Bob's rate to stuff envelopes (or, Bob will not work at the pay that stuffing envelopes will pay).

The law of supply and demand applies to labor as well as goods and services. The only way to repeal it is with government intervention and we all know how well that works out.

[Doctor Stochastic]

Good analysis. It also shows (in the gardening example) why management is so important. However, the Marxist-Buchannanist-Merchantilists still haven't risen to the level of Adam Smith, much less Ricardo, and thus won't understand.