Comparative Advantage

The theory of absolute advantage makes intuitive sense. Unfortunately, the theory is flawed. What happened to trade if one country has an absolute advantage in both products? The theory of absolute advantage incorrectly suggests that no trade would occur. David Ricardo, an early-nineteenth-century British economist, solved this problem by developing the theory of comparative advantage, which states that a country should produce and export those goods and services for which it is relatively more productive than it is.

The difference between the two theories is subtle: Absolute advantage looks at absolute productivity differences: comparative advantage looks at relative productivity differences. The distinction occurs because comparative advantage incorporate the concept of opportunity cost in determining which good a country should produce. The opportunity cost of a good is the value of what is given up to get the good. Most of us apply the principles of comparative advantage and opportunity cost without realizing it. Consider a brain surgeon who is better at both brain surgery and lawn mowing than her neighbour’s teenaged son is.  If the surgeon is comparatively better at surgery than at lawn mowing, she will spend most of her time at the operating table and pay the teenager to mow her lawn. The brain surgeon behaves this way because the opportunity cost of mowing the lawn is too high: Time spent mowing is time unavailable for surgery.

Let us return to the example in Table 6.1 to contrast absolute and comparative advantage. Recall the France has an absolute advantange in wine and Japan has an absolute advantage in clock radios. The theory of absolute advantage says that France should export wine to Japan and Japan should export clock radios to France. As Table 6.1 shows, France also has a comparative advantage in wine: With 1 hour of labor it produces 2 times as much wine as Japan does but only 0.6 times as many clock radios. Thus  France is relatively more productive in wine. So Japan is relatively more productive in clock radios: With 1 hour of labor it produces 1.67 times as many clock radios as France does but only 0.5 times as much wine. So Japan is relatively more productive in clock radios. The theory of comparative advantage says that France should export wine to Japan and Japan should export clock radios to France. For the example in Table 6.1, the theory of absolute advantage and the theory of comparative advantage both yield the same outcome.

            Now let us change the facts. Suppose productivity stays the same in Japan but doubles in France as the result of new job training programs. Table 6.2 shows this new situation, France now can produce 4 bottles of wine or 6 clock radios per hour of labor. France now has an absolute advantage in both wine and clock radios: For each hour of labor, France can produce more bottles of wine (4 minus 1) or 1 more clock radio (6 minus 5 ) than Japan can. According to the theory of absolute advantage, no trade should occur, because France is more productive than Japan in producing both goods.

Table 6.2

The Theory of Comparative Advantage : An Example

Output Per Hour of Labor

France	Japan
Wine                                                 4	1
Clock radios                                     6	5

 

            The theory of comparative advantage, on the other hand, indicates that trade should still occur. France is 4 times better than Japan is in wine production but only 1.2 times better in clock radio production. (Alternatively, Japan is only 0.25 times as good as France in wine production but 0.83 times as good in clock radio production). France is comparatively better than Japan in wine production, while Japan is comparatively better than France in clock production.

            By the theory of comparative advantage, France should export wine to Japan and Japan should export clock radios to France. If they do so, both will be better off. In the absence of trade, 1 bottle of wine will sell for 1.5 clock radios in France and for 5 clock radios in Japan. In Japan offers to trade 2 clock radios for 1 bottle of wine, France will be better off---even though France has an absolute advantage in clock radio production. Without trade, sacrificing 1 bottle of wine domestically would yield France only 1.5 clock radios in increased production. With trade, France could get 2 clock radios by giving up 1 bottle of wine to Japan. France get more clock radios per bottle of wine given up by trading with Japan than by producing the clock radios domestically.

            Japan also gains. Without trade, Japan has to give up 5 clock radios to get 1 more bottle of wine. With trade, Japan has to give up only 2 clock to obtain 1 more bottle. Japan get more wine per clock radio given up by trading with France than by producing the wine domestically. Even though France has an absolute advantage in both wine and clock radio production, both countries gain from his trade. It is comparative advantage that motivates trade, not absolute advantage. For another insight into comparative advantage and the problems inherent in neomercantilism, see “Bringing the World into Focus”.

Bringing the World into Focus

The Lincoln Fallacy

            For centuries professors and politicians have debated the wisdom of allowing foreign producers to sell their goods on equal footing with domestic producers. To free trade advocates, limiting consumer choice to domestically produced goods is a violation of free-market principles and the spirit of competition. Many other groups, however, see free trade are selling out our fellow citizens. According to these groups, buying foreign goods sends our jobs and hand-earned money to foreign nations, building their economies by tearing down ours. This timeless argument is a common today as it was when Abraham Lincoln endorsed it in his characteristically direct fashion. “I know this much. When we buy goods manufactured abroad, we get the goods and the foreigner gets the money. When we buy goods manufactured at home, we get both the goods and the money.

            To the trained eye Lincoln’s argument in conspicuously and dangerously flawed. But how many people disagree with his logic or understand what they should? Like most misleading arguments, Lincoln’s case against free trade is true in and of itself, but it also incomplete. Is it true that buying domestic goods keeps our money in the country whereas buying foreign goods sends our money abroad, but this only part of the story. What we also need to consider are the resources needed to produce goods. When we buy goods produced domestically, some local resources must be used: labor, materials and a physical location. When we buy goods from abroad, however, foreign resources are used, leaving the domestic resources free to be used to make something else. In other words, buying from abroad frees up domestic resources that can be used in a more productive manner, leading to greater wealth for our country.

            Adding this part of the story to Lincoln’s argument renders a more complete comparison between buying domestic goods and buying foreign goods. The complete comparison could be phrase like this: “When we buy goods made at home, we get the goods and the money but have to use up resources that could have been used to make other goods. When we buy goods manufactured goods, the foreigner gets money, but we get the goods and get to keep the resources which then can be used to make other goods”. If those freed resources are used in more productive industries, we will have more goods to consume when we are open to international trade then we would if we were not open to trade. The same logic holds for our foreign trade partner, and so this argument implies that free trade makes all countries better off.

            The idea that free trade is better for everyone boils down to an argument for specialization that is similar to the commonsense notions we use in our daily lives. Most of us buy almost everything we consume. We buy our food from markets, our clothes from stores, and our cars from automobile manufactures. It is certainly true that when we buy our clothes from our store, but this is a good thing, isn’t it? After all, buying our clothes from a store rather than making them ourselves frees up the time it would have taken us to make our clothes. Most of us use this times to specialize in our own productive specialty, whether it is carpentry or computer programming. We then trade our services in what we do best for those that others do better than us. By specializing and trading, rather than producing everything ourselves, we channel production to the most efficient producers, thereby ensuring more production overall and more goods and services for everyone to consume. This principle holds for nations just as it does for individuals. By specializing in what they do best and trading freely, countries are able to produce most of everything and, consequently, their citizens have more to consume than they would if trade were limited by tariffs, quotas or other barriers.

 

Source:  We are grateful to our colleague Peter Rodriguez for allowing us to reproduce his analysis here. Reproduced with permission from Leonard Bierman et al.., The Legal Environment of Business, 3^rd ed. (Dubuque, IA : Eddie Bower Publishing, 2000).