of Principle Comparative Advantage
The theory of comparative advantage is perhaps the most important concept in international trade theory. It is also one of the most commonly misunderstood principles. There is a popular story told amongst economists that once when an economics skeptic asked Paul Samuelson (a Nobel laureate in economics) to provide a meaningful and non-trivial result from the economics discipline, Samuelson quickly responded with, "comparative advantage." http://internationalecon.com/Trade/Tch40/T40-0.php
The punch line of this theory is, indeed, hard to believe. Country A is technologically superior to Country B in every possible industry. Yet it is always possible for both countries to benefit from trade even if Country A has more of every productive resource (more land, more labor, more capital, more education)! The principle of comparative advantage was discovered by Robert Torrens around 1815, but is more commonly associated with the great classical economist, David Ricardo. The underlying idea comes from opportunity cost. Ricardo's example related to British cloth and Portuguese wine. Imagine that England has superior technology in both industries. For example: Portuguese wine costs twice as much as British wine and Portuguese cloth costs four times as much as British cloth. Wine: requires one hour of labor per jug in England, two hours in Portugal Cloth: requires one hour of labor per yard in England, four hours in Portugal The bad news for Portugal is that cloth has a lower opportunity cost in England than in Portugal. A yard of cloth costs one just of wine in England, but two jugs in Portugal (the four hours required to produce a yard of cloth could be used to produce two jugs of wine). The good news for Portugal is that (remember from the notes on opportunity cost) opportunity costs are reciprocal. This means that wine must have a lower opportunity cost in Portugal than in England! A jug of wine costs one yard of cloth in England, but only of a yard of cloth in Portugal. So, if England wants more wine, it should produce more cloth and trade it for Portuguese wine. A. Passing the Exam Exam questions will always focus on two entities (countries, regions, people) producing two goods like England and Portugal producing cloth and wine or Brazil and Venezuela producing pudding and spoons or Dan and Jennifer producing cookies and rum cakes. To answer exam questions correctly, you must be able to determine opportunity cost from numerical information that can get confusing. Then you need to understand four simple principles: (1) Absolute advantages are not relevant. England is the more efficient producer of both goods, but trade will always be mutually beneficial. Look at relative costs and always think in terms of opportunity cost, what a country must sacrifice of one good to produce one more unit of the other. (2) A country's comparative advantage lies in producing the good for which it has the lower opportunity cost. In the example, England has the comparative advantage in producing cloth because cloth costs one jug of wine in England, but two jugs of wine in Portugal.
(3) Each country can get more of both goods by specializing in its comparative advantage. England specializes in cloth and Portugal specializes in wine. In the extreme, specialization means producing one good exclusively. Whether or not specialization is complete, each country will export (sell) the commodity in which it has the comparative advantage. England will export cloth to Portugal and import wine from Portugal, and vice-versa. (4) The terms of trade (ratio of international prices) will always lie in between the opportunity costs. A yard of cloth will trade for somewhere in between 1 and 2 jugs of wine. So the price of wine will be between and 1 yard of cloth. The price ratio is such that 1 < pw/pc < 2 or < pc/pw < 1.
Regional Differences in Resources and Productivity
Labor Productivity (output per one hour of labor) Cattle Texas Senegal 5 1 Cotton 10 8
Texas Senegal
Cotton Cattle Cotton Cattle
1000 800 600 400 200 -
0 500 0 100
200 400 200 75
400 300 400 50
600 200 600 25
800 100 800 0
1,000 0
Slope = - Each bale of cotton costs half a head of cattle
Determine the opportunity cost of cotton in (a) Texas, (b) Senegal Assume one hundred hours of labor in each country. Determine each country's production possibility curve.
0
100
200
300
400
500
R esour ce R equir ement and s E ndowment s
Brazil Pudding Spoons Endowment 12 6 180 Venezuela 2 4 60
The relevant information can be presented in various ways (see above). The data in the first table relate to productivity. In Texas, a worker can produce twice as much cotton as cattle: so the opportunity cost of a head of cattle must be two bales of cotton. A worker in Senegal can produce eight times as much cotton as cattle: so the opportunity cost of cattle is eight bales of cotton. Texas will specialize in cattle and Senegal will specialize in cotton. Texas will export cattle to Senegal. If you know the resource "endowments" (e.g., labor), you can translate these numbers into production possibility schedules or curves (lines), as in the diagrams. Slopes of lines represent opportunity costs, but you should always think through the numbers (e.g., to produce 500 head of cattle, Texas would have to forego producing 1000 bales of cotton so each head of cattle costs two bales of cotton, and vice-versa). The information could be stated as succinctly as: Texas could produce either 500 head of cattle or 1000 bales of cotton". The second table expresses technology in terms of resource requirements (costs). Brazil has absolute advantages in both goods, just as Texas had absolute advantages in both cotton and cattle. Ask the question: how much does a cup of pudding cost in Brazil? Answer: two spoons (12 "resources" is correct, but irrelevant). Then: how much does a cup of pudding cost in Venezuela? Answer: half a spoon.
B. Does Comparative Advantage Work in Reality? Wrong question. Of course it works all countries engage in international trade, but the world is obviously more complex than the one-resource, two-commodity, bilateral trade example. In fact, the world is too complex for anyone to work out what any country should be trading (or not trading) to any other country. In the classroom game, it was easy for you to figure out who should trade what and the 1-1 price ratio was staring you in the face. What the model illustrates so well is that mutually beneficial terms of trade always exist. The next step is that competitive market forces will generate the prices. Free trade enables the process to work in theory. Unfortunately, free trade has never been tried and dismantling trade barriers is an ongoing headache. So the US subsidizes cotton in Texas and Arizona; this raises the cost of textiles in the Carolinas; so we impose tariffs and quotas on imported clothing; this props up the Carolina textile industry, but cuts the demand for domestic cotton. No one believes that the future of the Carolinas lies in textiles, but trade barriers continually send out such false signals. C. Does Outsourcing Destroy Jobs? Obviously. But, again, wrong question. The right focus is on the jobs that outsourcing creates indirectly. There is a multitude of ways this can happen, as discussed in articles by John Stossel and Thomas Sowell. http://www.jewishworldreview.com/0205/stossel.php3?printer_friendly http://www.capmag.com/article.asp?ID=3565 The most important thing to keep in mind is that the jobs that "come back" are diffused over space and time. So it is easy to do TV sound bites interviewing people who have lost their jobs, but the recovered jobs cannot be identified as readily. It is still possible to measure the positive impact upon employment, but serious effort and (boring) statistics are necessary. For example, aggregate unemployment rates fluctuate pretty steadily around 5%, so outsourcing cannot be "destroying" net jobs in the aggregate. What kind of jobs does it create? Interesting question, but probably (on average) better than the ones that are shipped offshore per capita national income keeps rising. D. The Moral Argument Just as one-sided arguments against outsourcing ignore the job-creation aspect of the process, moral arguments against free trade ignore the opportunity-creating side. I highly recommend Travels of a T-shirt in the Global Economy, by Pietra Rivoli. Rivoli points out the silliness of blaming low wages and terrible working conditions on international trade. Trade expands opportunity. Working 12+ hours each day in a sweat shop for 20 cents an hour and sharing a small apartment with several co-workers is not something I would recommend as an internship, but the actual workers choose to do so and (according to Rivoli) consider it to be a "liberating" experience!