Talk:Comparative advantage
A nameless contributor says:
- The theory of "comparative advantage" depends on a basic necessary condition. That is, capital from one country cannot be moved to the other country (capital immobility). Ricardo pointed out that if capital were as freely mobile between England and Portugal as between London and Yorkshire, then trade between the two countries would be governed by the labor theory of value (absolute advantage in terms of labor cost) rather than comparative advantage (assuming labor is immobile).
- Many who champion the freemarket ideology today continue to cite comparative advantage as the theoretical economic underpinning. Ironically, the free flow of capital, now a part of the international freemarket framework, removes the necessary condition for comparative advantage theory to work.
- If you want to test a freemarket advocate, ask them about the role of comparative advantage. Then, ask them how capital mobility fits in. If they cannot explain this, you can conclude they don't know what they're talking about.
- See: "For the Common Good" Herman Daly, Chapter 11
and added this text to the article:
- The theory of comparative advantage rests on the necessary condition of "capital immobility." If the wine or cloth makers can move financial (or labor) resources between countries, then the ratios discussed above become imbalanced, and the theory erodes. Given the liberalization of capital flows under free trade agreements of the 1990s, the necessary condition of capital immobility no longer holds. As a consequence, the economic theory of comparative advantage no longer supports free trade theory.
This appears to be a minority position among trade economists (e.g., see this discussion of some of the issues). It's also misleading to go after Ricardo's original version of comparative advantage without taking into account further developments in the last 180 years. So I'm pulling this paragraph out for the moment. Perhaps it can be replaced by a less one-sided discussion of how the theory is complicated by capital mobility and other effects? Populus 02:48, 16 Dec 2003 (UTC)
Examples
I have come up with a story that made this idea clear to me; Perhaps you may like to incorporate it into the page somehow.
You live in the sand dunes. In the sand dunes, you can spend 3 days, to make clothes, or 5 days, to make wine.
You live next to the fertile fields. In the fertile fields, you can spend 1 day, to make clothes, or 1 day, to make wine.
If you want wine, you should spend 3 days making clothes. Then, go to the fertile fields. Trade the clothes for wine, because they have equal value. Then, bring the wine home.
I suspect that in the long term, the people in the fertile fields will make slightly less clothes and slightly more wine, because there's suddenly a bunch of desert people selling nifty clothes and buying up wine.
So, it works out.
However, I still don't understand what the "comparative advantage" is here. I understand the machinery. I understand the model. Now I just need to know what parts of it form the "comparative advantage."
- Ricardo used the term "comparative advantage" to differentiate it from Adam Smith's "absolute advantage". According to Smith, not only do the ratios need to differ, but there must be an advantage in absolute numbers for each of the participant before trade will occur. But according to Ricardo, absolute advantages are not required, just relative, or comparative advantages. There could be trade even if one producer is absolutely more efficient at producing both commodities. mydogategodshat 07:37, 13 Feb 2004 (UTC)
Is it the 1:3 vs. 1:5? Is it that, since the ratios are different, the mathematical system adjusts to an equalibrium, to account for everyone present?
- The comparative advantage is the opportunity cost of making clothes. In the Sand Dunes, one unit of clothes costs 1.66 units of wine. In Fertile Fields, one unit of clothes costs 1.0 units of wine. Since clothes are cheaper in Fertile Fields than they are in the Sand Dunes, then the Fertile Fields has a comparative advantage in making clothes.
- Note that in the Sand Dunes, one unit of wine costs 0.6 units of clothes. In Fertile Fields, one unit of wine costs 1.0 units of clothers. So the Sand Dunes actually have a comparative advantage in making wine. Anonymous User
Hope this helps.
The story certainly helped me - and so I looked up the theory in a 1st October 1998 article in The Economist magazine, and developed your excellent idea of the story into what I've just added to the article.
Please edit and criticise!
Chris Baker 6 April 2004
Example 2 seems to be incorrect on one count (confusing numbers with their reciprocals) and not ideally presented in another (the order of the rows is not the same in each table). Making the tables consistent with the text at the start of the example gives:
Cost in days of each item
| Country | Clothes | Wine |
|---|---|---|
| Northland | 3 | 5 |
| Southland | 1 | 1 |
Production capabilities each day
| Country | Clothes | wine |
|---|---|---|
| Northland | 0.33 | 0.2 |
| Southland | 1 | 1 |
If 1 day is used to produce wine and 4 days are used to produce clothes:
| Country | Clothes | Wine |
|---|---|---|
| Northland | 1.33 (4*0.33) | 0.20 (1*0.20) |
| Southland | 4.00 (4*1) | 1.00 (1*1) |
| Sum: | 5.33 | 1.20 |
Southland produces wine in all 5 days and Northland produce clothes all 5 days:
| Country | Clothes | Wine |
|---|---|---|
| Northland | 1.67 (5*0.33) | 0.00 (0*1) |
| Southland | 0.00 (0*1) | 5.00 (5*1) |
| Sum: | 1.67 | 5.00 |
Example 2 does not use the best choice of figures to explain comparative advantage, because trading gives us much more wine, much less clothing, and therefore a lot of drunks wearing rags. Of course, supply and demand will prevent this happening. I think the example on the German Wikipedia [1] is easier to understand as a first example, because trading gives a small surplus of both commodities.
Is it biased to point out the flaws in a broken theory?
- Yes, generally speaking, it is. You should cite notable experts in the field, rather than just expound on your opinions. - Nat Krause 13:07, 21 Sep 2004 (UTC)
Comparative advantage is a broken theory. It sounds good on paper, but that was before the gold standard died. Also, the nameless contributor above is right about the issue of capital flight.
The main problem with comparative advantage has to do with checks and balances, and the fact that money is a good. When the theory was first created the world was on the gold standard, meaning gold was the medium of exchange. Since there was a finite supply of gold, trade was kept in check. If a country bought too many goods it ran out of gold and had to cut back on it's consumption. With the dissolution of the gold standard in the 1930's came the rise of fiat money, money created by government decree. Now a country can buy all the goods it wants just by printing more money.
- I disagree. Money is simply a means of facilitating exchange. Goods and services are valuable while money just facilitates the trade of these items. Raising the money supply has no effect in the long run. It simply increases the number of zeroes behind the price of a gallon of milk. The milk itself is still worth the same.
The only thing stopping the country from spending like crazy is that the more a country spends the less its money is worth relative to other currencies. However, there are ways to stop a currency from losing value. The first way is to have a strong military and to force the world to use the currency as a medium of exchange. The second way is trade. The cheaper a currency, the cheaper its goods. So whoever has the cheapest currency can sell the most goods at the lowest price. So if country A buys the currency of country B and takes it out of circulation, this causes the value of currency B to be artifically high and the value of currency A to be artifically low. As a result, country A can export more goods to country B than it would otherwise. Country A can thus destroy the industry of country B by flooding it with cheap goods. In the process country B will have a huge trade debt to country A, since country A only imports money from country B. If left unchecked country A will eventually be able to dictate politics in country B and will eventually control or own country B. The big flaw with comparative advantage is that money is a good.
Another wrinkle in comparative advantage is what happens if the market ever becomes saturated beyond it's ability to consume goods and services. How does comparative advantage deal with this unemployment? Should country B lay off half it's workforce because country A has a comparative advantage? As a side note: Since the supply of workers will forevermore be greater than demand, this will cause wages to spiral to zero for the majority of workers.
- First, it should be noted that in David Ricardo's time credit money was widespread enough that there was indeed an endogenous money supply and that it wasn't entirely fixed. It is also possible to have an improperly valued currency under a gold standard.
- However, this doesn't relate to comparative advantage. Comparative advantage is more fundamental than that, and Ricardo clearly recognized that the market could be distorted by aggressive practices. As long as a person has any productive capacities, comparative advantage can be applied; the sole implication of it is that, sometimes, people will benefit from trade, and that people (aggressive practices aside) are better off being given that option.
- The theory also doesn't explain or argue against unemployment, or relate to the way that wealth will be distributed. Although later Ricardo would become the first to really look into this from the perspective of an orthodox economist, it doesn't contradict the incredibly basic idea that people, as long as they can produce something, will benefit from trade if their relative value of the goods exceeds the relative price. Although you can indeed have a massive trade deficit, no money, and no property, the implication of comparative advantage still stands. Your points are valid arguments against free trade, but they kind of 'go over the head' of comparative advantage. Adam Faanes 21:06, 7 Oct 2004 (UTC)
- The theories of currencies above are flawed, but whether they are or not does not affect comparative advantage, which is a real concept (independent of money). As long as there is a fixed ratio of exchange between goods (including currencies if you like) competitive trade can be defined. CSMR 01:43, 3 October 2005 (UTC)
CA is not the whole story
There seems to be *a lot* of confusion here about what comparative advantage is, and what it sets out to explain. It is not supposed to be a full theory of international trade - it is the basic, page 1, textbook model which explains why countries might want to trade with each other. Its pivotal assumption, which by your capital mobility etc. criticism you wish to attack, is that each country's production function is fixed ie. in Country A for every day you work you can make 5 potatoes or 3 tomatoes and that rate of transformation is fixed. Now, given this assumption, what the theory basically says is that countryies relatively better at making potatoes should make potatoes, countries relatively better at making tomatoes should make tomatoes - and they should then trade with each other. The story submitted above is a very helpful illustration of this intuition.
Now, your point about capital mobility. Fast forward 100 years or so from Ricardo, and you get the Hecksher-Ohlin theory. Now these guys said that technology wasn't fixed as Ricardo assumed, but that it depended on what resources a country had. In a country relatively rich in capital, capital will be relatively cheap, and hence the country will have a comparative advantage in making capital-intensive goods. Conversely, countries which are capital-poor, but have a large labour force, will have a comparative advantage in labour-intensive goods, because wages will be low. As you say, if a country gets a major injection of capital it will become relatively better at making capital-intensive goods, and it will reorient its exports towards those goods. BUT an important conclusion of their theory is that there is no reason under such circumstances for capital to move. To see why will require a little example, but it doesn't get too technical...
Imagine we have two countries, lets call them America and Europe. Both countries make two goods - food, which is labour-intensive, and cars, which are capital-intensive. Europe has a relatively large population, while America has a relatively small one. To start with neither country trades, so they both produce both goods. Now open trade. America will be eager to import European food - cheaper than American because Europe has a large labour force, and hence low wages. Conversely, Europe will be more than happy to reduce its production of cars, and instead import cheap American ones (cheap because capital is relatively cheaper in America). So what we'll see is a big increase in demand for European food, and a big increase in demand for American cars. So gues what will happen. European entrepreneurs will be desperate to get out of car manufacture and start producing food, which will cause demand for European labour to rise, and thus raise European wages. Conversely, demand for European capital will fall, and European capital will get cheaper. The opposite will be happening in America. So what do we have at the end of all this - European wages will have risen until they're equal to American wages, and the price of capital in America will rise until it equals the price of European capital (and European capital will be cheaper, and American wages lower). So the grand conclusion of all of this: if you have free trade, you don't need factor mobility. By the end, the returns to capital in America and Europe are the same, so there's no incentive for anyone to shift capital from one country to the other.
Now, I'm not going to pretend that this theory is perfect either - there's plenty of empirical evidence to contradict it, and there's plenty more theoretical complications you can add on so that factor price equalisation no longer holds. But the important point I'm trying to make here is that no theory is perfect, nor do they pretend to be. Comparative advantage isn't perfect, but gives a good basic story about why countries trade with each other. Hecksher-Ohlin isn't perfect, but fills out the story somewhat, and makes some more predictions about what happens when two countries trade with each other. Economic theories seem to come in for bitter attacks from people, for not being perfect. Now I'm sure the reason for this is a lot of disgustingly simplistic and ideological reasoning on the part of certain free-trade lobbiers, and of course, they are wrong to use these theories as if they are perfect. But academic economics is about the most self-conscious of all the sciences in realising how imperfect its theories are, and how much they fail to explain. But this doesn't mean we should discard the theories, because even the most basic have something important to say. Discarding Comparative Advantage, would be as stupid as saying that since Einstein came up with relativity, there's no point understanding Newtonian physics. This is especially so in economics, where the simplest theories tend to have the strongest explanatory power - refinements almost always come at the cost of reduced scope, and certainly at the cost of simple intuition. The reason people cite theories like CA, is that they are a good starting point for a discussion of free trade, and most people can easily get their head round them. So my basic point is: criticize the misuse of CA theory (or any theory) but don't lay to heavily into the theory itself.
Briefly on the money stuff. Yes, currencies can be manipulated to influence world trade - an important example recently has been East Asian central banks buying dollars to keep the dollar strong, so that they can keep flogging plenty of exports to America. But this is a pretty peripheral influence - central bank resources are tiny compared to the sway of the market, a by far more important determinant of the exchange rate is how many people want to buy your goods, and this comes down to your fundamentals - what do you make, and how cheaply do you make it?
But for the sake of argument, let's go with this example of nasty big country A, buying lots of B's currency so that people in B will buy A's goods and have a huge trade defecit. Now, A when it buys B's currency, isn't just buying "money" - no one sits around holding large quantities of cash, because you'd be stupid to do so. You'd either use your currency to buy goods, or you'd use it to buy investments with a return. (That's why changing the interest rate is the main instrument country's use to alter the value of their currencies - raise the interest rate, and money will flood in from people wanting to earn that higher rate on their savings.) Now for the first thing country A is going to buy investments, and thus develop an interest in the performance of businesses in country B - you wouldn't deliberately cripple that country's economy, because it would damage your investments. Now there is potentially a serious problem with country A taking over businesses in country B, and hence taking control of the country's resources. (Let's briefly note that the two countries who have the notorious problem of running prolonged trade defecits while maintaining relatively strong currencies are the USA and the UK.) But let's say country B is in this position, and is worried that A investors are taking over the country's productive assets, because people in country B are buying too many foreign goods and selling their assets in order to buy them (because that's essentially what's happening here). Simple solution: drop your interest rates. Foreign investors will go flooding out of the country, the exchange rate will fall. Imports will be expensive, and people in country B will stop buying them, at the same time demand for country B's suddenly cheaper exports will surge. To pay for all these exports, people in other countries will either sell you their own goods, or if you don't want that they will sell you their assets - holdings in their country or yours.
As for being able to print money, for every dollar you print, you simply devalue the dollar, at least in the long run. There are important short-term effects, which I'm not going to go into, but basically printing money is used to manipulate *prices*, specifically those of assets, to manipulate people's consumption patterns. Nothing so simplistic as just printing off money and buying everything you want - if it was that easy everyone would be doing it (note again, that the countries with the tightest monetary policies are those in North America, Europe and East Asia).
But anyway, the problem you're getting at in these stories is an imbalance of power, not anything particular about the current economic system. Obviously, it's a concern that large countries could dominate smaller ones, and presumably if they had the will and the resources, manipulation of the economic system could be one way to do that. The Soviet Union rarely used to bother - they just sent in a load of tanks. But you're stories just don't refelct anything that's happening at the moment in the real world - quite the opposite in fact. The IMF (and implicitly, its larger donors) frequently gets criticised for being too harsh on countries - for concentrating on reducing their trade imbalances swiftly without concern for the adverse effects on the rest of the economy, or poor parts of the population. The main problem for small developing countries is that they can't import large quantities of the goods they need without the currency weakening seriously.
I apologise for this lengthy, and slightly confused rattle through some basic trade theory. I just think that economic theories come under a lot of criticism, get mangled and misinterpreted, and it all comes out sounding like witchcraft. Actually most of the major economic theories, especially the important ones, are deceptively simple, but communicating this is the difficult part. Like any subject, economics has its flaws, and no one (with any brains) pretends otherwise. I have plenty of problems with the way the economic system works, the insistence on trade liberalisation, the lack of generosity towards developing countries, and the dogmatic use of theories like CA by people who want to push through politically motivated agendas. But go after them, not a harmless, useful, and relatively intuitive economic theory.
Krugman
Is there any better reference than Krugman? His article is reasonably well-written, but he cannot himself restrain himself from expressing en passant his opinions on the evolution, computation and intelligence, and writers in those areas. CSMR 01:48, 3 October 2005 (UTC)
overall
This article is rather basic. Does anyone really understand the theory of trade thoroughly here?