The Famous (and Almost Never Understood) Theory of Comparative Advantage

To understand comparative advantage, it is best to start with its simpler cousin: absolute advantage. The concept of absolute advantage simply says that if some foreign nation is a more efficient producer of some product than we are, then free trade will cause us to import that product from them, to the benefit of both nations. It benefits us because we get the product for less than it would have cost us to make it ourselves. It benefits the foreign nation because it gets a market for its goods. And it benefits the world economy as a whole because it causes production to come from the most efficient producer, maximizing world output.

Sounds good.  Indeed, absolute advantage is a set of fairly obvious ideas. It is, in fact, the theory of international trade most people instinctively hold, without recourse to formal economics, and thus it explains a large part of public opinion on the subject. It sounds like a reassuringly direct application of basic capitalist principles. It is the theory of trade the great Adam Smith himself, founder of modern economics, believed in.

It is also false. Under free trade, America observably imports products of which we are the most efficient producer—which makes no sense by the standard of absolute advantage. This causes complaints like conservative commentator Patrick Buchanan’s below:

Ricardo’s theory…demands that more efficient producers in advanced countries give up industries to less efficient producers in less advanced nations…Are Chinese factories more efficient than U.S. factories? Of course not. (The Great Betrayal, p. 67.)

Buchanan is correct: this is precisely what Ricardo’s theory demands. It not only predicts that less efficient producers will sometimes win (observably true) but argues that this is good for us (the controversy). This is why we must analyze trade in terms of not absolute but comparative advantage. If we don’t, we will never obtain a theory that accurately describes what does happen in international trade, which is a prerequisite for our arguing about what should happen—or how to make it happen.

At bottom, the theory of comparative advantage simply says this:

Nations trade for the same reasons people do.

And the whole theory can be cracked open with one simple question:

Why don’t pro football players mow their own lawns?

Why should this even be a question? Because the average footballer can almost certainly mow his lawn more efficiently than the average professional lawn mower. The average footballer is, after all, presumably stronger and more agile than the presumably mediocre workforce attracted to a badly paid job like mowing lawns. (If we wanted to quantify his efficiency, we could measure it in acres per hour.)

Efficiency (also known as productivity) is always a matter of how much output we get from a given quantity of inputs, be these inputs hours of labor, pounds of flour, kilowatts of electricity, or whatever.  Because our footballer is more efficient, in economic language he has absolute advantage at mowing lawns. Yet nobody finds it strange that he would “import” lawn-mowing services from a less efficient “producer.” Why? Obviously, because he has better things to do with his time.

This is the key to the whole thing. The theory of comparative advantage says that it is advantageous for America to import some goods simply in order to free up our workforce to produce more-valuable goods instead. We, as a nation, have “better things to do with our time” than produce these less valuable goods. And, just as with the football player and the lawn mower, it doesn’t matter whether we are more efficient at producing them, or the country we import them from is.  As a result, it is sometimes advantageous for us to import goods from less efficient nations.

This logic doesn’t only apply to our time, that is our man-hours of labor, either. It also applies to our land, capital, technology, and every other resource used to produce goods. So the theory of comparative advantage says that if we could produce something more valuable with the resources we currently use to produce some product, then we should import that product, free up those resources, and produce that more valuable thing instead.

Economists call the resources we use to produce products “factors of production.”  They call whatever we give up producing, in order to produce something else, our “opportunity cost.” The opposite of opportunity cost is “direct” cost, so while the direct cost of mowing a lawn is the hours of labor it takes, plus the gasoline, wear-and-tear on the machine, et cetera, the opportunity cost is the value of whatever else these things could have been producing instead.

Direct cost is a simple matter of efficiency, and is the same regardless of whatever else is going on in the world. Opportunity cost is a lot more complicated, because it depends on what other opportunities exist for using factors of production.

Other things being equal, direct cost and opportunity cost go up and down together, because if the time required to mow a lawn doubles, then twice as much time cannot then be spent doing something else. As a result, high efficiency tends to generate both low direct cost and low opportunity cost. If someone is such a skilled mower that they can mow the whole lawn in 15 minutes, then their opportunity cost of doing so will be low because there’s not much else they can do in 15 minutes.

The opportunity cost of producing something is always the next most valuable thing we could have produced instead. If either bread or rolls can be made from dough, and we choose to make bread, then rolls are our opportunity cost. If we choose to make rolls, then bread is. And if rolls are worth more than bread, then we incur a larger opportunity cost by making bread. It follows that the smaller the opportunity cost we incur, the less opportunity we are wasting, so the better we are exploiting the opportunities we have.

Therefore our best move is always to minimize our opportunity cost. This is where trade comes in.

Trade enables us to “import” bread (buy it in a store) so we can stop baking our own and bake rolls instead. In fact, trade enables us to do this for all the things we would otherwise have to make for ourselves. So if we have complete freedom to trade, we can systematically shrug off all our least valuable tasks and reallocate our time to our most valuable ones.

Similarly, nations can systematically shrink their least valuable industries and expand their most valuable ones. This benefits these nations and under global free trade, with every nation doing this, it benefits the entire world. The world economy, and every nation in it, become as productive as they can possibly be.

Or so goes the theory…

Here’s a real-world example: if America devoted hundreds of thousands of workers to making cheap plastic toys (we don’t; China does) then these workers could not produce anything else. In America, we (hopefully) have more-productive jobs for them to do, even if American industry could hypothetically grind out more plastic toys per man-hour of labor and ton of plastic than the Chinese. So we’re better off leaving this work to China and having our own workers do that more-productive work instead.

This all implies that under free trade, production of every product will automatically migrate to the nation that can produce it at the lowest opportunity cost—the nation that wastes the least opportunity by being in that line of business.

The theory of comparative advantage thus sees international trade as a vast interlocking system of tradeoffs, in which nations use the ability to import and export to shed opportunity costs and reshuffle their factors of production to their most valuable uses.

This all (supposedly!) happens automatically, because if the owners of some factor of production find a more valuable use for it, they will find it profitable to move it to that use. The natural drive for profit will steer all factors of production to their most valuable uses, and opportunities will never be wasted.

It follows that any policy other than free trade (supposedly!) just traps economies producing less-valuable output than they could have produced. It saddles them with higher opportunity costs—more opportunities thrown away—than they would otherwise incur.

In fact, when imports drive a nation out of an industry, this must (supposedly!) be good for that nation, as it means the nation must be allocating its factors of production to producing something more valuable instead. If it weren’t doing this, the logic of profit would never have driven its factors out of their former uses. In the language of the theory, the nation’s “revealed comparative advantage” must lie elsewhere, and it will now be better off producing according to its newly revealed comparative advantage.

Or so goes the theory, and it’s easy to see where it leads.  Next time, I’ll tell you why it isn’t true.
 

Ian Fletcher is Senior Economist of the Coalition for a Prosperous America, a nationwide grass-roots organization dedicated to fixing America’s trade policies and comprising representatives from business, agriculture, and labor. He was previously Research Fellow at the U.S. Business and Industry Council, a Washington think tank founded in 1933 and before that, an economist in private practice serving mainly hedge funds and private equity firms. Educated at Columbia University and the University of Chicago, he lives in San Francisco. He is the author of Free Trade Doesn’t Work: What Should Replace It and Why.