Comparative Advantage - A Primer
To understand what comparative advantage is, and how it affects our theories about free trade, let’s recall two economists who have left indelible, if very different, imprints on free trade theories: Adam Smith argued that there are no inherent differences between people’s productive capacities – that any street porter could just as well be a philosopher (with some transition – education, presumably). David Ricardo argued, on the other hand, that people differ in their capacities to produce goods and services – that some people are better at hunting deer and others are better (more productive) at hunting beavers.
The Smith-Ricardo argument is critical to framing our understanding of trade. The winners and losers – and, therefore, the policy implications – associated with trade depend almost wholly on whether one subscribes to the Smithean or the Ricardian theory of trade.
In the end, the realities of trade are a bit Smithean and a bit Ricardian. So the returns from trade – increasing, not constant – come from the specialization of labor. The U.S. is more productive if it focuses on technology R&D and services and China is more productive if it focuses on manufacturing. In increasing productivity, incomes rise, and everyone – producers and consumers – wins.
But those specializations don’t arise by lottery or happen-stance. Instead, they result from one economy’s comparative advantage over the other. The U.S.’ comparative advantage today lies increasingly in services (financial and otherwise) and, to a lesser extent, high value-added manufacturing and agricultural products. China’s comparative advantage is in labor-intensive manufacturing – clothing, textiles, toys, electronics, and machinery.
In a world where high-income production methods were fixed, economies would forever be like dogs at the bowl – fighting over a fixed set of the most lucrative types of production. But if high income production methods were fixed we’d all still be riding around in buggies drawn by horses. Instead of fighting at the dog bowl, leading producers are constantly innovating, constantly looking for that next type of production that will be high-demand and high-margin. It’s that constant search for the “next great idea” that keeps our incomes and our standards of living – in the U.S. and in China – growing.
In this world, as Smith predicted, the gainers from specialization aren’t permanently ensconced. They are constantly at risk of being one-upped by the newest bigger, better specialization. The inventor of that newest specialization is determined, in part, by comparative advantage – which is why economies must always be working to maintain and improve their advantage (in the U.S., a highly educated workforce, for example, is key).
WTO Director-General Pascal Lamy explained it well:
“[L]et me recognize Paul Krugman’s intellectual contribution to international trade theory – the so-called “new trade theory”– in which he shows that, even in the absence of productivity differences between two countries, trade benefits them both. He focuses on the presence of increasing returns to scale, in which a firm’s average cost per unit declines as production increases and underscores that consumers value variety in consumption.
While the new trade theory reduces the role played by comparative advantage, it identifies new sources of benefits from trade that were not emphasized or recognized by the classical economists. More trade benefits all countries because specialization in production reduces average cost and consumers gain access to a wider variety of products. In contrast, traditional theories of trade assume the variety of goods remains constant even after trade-opening.”[1]
And from the Peterson Institute for International Economics:
“Comparative advantage motivates people to trade. Because comparative advantage comes from differences in relative prices, it means that characteristics of both supply and demand matter. Thus comparative advantage for a country results from a complex combination of the characteristics that are difficult to change (such as natural resource endowments), characteristics of the overall country that change relatively slowly (such as the share of production and consumption of services relative to the share of manufacturing, mining, and agriculture), characteristics of production technology that in some cases can change relatively quickly (such as through turnkey production technology), and characteristics of individual preferences (such as for a particular kind or quality of products, services, or financial assets).”[2]
Think of the blend of Smith’s specialization and Ricardo’s comparative advantage at the level of the individual. Economists have been arguing for several years now about whether global outsourcing in middle-income white-collar jobs disrupts conventional theories about the benefits of trade. The answer is no, and here’s why: imagine a white-collar software engineer; he has enjoyed a good income for two decades programming software for Microsoft. But recently the company outsourced his job to a firm in India that can do the same software programming at a much lower cost.
What does our engineer do? Does he sit at home and cry? Perhaps, but he’d be better off if he figured out what he’s good at that someone in India or China or the house next door isn’t. Perhaps he has in the past been praised for his project management skills. Most U.S. companies that outsource programming work to other countries want U.S.-based project managers to maintain the tie between the offshore program and the U.S.-based company.
That principle applies not only to individuals but to entire economies as well: if someone else becomes more productive doing your job (because they can do it as well for less money) then you have three choices: to sit down and cry, to lower your own cost of production, or to figure out what your new comparative advantage is going to be – what you can do more productively than the next guy.[3]
That new comparative advantage might come from your educational background, or something about your inherent nature, or perhaps it’s a function of your location. Maybe you need to go back to school. But you can find a new comparative advantage, and then you’re still as well (if not better) off as you were before, and the software engineer in India is better off, as are the consumers of that software who can now buy it more cheaply. Everyone wins.[4]
This article is part of Issues in Depth: Free Trade and Comparative Advantage. Click here to explore this issue in depth – to read more articles similar to this one, see relevant data charts and graphs, and hear from the experts.
[1] World Trade Organization speech, “Comparative advantage is dead? Not at all, Lamy tells Paris economists”
[2] Peterson Institute for International Economics, “Has US Comparative Advantage Changed?”
[3] For an excellent explanation of these choices at the macro level see Comparative advantage is dead? Not at all, Lamy tells Paris economists: “Some have argued that more trade will drive governments in rich countries to lower their social or labour standards. More trade would hurt workers in rich countries. The problem with this argument is that there is very little empirical basis for it. It is difficult to find examples where countries have lowered social or labour standards in response to trade competition.”
[4] From Woodrow Wilson International Center for Scholars, New Thinking in International Trade: Global Competition and Comparative Advantage : “Both Gomory and Baumol stressed the ability of countries to invest in ways that would shape and change their comparative advantage. In contrast to the 19th century world where factors of production – often land and labor – were relatively fixed and did not flow easily between countries, 21st century national policies could guide the development of new comparative strengths based on investment, research and development, and education.” And: “The growing focus on innovation in Europe, China, India, and much of the rest of the world points to a 21st century in which the comparative advantage of a country will continue to change. To remain a world leader, the United States will need to strengthen its own innovation system and sharply improve its K-12 education system.”
