CandidCapital

Comparative advantage is one of the key concepts in modern economics but is still often confused with competitive advantage.

Candid Capital mentioned a few days ago one of the most interesting new ways of understanding how the modern, internet-based economy works: the long-tail, first discussed by Chris Anderson in an Article in Wired in October 2004.

Given the persistent anxieties over globalisation, it is worth going back to another seminal theory of economics that suggests how trade can benefit us all. In the first half of the 19th century, Britain was divided over the merits of imposing tariffs on the imports of cheaper grain from overseas to protect domestic agriculture. David Ricardo, an MP and stockbroker influenced by Adam Smith and James Mill, was among the first to spot the crucial difference between absolute and relative advantage.

What matters is the opportunity cost – how much the production of good X is reduced to produce one unit of good Y in the same country.

His famous example involved trade between England and Portugal. In Portugal it is relatively easy to produce both wool and wine; in England it is hard to produce wine but only somewhat difficult to produce wool for cloth. Although Portugal had an absolute advantage in both, it is still overall cheaper for Portugal to produce more wine than it needs and exchange it for the excess cloth produced in England. England benefits because the cost (time, difficulty, investment) of producing cloth stays the same but the cost of obtaining wine comes down.

When taught in Economics classes, the theory of comparative advantage is often illustrated by taking the example of two people marooned on a desert island. They both need shelter and food. Since Miss A is fit and able, she can climb trees to harvest 7 coconuts a day and she can chop 3 logs a day to make a shelter, and this is the best balance between nuts and logs she can achieve on her own. Mr B is infirm, so he can only manage 2 coconuts and 3 logs – he has trouble climbing trees to harvest the fruit.

If absolute advantage were more important than comparative advantage, A would not cooperate with B. So total nut production on the island would 9 and total log production would be 6. And production and consumption would be equal to each other.

Now the insight provided by looking at the comparative advantage of both A and B as opposed to focusing on the absolute advantage of A is that it is still worth both of them cooperating. First of all, logs and nuts are not fully interchangeable in terms of the personal preferences or production costs that A and B have; all we have seen so far is that each has found out what balance of the two he or she individually will produce to satisfy most closely their individual needs given their limitations of time and energy.

We know that B can produce at a rate of 2 nuts to 3 logs (2:3). But he has also found that he could trade off production of 1 coconut for 3 logs. So his ‘personal exchange rate’ is 1:3. By contrast, A produces 7 nuts for each 3 logs she chops, but she can produce either nuts or logs at the same rate (1:1).

Once A and B cooperate – or start to trade – A will have an incentive to offer B some nuts in exchange for logs. B will be keen to sell some logs as his production rate runs at 1 nut for each 3 logs he produces, but he would eat more nuts if he could without sacrificing his shelter. He needs nuts but they are costly in terms of time and energy to gather each day. For B, logs are cheap in relation to nuts – that is his comparative advantage.

Once A can trade coconuts for the logs gathered by B, she can also take advantage of the fact that her production costs are identical for each item. At any price above 1:1 she can even stop chopping logs and specialise in nuts.

The table below shows how Miss A and Mr B change their production and consumption patterns as a result of co-operating or trading with each other. We do not know exactly at what rate logs and nuts will be traded against each other but it will be between the initial 1:1 of A and the 1:3 of B and for simplicity in the table we’ve gone for 1:2 as the nut to log exchange rate between A and B.

The advantages of international trade look clear when put like that. But in this simple example the figures – and hence the benefits – have been transparent. There are only two parties, so no complex trade-offs and no real haggling over the 1:2 exchange rate.

Unlike in world trade, there is no disagreement over currency exchange, no price arbitrage exploiting local rules or customs, no vested interests, no transport costs, no distinction between labour and capital, or between the moderate benefits of society as a whole through lower prices and the high costs to a relative few through redundancies or out-sourcing.

And Miss A and Mr B both found it easy to retrain and retool to pursue their respective nut and log specialisms, whereas flexibility in the workforce continues to elude developed countries. But for all that globalisation still matters. Imagine that Mr B on 2 nuts a day was living below subsistence nutritional levels.

26 May 07

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