The comparative advantage fairy tale

David Ricardo explicated the theory, two and a half centuries ago, in order to complement Adam Smith’s theory of absolute advantage. They used the renowned example of two countries, Britain and Portugal, two products, clothing and wine and one factor of production, labour.

They examine economic models that are an oversimplification of reality. These are very helpful but they should never be mistaken for reality. Reality has many details and unpredictable factors that may change the outcome considerably. Theories are extremely useful if they do not get confused with reality. Mathematical models are also very helpful but cannot predict life accurately. Why the theory of comparative advantage often does not apply in real life, is a research worth a Nobel Prize.

Let’s take a slightly different example than Ricardo’s. Greece and China produce shoes and computers. Greece is more effective in producing shoes and China in producing computers. According to Adam Smith’s theory of absolute advantage, Greece should specialize in making shoes and China in making computers. Now let’s assume that China produces more effectively shoes and computers compared to Greece. At the same time Greek production of shoes is more effective compared to Greek production of computers. David Ricardo’s theory proposes that Greece should specialize in shoes even though China is more effective in doing that. Adam Smith argued that a country should specialize in what it does better than other countries, while David Ricardo that it should specialize in what it does best of all regardless if other countries do it better.

This is what theory says. In real life, a Chinese producer will not think in terms of comparative advantage theory. He is not going to say; “Greece has a comparative advantage in producing shoes, so I will not produce shoes and I will let Greece do it”. Or the Greek importer will not say “I will not import shoes from China because Greece has a comparative advantage in producing shoes”.  Most likely they will not know and will not care to know about the theory. Only Economic professors care.

If they can bring shoes to Greece at lower prices than locally produced shoes, they will do it. There are some additional transportation costs but the labour cost difference is more than enough to make up for that. What determines the price of a product are various costs such as labour, capital, transportation and additionally exchange rates, subsidies tariffs. With a weaker Greek currency, Chinese products would not be as cheap. Euro makes Greek products expensive. By inducing tariffs, Greek government could protect the Greek shoes industry. This would be beneficial not just for the manufacturers but for the workers and the economy as a whole.

It is possible but not certain that with free trade there may be a slight increase in world's economic growth. Does this mean that everyone will be better off? Not at all! This is not the end of the story. This is part of the picture and not the whole picture. It does not mean that every one will benefit from that. What really matters is how product or income are divided. As a matter of fact, advanced nations will see a sharp decrease in their incomes while less advanced will have a slight increase.

The advantage theories are erroneous at their core. They have a static and not dynamic view. In the long run there is not such a thing as an advantage. The only advantages derive from natural conditions and resources. Switzerland has an advantage in winter tourism targeted at mountain activities. Spain has an advantage in summer tourism targeted at beach activities. Resources can be traded so the advantage is of a lesser importance.  

The argument that globalization should be credited for GWP (Gross World Product) growth is a false one. There has always been a steady long term growth trend in the World’s Product accompanied with business cycles. A comparison should be made with what the situation would be without the globalization process. Such a comparison is impossible since we do not know how things would be otherwise.

Why this did not happen in EU? It was one of the main promises that politicians gave in poorer EU countries. In theory this could have happened. There would be a slight decrease in richer countries and a slight increase in poorer ones. Income differences between European countries are not huge like in the world. Also the proportion of poorer countries is not 6 times more.

There are certain assumptions though. EU market had to be autonomous from the rest of the world. This was not the case. EU has only 18% of GWP. The rest of the world has five times more. In an economy, there are several factors that affect the outcome at a certain time. There were very strong forces from trading with the rest of the world. In the case of the world there is not another market in the moon. The world market is autonomous.

In theory a German factory should move to Greece since the wages are lower. In reality, it moved to Turkey or China. In addition, tariffs and duties are not the only barriers. There are several others like language, legal, accounting and tax, cultural differences. Also, evil Brussels bureaucracy controlled matters and moved them towards the direction that suited to them. German and French politicians wanted to have their voters happy at the expense of voters in other countries.

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