The comparative advantage fairy tale

The comparative advantage fairy tale

Once upon a time there were free markets around the world. This is how the comparative advantage theory should start. Much of the free trade argument is based on comparative advantage theory. It is very useful as a theory but disastrous if it is taken for real. 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.

We have the case of a world class American economist and Nobel Prize winner who said; “who ever is against globalization does not understand comparative advantage”. The good thing about him is that he recognized his mistakes. We do not doubt his theoretical expertise but we are uncertain about his understanding of economic reality. Perhaps he should stop studying books, get out of his office and take a ride to nearby states that voted for Donald Trump.

There are two problems with economic professors. First, you need at least a bachelor degree in economics to understand them. Second, they know very well economic theory but they have some difficulty to understand economic reality. 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.