Comparative Advantage

Comparative Advantage

All competitive advantage is temporary. Some advantages last longer than others, but all sources of advantage have a finite shelf life.

—ERIC D. BEINHOCKER[13]

The principle of comparative advantage, also known as the Ricardo principle, states that as long as one party in an exchange has a higher opportunity cost for producing something than the other, it makes sense for each to specialize and trade. This can hold even if one party is more efficient at producing every good. David Ricardo formulated the argument in the nineteenth century. The comparison concerns what each party gives up to produce a good, rather than which country produces it most efficiently in absolute terms.

Some economists have debated whether the principle of comparative advantage and associated free trade is really always that mutually beneficial for both parties. Raúl Prebisch argued that trade between two countries with disparate wealth can actually limit growth for the poorer nation and reinforce the wealth of the richer nation. Prebisch’s concern was that specializing in primary products, such as food, could disadvantage a poorer country trading with a richer country that exports manufactured goods.

Often, specialization is a consequence of the resources available in a particular country. That country can focus on producing goods related to its resources, then sell them to the rest of the world. Countries with an abundance of valuable natural resources can get locked into a cycle of selling those resources in their unprocessed form to other nations, which then process them and resell at a high markup.

Why does trading in these circumstances reinforce income disparity between the two countries? Niall Kishtainy summarizes Prebisch’s reasoning:

When the economy of a poor country grows, its demand for the cars that it imports from rich countries rises. But when a rich country grows, the country’s demand for the sugar that it imports from poor countries rises much more slowly. In consequence, the price of cars rises faster than the price of sugar: the poor country’s “terms of trade” worsen.[14]

The solution proposed is for the poorer country to diversify, protecting homegrown industries as they develop while creating incentives to make sure that development will allow them to compete internationally—much as the United States did early in its nationhood, and countries like Japan and South Korea did in the latter half of the twentieth century.

Nancy Folbre also cautions readers when taking the thought experiment of comparative advantage and applying it in the real world. Even in Ricardo’s time, the reality of trade rarely fit the theory. She writes of Ricardo:

While his reasoning was correct, it was incomplete. All else equal, free trade could make everyone better off. But little else was equal. Countries could use their military power to force trade on their own terms, as the British did in India—where they virtually prohibited handloom weaving, and in China—where they sent their battleships to expand the opium trade.[15]

Differences in opportunity cost can make specialization and trade beneficial even when one country is more productive in every activity. The critiques here concern how those gains are distributed and how power, changing prices, and industrial development affect the result.

Modern expertise comes partly at the expense of narrowness, and of ignorance about what other people do. —GARY S. BECKER[16]