Comparative advantage: Doing what you do best
The mathematician Stanislaw Ulam did not have a high opinion of the social sciences. He once challenged Paul Samuelson, Nobel laureate in economics, to name one social science proposition that was both true and non-trivial. Samuelson nominated comparative advantage: “That this idea is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.”
Samuelson was right. The absolute advantage Adam Smith talks about is simple and intuitive: it makes obvious sense for France to export wine to Scotland and import Scotch whisky. Comparative advantage is much more complicated. Ricardo introduced the notion in his 1817 book On the Principles of Political Economy and Taxation, using the example of England and Portugal and the production of cloth and wine. Portugal is more productive than England in both. Intuitively, you’d say that it makes sense for Portugal to export both, and that English industry would have little to gain from trade.
However, no country can develop a comparative advantage in everything because comparative advantage is a concept of the relative costs of doing things, so some things have to be comparatively more or less advantageous. Moreover all countries must have a comparative advantage in something. (You can find a good explanation of why this is the case here).
Ricardo demonstrated numerically that in fact if England specialised in one of the goods and Portugal in the other, total output of both goods would rise, allowing both countries to gain from trade.
Two centuries after Ricardo, can comparative advantage still provide useful guidance to policy makers? A new working paper from OECD’s Przemyslaw Kowalski argues that it can. Kowalski looks at what determines comparative advantage today, as part of the OECD project on The Effects of Globalisation: Openness and Changing patterns of Comparative Advantage. Kowalski analyses the bilateral trade of 55 OECD and selected emerging market economies and 44 manufacturing sectors covering the entirety of merchandise trade He examines physical capital, human capital, financial development, energy supply, business climate, and labour market institutions as well as import tariff policy.
Comparative advantage is still an important determinant of trade, but the OECD countries’ economies are more similar than they used to be, so the possibilities of trade driven by comparative advantage differences within the OECD grouping aren’t as great as they once were. However there are still marked differences between OECD and non-OECD countries, while the differences among non-OECD countries don’t seem to be diminishing much. That means that comparative advantage is more important for North-South and South-South trade than for North-North trade.
If you look at OECD and non-OECD countries as a whole, it’s interesting to see where differences have been decreasing and increasing. these differences decreased (although there are still big variations) as regards physical capital, average years of schooling, tertiary education, primary energy supply, and availability of credit. On the other hand, cross-country variation increases for regulatory quality, rule of law, control of corruption as well as import tariffs.
Most of these factors can be influenced significantly by policy. The trick is to make sure that trade and other policies don’t cancel each other out, but with so many factors interacting it’s not easy. Luckily for government policy makers, help is at hand from this year’s Nobel laureates in economics, Thomas J. Sargent and Christopher Sims.
Working separately, but in a complementary fashion, they’ ve developed methods for analysing causal relationships between economic policy and what happens in the economy. Sargent has mainly studied the effects of systematic policy shifts – such as attempts to reduce fiscal deficits – while Sims looks at how shocks spread through the economy.
Even if you’re one of those important and intelligent men who can’t grasp comparative advantage, you can probably see why the Sveriges Riksbank gave Sargent and Sims the prize this year.
Globalisation, Comparative Advantage and the Changing Dynamics of Trade collects OECD work that builds on recent contributions to the theory and empirics of comparative advantage, emphasising the role of policy in shaping trade. Click on the image to find out more and browse the book.