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Two hundred years of 'Comparative Advantage'

| Updated: October 25, 2017 05:26:52

British economist David Ricardo. Image credit: Moneyweek British economist David Ricardo. Image credit: Moneyweek

In a recent seminar, an economics entrant asked a question: what can a small country like Nepal offer for trade to say, India or other SAARC countries that can lead to win-win outcome on both sides? It was indeed a good question, but fortunately, this one had been answered rather well, back in 1817 by the British economist, David Ricardo (1772-1823).



Since 2017 marks the birth of the idea 200 years earlier, this calls for a wider public recognition of the genius of Ricardo. He could only devote a very short period of his short life to what Thomas Malthus, his contemporary, had labelled the 'dismal science'! Even over this brief span, he easily made many seminal contributions for the lesser mortals to debate and embellish over many epochs to come (e.g., 'labour theory of value', 'theory of economic rent', 'Ricardian equivalence', 'Law of diminishing returns' etc), not to speak of what was perhaps the greatest insight in all of economics, 'comparative advantage'.



Ricardo was the first to point out that for mutually beneficial trade to occur between any two countries, it is merely sufficient that one possess 'relative' or 'comparative' advantage over the other in the production of some goods and vice-versa. In what follows I assume no prior knowledge of economics but mere grade-5 arithmetic (all on board, I dare say), since a numerical illustration is the expeditious route to driving the point home.



Imagine two countries, A (large, or 'Mighty') & B (smaller, or, 'Minnow') where each makes only two goods, X (say, solar panels) and Y (bicycle/its parts). The countries differ in size and hence in the aggregate resources under command, but more importantly the technology available to each are different. Here by 'technology' read 'the knowledge implicit in the production of goods'. The production knowledge is given in the following table. Given their current level of production, each cell below (Table-1) shows the amount of additional quantity of 'resource'(F) that will be used up in producing an extra unit of X or Y. For simplicity, I am amalgamating labour, machinery, energy etc into one 'composite' Resource (F), which is available in finite, but different magnitudes, in each country. F is taken to be not tradable and hence its domestic price is not relevant to the discussion.



The first thing you notice is that Minnow, the smaller country (B), is rather inefficient in the production of each good vis-à-vis the larger one (A); B uses nine times the resource in making one X than Mighty-A  and 1.5 times that for Y. Thus, as Adam Smith had taught us earlier, A possesses 'absolute advantage' over B in the production of both goods.



Undaunted, lacking any trade between these two countries, they each produce some common goods as per local demand. But Ricardo argued that these two can still mutually engage in win-win trade! How?



The second thing you notice from the table above is that while Mighty A can only eke out half-a-unit of Y if it gave up one X, Minnow B can churn out 3Y if it gave up on one X! Ergo, B has a comparative advantage in the production of Y. Likewise, you can now easily argue to complement the above reasoning that A, on the other hand, has a comparative advantage in making X (since it gains 2X by foregoing 1Y, while B can only scrape in 1/3rd of X by surrendering 1Y). Thus, if they focussed more on goods that they were relatively more proficient in making, there are gains to be had for all vis-à-vis the no-trade situation.



To render the above 'logic' more transparent, let us implement the mental process just described. Vis-à-vis autarky, we persuade B to give up one X (& divert the same resource to Y), and likewise, lean of A to give up one Y (& re-engage the same resource to X).The following table then emerges depicting the actual changes in both country-specific and combined regional/world output (assuming these two by themselves make up a region). By the way, mark the contrast between the Tables 1 & 2; in the former we have 'inputs' needed to get one unit for each good, but below these are the changes in output resulting from revisiting the strategy of what to produce. 



We are now in a world of plenty, surrendering one each of X & Y, collectively, we now have a net gain 2 units of Y, and one unit of X (column iii above). Who says that ours is a 'dismal science'?




Recognise that these gains are net additions to what they had been accustomed to doing pre-trade. Who should these gains go to? Well, that depends on demand & supply, but as I said, no economics please! …Not today. In that case, some old-fashioned but 'good-faith bargaining' may be invoked. The scope for win-win trade is palpable; just as an example, B can offer one Y to 'A' in exchange for, say, one X. Should Mighty sneer at that? Not plausibly, for on its own, it can only do far worse; recall it could only fetch half-a-Y by giving up one X! If this offer is accepted, 'A' now ends up with additional consumption of (1X plus 1Y) through the contrivance of trade with its Minnow neighbour. (A's new production was 2Y, but it sold one of these in exchange of one X, which would have been far costlier if no trade.) B has impressive gains of her own; while just producing an extra 3Y, it can keep 2 of these and earn 1X via trade with Mighty A. (On her own, to obtain one of X she had to forego all 3Y!) The new consumption possibilities are shown in column (v) of Table 2 above. Surely, there are many more mutual win-win outcomes here as the perceptive reader can decipher on his/her own.



Please observe that the gains in the above illustration were 'incremental' in nature by undertaking a minor shift in production strategy, namely indulging more in the good that each had possessed comparative advantage over the other. Logically the gains would be commensurately larger for each if countries were to embrace the above advice wholeheartedly, eschewing nationalism (see below). Indeed in the extreme scenario, as in Ricardo's own illustrations, they each could go for complete 'specialisation', namely to produce only one of the two goods and then obtain all it desired (i.e., within means) of the second good by trade.



Truth Telling: Even though the present is a brief sojourn into the history of economic thought, and not a prescriptive piece of trade policy for the 21st century, let me acknowledge some limits to specialisation just to contain unnecessary confusion.



(a) First note that there is little cleverness in choosing the particular numbers I chose in Table 1 above; all is needed is that the ratio of resource requirement between the two goods differs between the two trading nations. Here it was (1/2) for A & 3 for B. Some may liken that to be a bit on the extreme side (but hey, we are dealing with Mighty & Minnow).

(b)        Secondly, it is evident that if the resource utilisation ratios, as identified in Table 1 above, were closer to each other, the gains were to be considerably smaller (and the arithmetic more tedious), though they exist.

(c) Thirdly, some of these gains (induced by innate differences in production knowledge), if small, could easily be whittled away in real life, even if free trade broke out, by inconveniences such as transport/insurance/perishability, not to speak of modern day regulations even those not trade-related. Often many goods are rendered 'non-tradable' on such accounts.

(d)       Fourthly, are the difficulties implicit in the 'deployment' of resources between industries. One does not require a lot of training in economics to observe that if specialisation has to occur in earnest, resources (typically involving lots of labour) have to be re-deployed from one sector to another. But real life execution of such strategies is itself resource using (re-training of labour, re-tooling of factories etc) and there are familiar hurdles evident in many economies, though importantly not all being trade-driven (e.g., in agriculture). Joan Robinson's celebrated displeasure with free trade in the historical context of the Portugal-England trade can be related to Portugal's inability to re-direct resources between declining and expanding industries! Some countries have handled such transitions better than others (e.g., Germany in absorbing 20 million Easterners post-1991 than US in discovering good jobs to replace those gradually lost in the rust belt)! While generally mutual gains from trade accrue to all, these gains need not be proportional for all. The burden of adjustments, in the absence of adequate social safety nets, may tear away at the social fabric (... witness US?).

(e) Lastly, while Ricardo highlighted the difference between countries in the production technology (as above) in explaining the riches of free trade, many other ideas (some built entirely on different, even contradictory, premises) have emerged over the decades, even attracting several Nobelsen route! For example, one can recall the Heckscher-Ohlin model of the 1920s, which was built on the hypothesis that relative factor abundance, never mind technological differences, alone can explain trade. But as scholars such as Leontief (1950s), Leamer (1980s) and Trefler (1990s) have demonstrated, this idea fails miserably to explain much of real-world trade at all. On the other hand, greater specialisation may permit even a smaller country (e.g., Canada) to exploit trade gains more fully if it could produce the larger output at a lower unit cost than prior to trade (so-called 'increasing returns to scale'), an idea that entitled Paul Krugman (2008) to claim a prize of his own. Thus it would be fair to say (and here, I hope my fellow economists would agree) that Ricardo's 'comparative advantage' (driven by technological differences) has remained a sustained legacy of human ingenuity, even though developed 200 years ago!



Allow me to end this piece by indulging in a bit of self-musing. Even in the lyrics of mystics such as Khayyam's, the 11-12th century poet/mathematician (1048-1131), who was apparently hugely enamoured by the priceless produce of the vintners, managed to tag a 'price' on its virtues:


I wonder often what the vintners buy one-half so precious as the stuff they sell'

(Rubaiyat, verse # XCV, first published, 1120 AD).



Who am I to see through the mind of the mystic, but allow me to lay claim that even in a state of ecstasy, Omar had endorsed trade! Exchanging your goods with those of another can often be mutually joyful!



The writer is Professor Emeritus at Concordia University, Montreal and Visiting Professor of Economics, South Asian University, New Delhi.

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