An Economic Principle For Us All: Comparative
Advantage
In
an update to his popular A
Concise Guide to Macroeconomics,
David
Moss explains
how the state of the macro economy affects managers, executives,
students—and all the rest of us. In this excerpt, Moss
illuminates David Ricardo's theory of comparative advantage.
The
first edition of A
Concise Guide to Macroeconomics,
By
David
A. Moss was
published in 2007—just as one of the world's great economic
downturns was taking off. The second edition has just been
published, which includes an epilogue on the crisis and the
contrasting actions taken by world governments to fight the
downturn. "It seems likely that economic historians will look
back at the years since 2007 as a grand natural experiment for
assessing the effectiveness of alternative macroeconomic responses
to a financial crisis," he writes.
In
this excerpt, Moss discusses one of the great principles in
economics: the concept of comparative advantage and how it
influences everything from nations to house painters. —Sean
Silverthorne
BOOK
EXCERPT
A BRIEF ASIDE ON THE THEORY OF COMPARATIVE ADVANTAGE
From
A
Concise Guide to Macroeconomics
By
David A. Moss
One
of the most important principles in all of economics is that of
comparative advantage, first articulated by the British political
economist David Ricardo in 1817. Intent on persuading British
lawmakers to abandon their protectionist trade policies, Ricardo
set out to prove the extraordinary power of trade to increase total
world output and thus consumption and living standards. On the
basis of a simple model with just two countries and two goods, he
showed that every country—even one enjoying an absolute
productivity advantage in both goods—would benefit from
specializing in what it was relatively best at producing and then
engaging in trade for everything else.
In
his now-famous example, Ricardo imagined that Portugal was more
productive than England in making both wine and cloth.
Specifically, he assumed the Portuguese could produce, over a year,
a particular quantity of wine (say, 8,000 gallons) with just 80
men, as compared with 120 men in England; and, similarly, that the
Portuguese could produce a particular quantity of cloth (say, 9,000
yards) with just 90 men, as compared with 100 men in England. In
other words, Portugal's productivity was 100 gallons of wine or 100
yards of cloth per worker per year, whereas England's was only
66.67 gallons of wine or 90 yards of cloth per worker per year.
Given Portugal's absolute advantage in both industries, why would
the Portuguese ever choose to buy either wine or cloth from
England?
Ricardo's
surprising answer was that both countries would benefit from trade,
so long as both specialized in what they were relatively best at
producing. In Ricardo's example, although Portugal was better at
making both wine and cloth, its advantage was greater in wine. As a
result, Portugal enjoyed a comparative advantage in wine, and,
conversely, England enjoyed a comparative advantage in cloth.
Ricardo concluded that if each country followed its comparative
advantage—with Portugal producing only wine and England only
cloth—and the two then engaged in trade with one another, each
would be able to consume more wine and more cloth than if it had
tried to produce both goods on its own.
“To make this more concrete, assume that each country had 1,200 workers, and that each allocated 700 to wine and 500 to cloth. This would mean that Portugal produced 70,000 gallons of wine and 50,000 yards of cloth, whereas England produced 46,667 gallons of wine and 45,000 yards of cloth. However, if each country devoted all 1,200 workers to its comparative advantage, Portugal would produce 120,000 gallons of wine and England 108,000 yards of cloth. If they now traded, say, 48,000 gallons of wine for 55,000 yards of cloth, Portugal would end up with 72,000 gallons of wine and 55,000 yards of cloth, and England with 48,000 gallons of wine and 53,000 yards of cloth. Both countries, in other words, would end up with more of both goods as a result of specializing and trading. In fact, to have produced these quantities on their own would have required 1,270 workers in Portugal and 1,309 workers in England. It is as if, as a result of specializing and trading according to the principle of comparative advantage, both countries got the output of many extra workers for free.
Economists
have since shown that Ricardo's result can be generalized to as
many countries and to as many goods as one wants to include.
Although we can certainly specify conditions under which mutual
gains from trade break down, most economists tend to believe that
these conditions—these possible exceptions to free trade—occur
relatively rarely in practice. Indeed, the Nobel Prize-winning
economist Paul Samuelson once acknowledged that "it is a
simplified theory. Yet, for all its oversimplification, the theory
of comparative advantage provides a most important glimpse of
truth. Political economy has found few more pregnant principles. A
nation that neglects comparative advantage may pay a heavy price in
terms of living standards and growth."
Remarkably,
most of us—even those who have never studied the theory of
comparative advantage—tend to live by it in our own personal
affairs every day. For the most part, we all try to do what we're
relatively best at and trade for everything else. Take an
investment banker, for example. Even if that investment banker were
better at painting houses than any professional painter in town,
she would still probably be wise (from an economic standpoint) to
focus on investment banking and to pay others to paint her house
for her, rather than to paint it herself. This is because her
comparative advantage is presumably in investment banking, not
house painting. Taking time away from her high-paying investment
banking job in order to paint her house would likely prove quite
costly, ultimately reducing the amount of money she could earn and,
in turn, the amount of output she could consume. In order to
maximize output, in other words, it makes sense for each of us to
specialize in our comparative advantage and to trade for the rest.
Reprinted
by permission of Harvard Business Review Press. Excerpted
from A
Concise Guide to Macroeconomics,.
Copyright 2014 David Moss.
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