Monday, April 11, 2011

Why the Theory of Comparative Advantage is False

I am one of those who remember the days when "made in Japan" meant cheap goods. Will my children someday remember the days when "made in China" meant the same? This article is about the Theory of Comparative Advantage, which Wikipedia explains as follows:

In economics, the law of comparative advantage says that two countries (or other kinds of parties, such as individuals or firms) can both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods. Even if one country is more efficient in the production of all goods (absolute advantage), it can still gain by trading with a less-efficient country, as long as they have different relative efficiencies.[1][2][3]

For example, if, using machinery, a worker in one country can produce both shoes and shirts at 20 per hour, and a worker in a country with less machinery can produce either 2 shoes or 4 shirts in an hour, each country can gain from trade because their internal trade-offs between shoes and shirts are different. The less-efficient country has a comparative advantage in shirts, so it finds it more efficient to produce shirts and trade them to the more-efficient country for shoes. Without trade, its cost per shoe was 2 shirts; by trading, its cost per shoe can reduce to as low as 1 shirt depending on how much trade occurs (since the more-efficient country has a 1:1 trade-off). The more-efficient country has a comparative advantage in shoes, so it can gain in efficiency by moving some workers from shirt-production to shoe-production and trading some shoes for shirts. Without trade, its cost to make a shirt was 1 shoe; by trading, its cost per shirt can go as low as 1/2 shoe depending on how much trade occurs.

This theory appears to me to be the economic equivalent of ethical egoism. In the end, the goal is to get everyone else to be altruistic, but not to be altruistic oneself. Similarly, it seems the economic goal is to pursue protectionist economic policies in order to get rich, and forbid other countries from doing the same, under the aegis of "free trade."

The Theory That's Killing America's Economy -- and Why It's Wrong

by Ian Fletcher, author, Free Trade Doesn't Work: What Should Replace It and Why

I wrote in a previous article how America's disastrous embrace of free trade is ultimately based on a false theory of how the global economy works: the so-called Theory of Comparative Advantage. This is what economists, from the government on down, believe in. This matters.

But I didn't explain why the theory is wrong -- which it is. Understanding its flaws is the price of admission to serious criticism of free trade, so it's well worth getting a grasp on them. Economic theory can be a tough chew, but it's worth the effort, if only to gain the intellectual confidence not to be intimidated by the so-called experts. So... let's take a look at some of that machinery behind the wizard's curtain, shall we?

The theory's flaws, which are fairly well known to economists but mostly ignored, consist of a number of dubious assumptions upon which the theory depends. To wit:

Dubious Assumption #1: Trade is sustainable.

The problem here is that the theory of comparative advantage pays no attention to the long term. So it can quite easily recommend a trade policy that gives us the highest possible living standard in the short run -- but by way of selling off our country out from under us.

This is what happens when a nation runs a trade deficit, which necessarily means that it's either sinking into debt to foreigners or selling off its existing assets to them.

The theory of comparative advantage is blind to this problem because it treats people's time horizons as a given. So if a nation wants a short-term consumption binge followed by long-term decline, the theory says "OK, no problem. You wanted it, you got it, what's not to like?"

A saner theory of trade (and of economics generally) would advise people that it's not a good idea to engage in decadent binges, regardless of how good it feels right now. It would recommend protectionist restraints on imports to force trade into balance, not free trade.

Dubious Assumption #2: There are no externalities.

An externality is a missing price tag. More precisely, it is the economists' term for when the price of a product does not reflect its true economic cost or value.

The classic negative externality is environmental damage, which reduces the value of natural resources without raising the price of the product that harmed them. The classic positive externality is technological spillover, where one company's inventing a product enables others to copy or build upon it, generating wealth that the original company can't capture.

If prices are wrong due to positive or negative externalities, free trade will produce suboptimal results.

For example, goods from a nation with lax pollution standards will be too cheap. So its trading partners will import too much of them. And the exporting nation will export too much of them, overconcentrating its economy in industries that are not really as profitable as they seem, due to ignoring pollution damage.

Positive externalities are also a problem. If an industry generates technological spillovers for the rest of the economy, then free trade can let that industry be wiped out by foreign competition because the economy ignored its hidden value. Some industries spawn new technologies, fertilize improvements in other industries, and drive economy-wide technological advance; losing these industries means losing all the industries that would have flowed from them in the future.

Dubious Assumption #3: Productive resources move easily between industries.

As noted in my original article, the theory of comparative advantage is about switching productive resources from less-valuable to more-valuable uses. It's about putting our economy to its own best use.

But this assumes that the productive resources used to produce one product can switch to producing another. Because if they can't, then imports won't push our economy into industries better suited to its comparative advantage. Imports will just kill off our existing industries and leave nothing in their place.

When workers, for example, can't move between industries--usually because they don't have the right skills or don't live in the right place--shifts in an economy's comparative advantage won't move them into a more appropriate industry, but into unemployment.

In the United States, because of our relatively low minimum wage and hire-and-fire labor laws, this problem tends to take the form of underemployment, rather than unemployment per se. So $28 an hour ex-autoworkers go work at the video rental store for eight dollars an hour.

The same goes for other inflexible factors of production, like real estate. That's why the shuttered factory rivals the unemployment line as a visual image of trade problems.

Dubious Assumption #4: Trade does not raise income inequality.

Even if free trade expands the economy overall (dubious), it can tilt the distribution of income so much that ordinary people see little or none of the gains.

For example, suppose that opening up a nation to freer trade means that it starts exporting more airplanes and importing more clothes than before. Because the nation gets to expand an industry better suited to its comparative advantage and contract one less suited, it becomes more productive and its GDP goes up.

So far, so good.

Here's the rub: suppose that a million dollars' worth of clothes production requires one white-collar worker and nine blue-collar workers, while a million dollars of airplane production requires three white-collar workers and seven blue-collar workers. So for every million dollars' change in what gets produced, there is a demand for two more white-collar workers and two fewer blue-collar workers. Because demand for white-collar workers goes up and demand for blue-collar workers goes down, the wages of white-collar workers go up and those of blue-collar workers go down.

But most workers are blue-collar workers -- so free trade has lowered wages for most workers in the economy!

This is not a trivial problem: Dani Rodrik of Harvard estimates that freeing up trade reshuffles five dollars of income between different groups of people domestically for every one dollar of net gain it brings to the economy as a whole.

Dubious Assumption #5: Capital is not internationally mobile.

The theory of comparative advantage is about the best uses to which America can put its productive resources, what economists call "factors of production." We have certain cards in hand, so to speak, the other players have certain cards, and the theory tells us the best way to play the hand we've been dealt. Or more precisely, it tells us to let the free market play our hand for us, so market forces can drive all our factors to their best uses in our economy.

Unfortunately, this relies upon the impossibility of these same market forces driving these factors right out of our economy. If that happens, all bets are off about driving these factors to their most productive use in our economy. Their most productive use may well be in another country, and if they are internationally mobile, then free trade will cause them to migrate there.

This will benefit the world economy as a whole, and the nation they migrate to, but it will not necessarily benefit us.

This problem applies to all factors of production, but the crux of the problem is capital. Capital mobility replaces comparative advantage, which applies when capital is forced to choose between alternative uses within a single national economy, with absolute advantage. And absolute advantage contains no guarantees whatsoever about the results being good for both trading partners.

Capital immobility doesn't have to be absolute, but it has to be significant and as it melts away, trade shifts from a guarantee of win-win relations to a possibility of win-lose relations.

David Ricardo, the British economist who invented the theory of comparative advantage in 1817, actually knew about this problem perfectly well, and wrote about it in his book on the subject. So there's no excuse for modern economists to ignore it.

Dubious Assumption #6: Short-term efficiency causes long-term growth.

The theory of comparative advantage is what economists call "static" analysis. That is, it looks at the facts of a single instant in time and determines the best response to those facts at that instant. But it says nothing about how today's facts may change tomorrow. More importantly, it says nothing about how one might cause them to change in one's favor.

So even if the theory of comparative advantage tells us our best move today, given our productivities in various industries, it doesn't tell us the best way to raise those productivities tomorrow. That, however, is the essence of economic growth, and in the long run much more important than squeezing every last drop of advantage from the productivities we have today. Economic growth is ultimately less about using one's factors of production than about transforming them--into more productive factors tomorrow.

The theory of comparative advantage is not so much wrong about long-term growth as simply silent.

Analogously, it is a valid application of personal comparative advantage for someone with secretarial skills to work as a secretary and someone with banking skills to work as a banker. In the short run, it is efficient for them both, as it results in both being better paid than if they tried to swap roles. (They would both be fired for inability to do their jobs and earn zero.) But the path to personal success doesn't consist in being the best possible secretary forever; it consists in upgrading one's skills to better-paid occupations, like banker. And there is very little about being the best possible secretary that tells one how to do this.

Dubious Assumption #7: Trade does not induce adverse productivity growth abroad.

When we trade with a foreign nation, this will generally build up that nation's industries, i.e. raise its productivity in them. Now it would be nice to assume that this productivity growth in our trading partners can only make them ever more efficient at supplying the things we want, and we will just get ever cheaper foreign goods in exchange for our own exports, right?

Wrong. Consider our present trade with China. Despite all the problems this trade causes us, we do get compensation in the form of some very cheap goods, thanks mainly to China's very cheap labor. The same goes for other poor countries we import from. But labor is cheap in poor countries because it has poor alternative employment opportunities. What if these opportunities improve? Then this labor may cease to be so cheap, and our supply of cheap goods may dry up.

This is actually what happened in Japan from the 1960s to the 1980s, as Japan's economy transitioned from primitive to sophisticated manufacturing and the cheap merchandise readers over 40 will remember (the same things stamped "Made in China" today) disappeared from America's stores. Did this reduce the pressure of cheap Japanese labor on American workers? It did. But it also deprived us of some very cheap goods we used to get.

And it's not like Japan stopped pressing us, either, as it moved upmarket and started competing in more sophisticated industries.


When Nobel laureate Paul Samuelson -- author of the best-selling economics textbook in history -- reminded economists of this problem in a (quite accessible) 2004 article, he drew scandalized gasps from one end of the discipline to the other. But nobody was able to explain why he was wrong.

They still haven't.

I don't expect most readers to get all the above analysis the first time through. But I do hope that everyone who's read this far now understands that there is no good reason -- regardless of what most economists say -- to assume that free trade is necessarily best. The economic logic of those who say it is, is riddled with enough holes to sink a container ship.

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