Monday, November 3, 2008

Comparative advantages (amv)

Here is one of the best statements of the principle of comparative advantages. It is concise and applied not only to international trade but to exchange as such. We owe it to Steven Horwitz:

“It is through exchange that difference becomes a blessing, not a curse.” So wrote Jonathan Sacks, the Chief Rabbi of Great Britain. In one concise and beautiful sentence, Sacks captured the essence of one of the most fundamental concepts in economics: the idea of comparative advantage and the role it plays in promoting human cooperation through specialization, the division of labor, and exchange.

The concept of comparative advantage was first conceived in the context of international trade, as David Ricardo, writing at the start of the 19th century, recognized that nations were better off when they specialized in the things they could do best and then traded the surplus above what they consumed themselves with other countries specializing in producing what they were relatively best at. Nations that tried to be self-sufficient would impoverish their citizens by trying to produce goods for themselves at a higher relative cost than could their trading partners. Instead, they could enrich their citizens by allowing them to trade for what they couldn’t produce efficiently themselves.

What was key to Ricardo’s insight was that a country could actually be better than a trading partner at producing both, for example, cotton and wine, but that it still made sense for them to specialize in the one of the two they were better at in comparison to that trading partner. That is where the “comparative” in comparative advantage comes from: by specializing in the one of the two that it is comparatively better at, each country can consume what it wishes and trade the surplus for the other country’s surplus. Specialization and exchange enables countries to consume more than they would be able to if each tried to do both themselves. The same logic applies when there are a larger number of traders. Free trade between nations enhances the well-being of all who trade.

Ricardo’s insight, however, goes far beyond international trade. We can apply to the same logic to the ways in which individuals specialize in particular productive activities and then trade their surpluses for other goods. I specialize in producing “economic education services.” I don’t need many of them myself, so I sell just about all of them to St. Lawrence University, who in turn pays me. I take that money and buy groceries, housing, clothing, a car payment, etc. with the proceeds. Each person or organization I buy from has themselves specialized by their comparative advantage and is trading their surplus with me. This process of specialization by comparative advantage, and the resulting division of labor and exchange activity, is the way in which free trade among individuals, households, and firms turns into benefits for all. What works at the level of nations, works at the level of individuals and vice versa. And as with nations, markets allow everyone who can produce positive value to find their comparative advantage and in so doing contribute to the betterment of all.

Notice an interesting aspect of the analogy between nations and individuals: when a country imports more than it exports with another country, we label that a “trade deficit” and it usually worries us. However, when I “import” more food from my local grocery store than I export in the form of “economic education services” that it buys from me (I don’t stand in the produce section giving economics lectures, after all), no one gets panicky about my “trade deficit” with the grocer. In fact, such “deficits” (including St. Lawrence’s “trade deficit” with me) are simply another label for the specialization and exchange process that makes it possible for me to obtain consumption items that are much too costly to produce myself. It is interesting to ask why we recognize the value of such specialization by individuals, but are often quick to condemn it when it involves nations.

Production by comparative advantage also enhances the peacefulness of human interactions. When we specialize and trade, we become interdependent. I am dependent upon the specialization of my grocer to get my food. Students rely on my specialization as a professor to learn economics. This form of social cooperation reduces the incentive for us to harm our trading partners, as harming those we depend upon harms us as well. Once again, what is true of individuals is also true of nations: countries that engage in free trade with each other are much less likely to go to war. Expanding the degree of international specialization through free trade is also a path to increased global peace.

And it is through this process of specialization and exchange that “difference becomes a blessing, not a curse.” It is fashionable these days to extoll the virtues of diversity. Most of the time, those discussions have little to do with economics. That is unfortunate, because once one understands the concept of comparative advantage, one can see how economics helps us to reveal perhaps the most important benefit of diversity: when people are free to produce by comparative advantage and then trade what they produce, human diversity becomes a source of both increased material well-being and expanded peaceful human cooperation. The more freedom we give to people to engage in the market process, the more that diversity and difference really do become humanity’s blessing and not its curse.