Friday, April 06, 2007

Testing for Comparative Advantage and Economics or Sociology?

When I taught undergraduate economics (1970 to the mid-80's)there was a regular question in tutorial exercises in Economics 101 concerning the theory of comparative advantage (attributed to David Ricardo). It was used to sort out the undergraduates among those who should be encouraged to go on to Economics 102 and those who should be encouraged to transfer to sociology.

It still seems to be a problem among economists working in the media.

In the "Isle of Man today", Peter Sharkey publishes a column called “PETER SHARKEY'S INVESTORS' DIARY" which includes the following paragraphs:

"ALTHOUGH Adam Smith is rightly heralded as the father of modern economic thinking, it was his neoclassical successor, David Ricardo, who added a crucial international element to economic thought by developing his law of comparative advantage.

Ricardo realised that if countries specialised in producing certain goods and services, they could trade with each other by exploiting their respective comparative economic advantages.

To simplify matters, Ricardo chose to measure all costs in terms of labour, a gauge which remains relevant today, not just in terms of how cheap or expensive labour is in different parts of the world, but how productive it is.

According to a paper published by the World Economic Forum (WEF) recently, true competitiveness is measured by productivity, a conclusion which suggests that Ricardo's theory still holds true.

Greater productivity not only increases output, but it creates time for people to explore other opportunities or even to enjoy their leisure time.

It follows that productivity is a function of (among other things) technological improvement, more efficient capital goods and, critically, a better-trained workforce.

For the last century, these factors have led to a halving of average working hours, while per capita gross national product has risen six-fold.

Greater productivity results in higher wages, better returns on capital and a higher standard of living. A productive economy, therefore, is a competitive one and vice versa."

It isn’t just that comparative advantage promotes specialization (because absolute advantage also promotes specialization). It is that a country can gain even if it is better at producing all traded goods than its partner; if it specializes in producing those goods that it has a high comparative advantage in and exchanges its output for goods produced by a partner over which it has a lower but positive comparative advantage than the partner, they are both still better off.

This did not just apply to trade between two countries, as implied in Peter Sharkey’s observation; it also applies in the general case of two employees dividing up the work as illustrated below:

A professor may be a better teacher and a better administrator of classes than her assistant, but by her specializing in teaching and the assistant specializing in administrating the classes, both become better off.

Another example could be from football. John may be both a better goal scorer and a better defender than Fred comparing their comparative advantage. But if John is comparatively better at goal scoring than defending, and better at both goal scoring and defending than Fred, it would still make sense to have John specialize in goal scoring and have Fred specialize in defending, for the team to do well in results, compared to John trying to both score goals and defend. He should specialize in what he is best at. Fred should specialize in defending if John is far superior in goal scoring, whereas if Fred, while well short of John’s skill at goal scoring, is only marginally worse than John at defending, he should become a defender and not a goal scorer.

With John working fulltime on scoring goals and Fred working fulltime on defending, even though marginally worse than John at defending, both players can be expected to do better than dividing their time between the two tasks.

The distinction was not only about the ‘international dimension’ that Ricardo allegedly ‘introduced’.

The distinction between Adam Smith’s presentation of absolute advantage (he used the example of growing grapes in hothouses in Scotland to make wine instead of buying it from Europe) and Ricardo’s introduction of comparative advantage (he used the examples of trading port from Portugal for wool from England) was not just the ‘international dimension’; it was the counter-intuitive principle embedded in comparative advantage.

[Read Peter Sharkey’s article at:]


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