Sunday, May 06, 2007

If You Must Quote Ricardo on Free Trade, Try to Get It Right!





Gavin Kennedy
People who lead with ‘economics 101’ should take care to get their economics correct when chastising other economists for their failings. A case in point is David Sirota in the Huffington Post (6 May) in his: ‘Econ 101: How Free Traders Distort "Comparative Advantage"’:

"Alan Blinder has a very interesting op-ed in the Sunday Washington Post about "free" trade and job outsourcing. He has been attacked lately for being an economist who is actually pointing out that "free" trade may not be the perfect thing its fundamentalist proponents have been saying it is. Yet, Blinder still falls prey to one of the most insidious distortions that rationalizes "free" trade orthodoxy: the distortion surrounding "comparative advantage." Blinder, invoking "comparative advantage," writes:

"The basic principles of free trade that Adam Smith and David Ricardo taught us two centuries ago remain valid today: Just like people, nations benefit by specializing in the tasks they do best and trading with other nations for the rest."

“But here's the problem - Ricardo's "comparative advantage," which when it works does bring on beneficial specialization, isn't what's going on most of the time with "free" trade today.” U.S. Sen. Byron Dorgan (D-ND) … explains what the theory of "comparative advantage" is:

"Time and time again, companies decide that they can move their jobs to Mexico, China, Indonesia, or other countries to save costs and boost profits...Economist say it is just something called 'comparative advantage' in action [and cite] the theory developed by David Ricardo in 1815 [who] used an example of trade between England and Portugal...The English-Portugese example described a natural comparative advantage each has with respect to the raising of sheep and the growing of grapes. It has to do with the climate and the soil, etc."

Oh dear. I am not sure that US Senator Dorgan is right in his apparently appealing scientific argument (did his speech writer pay attanetion in his Economics 101 class?).

I have no comment on his political case against free trade – US politics is dominated now by the run up to the Presidential election and we can expect hyperbole and spin by the bucket load. Anyway I do not comment on another country’s politics; I only comment on my own country’s in my own country.

The Senator and David Sirota confuse ‘absolute advantage’ with ‘comparative advantage’, which is not surprising because many Econ 101 students do so as well, and the Senator or Sirota were not paying close attention when they, presumably, attended their 101 classes, however, long ago.

Adam Smith analysed absolute advantage: countries trading goods in which they have an absolute advantage (he quoted wines which do not grow well in Scotland’s climate) will both benefit from the exchange. This was based on specialisation in the sense argued in the article.

David Ricardo, on the other hand – as we economists are fond of saying – extended the absolute advantage case to the comparative advantage case. In this situation, countries gain from trade by trading goods in which they have a comparative advantage.

Suppose two countries both produce aircraft and home entertainment systems. Further Amex is better than Chungwa in producing aircraft and also better that Chugwa in producing home entertainment systems, but not by so much as it is in aircraft. In short, it is better than Chungwa at producing both of these goods.

Should they still trade? Ricardo’s comparative advantage theory says ‘yes’. Amex should produce aircraft and exchange them with Chungwa for its home entertainment systems, because they would both be better off. How so?

Amex should specialise in goods for which it has the highest comparative advantage over Chungwa (aircraft) and not devote resources to producing home entertainment goods, which though it is better at doing so than Chungwa, it is better by a smaller margin. Resources in Amex devoted to home entertainment production, in which it has a small comparative advantage over Chungwa, are better devoted to aircraft production, in which it has a much greater comparative advantage over Chungwa.

The Senator and Sirota appear not to understand Ricardo’s theory, though they both call it into play with the confidence of those who may not know what they are talking about.

If the above economic example is a bit difficult for current Econ 101 students (and for those not paying attention when they were in their classes), try this example of comparative advantage.

David Sirota is a very busy journalist and broadcaster. Let us imagine he is extremely busy, so much so that he is hard at work most of the time. Further, he is busy because he is in great demand as a talented professional journalist and broadcaster, as is obvious from his profile.

However, suppose he is also greatly talented as a PC and Apple user, so good at these tasks in fact that he has never met a secretarial assistant as good as him at preparing his articles and books for press. Now, good as the best of the secretaries he hires are, while some comes close to his own secretarial skills, none have bettered them. And none of them come anywhere near him in his ability to conceive of articles, themes for books, and do the creative part of his journalistic and broadcasting work.

Now, because he is much better than his secretarial staff at both journalism and broadcasting, for which customers are keen to pay him small fortunes a year, should he do his own secretarial work because he is better at this work by a small margin than the very best of the secretaries he can hire?

Surely not! David should concentrate all of his time on journalism and broadcasting for the high incomes it brings him and his family, and he should hire a secretary for his secretarial work. Diverting any of his scarce time to secretarial work, even though he could do it better than his secretary, would reduce his income by the time he spent away from journalism and broadcasting doing secretarial work what somebody else, while not as good as him, nevertheless is good enough for that job.

Why? Because his comparative advantage is highest in the work he does better than his secretary could do in his place, and it is smallest as a comparative advantage he has over his secretary in the work his secretary does in place of him.

That is the real meaning of the gains from trade in comparative advantage according to Ricardo, and it is quite different from the presentation David (and the Senator) put together under the guise of sarcasm about Economics 101 and false claims about ‘insidious distortion’. Read David's column here.

Methinks I hear somebody whispering something about ‘kettles and pots’….


Blogger cbr said...

Not being a student of economics please excuse the noobish observations.

Your example for the theory appear based upon the assumption that there is a limiting factor that shifts work from 2 areas to one specialization. As I ponder this I don't see that in action. In a free capital market, capital from Chungwa would seek investment in either area of comparative advantage in Amex so capital would not be the limiting factor. Labor flexibility has a built-in temporal limitation so each industry in Amex would first seek to increase productivity rather than move and retrain workers from other industries. That would increase their competitive advantage over Chungwa. And even if full employment was happening, migrant workers could extend the competitive advantage that Amex would maintain in both areas. Finally human nature is to preserve what they have so the less lucrative but still successful Home entertainment systems industry in Amex would not voluntarily fold up or ship out, and neither would the Political leaders act to give Chungwa the Home entertainment industry. So Chungwa would get back likely the lesser returns of investment in Amex's Home entertainment industry while loosing whatever the local production's monetary and non-monetary benefits were when they close up as Chungwa's borrows to buy the cheaper goods from Amex. This could lead to a loss of infrastructure (say mass public education) in Chungwa, with a loss in standard of living for many and finally a basket case where wages and currency hit the bottom. Indeed looking at some poorer countries that have gotten poorer over the last 50 years maybe that is the case.

The countries that have not yet sunk to the bottom are those that had an accumulated wealth from years when trade was more local and internal, allowing for Companies etc. to gain value especially the intangible sort (IP, Brands, Structure etc.) that the capital markets often over-value.

5:56 am  
Blogger Gavin Kennedy said...

Thanks for your comment CBR. As a non-economist you show commendable facility in economic argument.

My post was an exposition of the David Ricardo model (1817), which the original article by David Sirota had completely gotten wrong. I showed what Ricardo actually said, using a two-product, two-country model at its simplest.

I was not making a comment on the content of David Sirota’s article against free trade, which would require a longer article.

However, I am delighted to respond to your interesting points. Outside the two-country model, the trade induced changes would be complex. Here we have to deal with trends and tendencies and not adjustments at infinite velocity. The real world is not a mathematical equation.

Countries produce more than two commodities, and they would continue to do so under free trade. Product cycles are not synchronised and rates of innovation are uneven. With free trade there would be free competition and the dynamics of change would work, slowly and gradually.

The main effect of one country having comparative advantages in certain commodities (longer experience in them, greater infrastructure support, higher productivity, or whatever) would be a tendency to concentrate on those that it had the higher comparative advantage and, from free trade and free competition, gradually shift out of producing those in which it had the least comparative advantages, probably under price competition from imports, as well as out of products in which it had disadvantages once rival countries solved shipping costs and quality problems.

In case of new technologies, both Amex and Chungua (and all other countries) would expand those new products in which it discovered comparative advantages over others.

Assembling aircraft could conceivably drift to another country, if the gain more from assembling aircraft than it does from other activities, including home entertainment.

If we assume no capital or labour shortages, then it could continue with both. However, once you allow for elastic factor supplies, you may also introduce continual technical progress across all products, which in capitalist economies is Schumpeter’s
‘perennial gale of creative destruction’ and this drives employment and capital formation suitable for all product innovation and endogenous technologies. In that mutual competition, adjustment and change, the thriving free trade economies flourish.

Protected trade regimes may also enjoy such technological change but it would be slower, less certain, and may be inhibited by protected monopolies enduring longer than they would otherwise last with political support from allies in the State.

Chungwa’s prospects for domestic prosperity from access to world markets, even though not fully reciprocated for a while, will in time cause it to open itself to adjustments in exchange rates and to domestic pressures to loosen State controls on wages, conditions and labour practices.

In China’s case, these trends are already happening at the grassroots’ level. Amex, with its more open society, may adjust quicker and with less dislocation, as it withdraws from products using scarce labour and capital resources which have more productive uses elsewhere in the economy.

Consider that forty years ago there were few jobs in entertainment (all media), now there are millions. There are fewer jobs in heavy industry, agriculture and manufacturing, and there would be fewer still with no loss in consumption if the protection imposed by the Government’s legislators were slackened and eventually removed.

Brand building takes time, I agree, but how many post-War brands are sourced from Japan compared to pre-War: In the next thirty years, how many new brands will be sourced in China and India? Growth is not at the expense of America or Europe because it is non-zero sum activity.

1:18 pm  
Blogger Paul C. said...

I am currently taking economics 101, and recently came across a discussion of comparative advantage published in the Quarterly Journal of Economics (1958) that I found interesting but difficult to fully understand. In the article titled "An Economic Justification of Protectionism," Everett Hagen argues that "real income will be increased by protectionism if, assuming factor costs identical in agriculture and industry, the economy could produce the industrial product at a lower cost,expressed in units of agricultural product, than the import price." This seems to be saying that one country could have a comparative advantage in making telephones relative to growing apples, but under free trade agreements is relegated to growing apples because another country has an absolute advantage in making telephones. Hagen seems to be arguing that in this case, it's worth it to subsidize the telephone making industry. But how do you measure a comparative advantage when imports are involved? Is this a current theory that still holds water?

8:25 pm  
Blogger holy roller said...

Paul C, After reading your comment I was quite interested in the argument and looked up the article. I did not find the main argument (section 3) very clear at all, probably because the author is using a framework and corresponding terminology that are outdated (in any case, many of the key terms are not defined or explained very well.) So it is hard to say why the author claims the "domestic exchange ratio" differs from the "transformation curve" or the marginal rate of transformation. What is clear from the previous sections, however, the author is concerned with disequilibrium factor prices, and so this is likely a non-market-clearing model of trade. Given this, my guess is that the article adds to the list of exceptional cases, such as economies of scale and infant industries, where free trade does not necessarily result in efficient outcomes.

4:55 am  

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