Saturday, August 30, 2008

Adam Smith On Absolute not Comparative Advantage

There are errors and there are double errors in proposing policies in economics. Here’s a typical week-end one:

Matthew Hisrich writes in (HERE):

From bananas and prunes, lessons for an election year’ (30 August)

“The only response that makes sense now is to begin a major overhaul of how we produce and consume potassium in this country. To put it bluntly, we are addicted to bananas.

Fortunately, The Linus Pauling Institute reports that prunes and prune juice are a much better source of potassium than bananas. It is high time that the federal government begin to foster alternative sources of potassium such as prunes by subsidizing their production and launching educational campaigns to help consumers make better choices.

Does this sound like an absurd argument to you? [GK: YES]

That's probably because economist Adam Smith dispatched this line of reasoning to the dustbin of history over two centuries ago. In his classic Wealth of Nations, he gives the example of grape growing in Scotland to make his point. While it might technically be possible, he says, it would hardly make financial sense. Rather, countries would do far better focusing on those areas of production to which they are best suited.

"What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom," Smith observes. "If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage."

What Adam Smith was explaining was the concept of comparative advantage. The party with the advantage in one field benefits by trading with a party who is better in another rather than trying to do everything themselves. Later economists built on this concept with the idea of absolute advantage. This means that even if you would be better at everything than anybody else, it is still in your interest to trade if for no other reason than you have a limited amount of time and resources.”

Adam Smith’s analysis was an example of ABSOLUTE not COMPARATIVE advantage (Matthew Hisrich gets it the wrong way round). Matthew then completes his double error:

Later economists built on this concept with the idea of absolute advantage.’

No, Matthew, later economists, especially David Ricardo, revised Adam Smith’s theory of ‘absolute advantage’ and produced the theory of ‘Comparative Advantage’.

Economist Frederic Bastiat got to this point when he famously said that "When goods do not cross borders, soldiers will."

Unfortunately, experience also shows that because of the perversion of ‘jealousy of trade’ (after David Hume), jealous, rival neighbours, enraged by the movement of another country’s goods across frontiers, their own and their customers, are likely to engage in warfare, or acts that lead to warfare, or at a minimum, punitive tariffs and prohibitions against successful trading nations. If only trade was allowed to enhance harmonious relations, the poisoned minds of ‘balance of trade’ demagogues, of which we have plenty of experience in the18th, 19th, 20th and 21st century, if they gain the ear of legislators, blow increased harmony out of the window.

I listened the other night to remarks by a normally intelligent and balanced professor who was abnormally upset at the balance of trade between China and the USA, considering it placed world trade in dire danger.

He considered it plausible that foreign governments held dollars and US government bonds this placed the cards in Chinese hands who could dump them all at a stroke and bring down the mighty dollar and “what’s left of US democracy” (yes, it’s all George W. Bush’s fault…).

If the Chinese were to dump the US dollars they would liquidate at a stroke their real claims on US assets; if they sold dollars at a discount, their buyers would raise demand for US exports; if they converted dollars for Euro, or Yen, they would transfer their claims on US assets to others. Such are the realities; China is in hock to the US as much as the US is in hock to China.


Blogger Matthew Hisrich said...

Thanks for catching this, Gavin. I don't know that it's so much of a double error as simply an accidental switch of the two names. Do you disagree with the overall premise, or my use of Smith's legacy?

1:13 pm  
Blogger Gavin Kennedy said...

Hi Matthew

I confess that I was not sure which side of the argument you were coming down on -- Smithian freer trade or domestic protection; I support Smithian trade policy and your reference to Smith's analogy with wine production in Scotland being possible but stupid, if we can buy wine from abroad much cheaper, is correct.

The transposition of comparative for absolute advantage is quite common and I tend to comment on the error as part of my role as an educator (albeit retired).

The domestic prunes versus imported bananas issue is similar to Smith's point about Scottish wine production, if that is what you were arguing.

Thanks for your comments.

2:56 pm  
Blogger Matthew Hisrich said...

Hello Gavin

I apologize if it was unclear which side I was coming down on, but I had definitely meant to advance free trade. I was trying to point to the problems with domestic production by taking the argument to the absurd level of banana production in the States, but I realize I could have been more clear.

In any case, I have contacted the editors and hopefully the error will be remedied soon. I do appreciate you catching it - I cringe at the thought of my writing misrepresenting Smith and misinforming readers at the same time.

Keep up the good work!

12:12 am  

Post a comment

<< Home