Thursday, December 14, 2017

Ricardo's Comparative Advantage After Two Centuries

Two centuries ago in 1817, the great economist David Ricardo published his most prominent work: "On the Principles of Political Economy and Taxation." Among many other insights, it's the book that introduced the idea of "comparative advantage" (especially in Chapter 7) and thus offered a way of thinking about the potential for gains from trade--both between countries and within areas of a single country--that has been central to economic thinking on these topics ever since. In Cloth for Wine? The Relevance of Ricardo’s Comparative Advantage in the 21st Century, Simon Evenett has edited a collection of 15 short essays thinking through how and when comparative advantage applies to modern economies. The book is published by the Center for Economic Policy Research (CEPR) Press, in association with the UK government Department for International Trade.

Most people have no difficulty with the idea that two countries can at least potentially benefit from trade if each one has a productivity advantage in a certain good. There are places in the Middle East where finding oil doesn't seem to involve a lot more than jamming a sharp stick into the ground. Those places should produce and export oil. The United States has vast areas of fertile soil. Those places should produce and export corn and wheat.

But an immediate issue arises. What about areas that don't seem to have a productivity advantage in any area? How can they possibly benefit from trade? Ricardo's theory establishes the point that the key factor in what areas or nations will choose to export or import is not whether there is an overall productivity advantage, but instead where that productivity advantage is greatest--or where the productivity disadvantage is smallest. It is the "comparative" advantage that matters.

In my own Principles of Economics textbook (which of course I recommend for quality and value), I offer a homely example to build some intuition for this idea, involving whether it is useful for a group of campers to specialize in certain tasks. I wrote:
"[C]onsider the situation of a group of friends who decide to go camping together. The friends have a wide range of skills and experiences, but one person in particular, Jethro, has done lots of camping before and is a great athlete, too. Jethro has an absolute advantage in all aspects of camping: carrying more weight in a backpack, gathering firewood, paddling a canoe, setting up tents, making a meal, and washing up. So here’s the question: Because Jethro has an absolute productivity advantage in everything, should he do all the work?
"Of course not. Even if Jethro is willing to work like a mule while everyone else sits around, he still has only 24 hours in a day. If everyone sits around and waits for Jethro to do everything, not only will Jethro be an unhappy camper, but there won’t be much output for his group of six friends to consume. The theory of comparative advantage suggests that everyone will benefit if they figure out their areas of comparative advantage; that is, the area of camping where their productivity disadvantage is least, compared to Jethro. For example, perhaps Jethro is 80% faster at building fires and cooking meals than anyone else, but only 20% faster at gathering firewood and 10% faster at setting up tents. In that case, Jethro should focus on building fires and making meals, and others should attend to the other tasks, each according to where their productivity disadvantage is smallest. If the campers coordinate their efforts according to comparative advantage, they can all gain."
This way of phrasing the situation clarifies the essential economic issue: not who is most productive at various tasks, but how to allocate all of the available productive power across a range of tasks in the most efficient way. In that problem, everyone has a role to play. Even a party with productivity advantages in every area will have areas where their advantage is smallest; conversely, a party who is least productive at every single task will have an area in which the productivity disadvantage is least. Focusing on those areas will provide gains from trade.

Of course, the camping example is just conceptual way of framing how division or labor and trade among friends can potentially provide gains. It leaves out many real world complications, which are the focus of many of the essays in this book. How large are the gains from trade? How will the gains be distributed across the parties involved in the trade? Does trade provide additional gains over time through heightened competition and incentives for innovation? How will trade affect the distribution of income? What are the underlying reasons why countries differ in their profiles of productivity across activities, and to what extent can those reasons be altered by public policy? What happens when comparative productivity levels shift, so some industries no longer need the same number of workers?  Do the potential gains from trade in goods also apply to gains in services? Do the potential gains apply to a global economy with "value chains" of production that cross and re-cross national borders? How do economies of scale fit into the picture? What about trade in similar-but-not-identical branded products, like cars? What is the appropriate reaction when countries erect barriers to trade or when there are persistent patterns of trade surpluses and deficits?

Ricardo actually had thoughts and analysis about a surprisingly large number of these questions, and the essays in this book take up most of the rest of them. Here, I just want to note a few points that seemed worth particular emphasis.

One is that although Ricardo's theory of comparative advantage never disappeared, and has been a mainstay of basic principles of economics for 200 years, there was a period of some decades when it seemed less relevant to the facts of international trade. As Jonathan Eaton explores in his contribution to this volume, Ricardo's basic example of comparative advantage involved one factor of production (labor) and different technology across countries linked to differences in productivity of labor. By the middle of the 20th century, the focus was on models that had a number of different factors of production, and thus chose different methods of production, although they shared access to the same technology. By the 1980s, emphasis had shifted to models of how large firms would trade similar but not identical goods across countries: for example, international trade in cars or airplanes or machine tools.

But perhaps surprisingly, as economists looked at data on international trade with many different products, and explored models where countries differed in technology and productivity, they were led back to a Ricardian framework. Eaton and his frequent coauthor Samuel Kortum were leaders in this modelling. In an essay discussing this approach in the Spring 2012 issue of the Journal of Economic Perspectives, they wrote in the abstract:
"David Ricardo (1817) provided a mathematical example showing that countries could gain from trade by exploiting innate differences in their ability to make different goods. In the basic Ricardian example, two countries do better by specializing in different goods and exchanging them for each other, even when one country is better at making both. This example typically gets presented in the first or second chapter of a text on international trade, and sometimes appears even in a principles text. But having served its pedagogical purpose, the model is rarely heard from again. The Ricardian model became something like a family heirloom, brought down from the attic to show a new generation of students, and then put back. Nearly two centuries later, however, the Ricardian framework has experienced a revival. Much work in international trade during the last decade has returned to the assumption that countries gain from trade because they have access to different technologies. These technologies may be generally available to producers in a country, as in the Ricardian model of trade, our topic here, or exclusive to individual firms. This line of thought has brought Ricardo's theory of comparative advantage back to center stage."
In short, when it comes to the modern analysis of international trade, Ricardo is back! Of course, this isn't the only approach or only set of questions. Indeed, one of the problems in thinking about the effects of international trade is that the patterns of international trade are deeply interwoven with other political, historical and social variables, so extrapolations are hard. For example, it would probably be unwise to believe that if the nations of Africa or Latin America or Asia sought to form a "Union," it would work out in the same ways (for better or worse) as the European Union. The laws about international trade are not the only relevant differences across regions.

Indeed, there is a long-standing argument in economics over whether trade leads to economic growth, or whether economic growth leads to more trade, or whether other external factors (like improved technology and transportation) affect both.

One other essay in this volume that especially caught my eye is by Ernesto Zedillo, and his title reveals his theme "Don’t blame Ricardo – take responsibility for domestic political choices." He writes:
"In the case of politicians opposed to international trade, the arguments put forward vary a lot, from the subtle to the grotesque, but all have in common the deflection of responsibility for domestic policy failures to external forces as the cause of those failures. The most extreme case of such deflection is to be found in the rhetoric of populist politicians, from both the left and the right. More than any other kind, the populist politicians have a marked tendency to blame others for their countries’ problems and failings. Foreigners who invest in, export or migrate to their country are the populist’s favourite targets to explain almost every domestic problem. That is why restrictions – including draconian ones – on trade, investment and migration are an essential part of the populist’s policy arsenal. Populists praise isolationism and avoid international engagement, except with their foreign populist cronies. The ‘full package’ of populism frequently includes anti-market economics, xenophobic and autarkic nationalism, and authoritarian politics. Populists display their protectionism and xenophobia as proof of their ‘authentic patriotism’ and excel at manipulating the public’s nationalistic sentiments to execute their retrograde economic and political agenda, which invariably includes a strong rejection of open markets.
"Unfortunately, asserting a causal relationship between globalisation and domestic ills is the rule rather than the exception even in countries governed by moderate democratic leaders, left or right. It is a rare event that a government confronting serious domestic problems would look first into its own policy failings rather than external causes in dealing with their citizens’ demands for effective solutions. Blaming imports, foreign capital volatility and migrants would seem always preferable to explain phenomena such as slow GDP growth, external disequilibria, stagnant wages, and high unemployment. Taking responsibility for domestic policies – or the lack of thereof – that may be at the root of such problems, even if the latter is flagrantly the case, would seldom happen without first trying to point to external factors as the culprits for the unwanted conditions." 
To put this point in a US context, think of issues like the extraordinarily high costs of the US health care system,  the disappointing performance of K-12 education, the low levels of investment in infrastructure, stagnant spending on research and development as a share of GDP, the looming problem of rising spending on government entitlement programs, problems with the individual and corporate tax code, concerns about the competitiveness of certain sectors of the economy, the appropriate level financial regulation, and the challenges of adapting to changes in robotics, artificial intelligence, and other technological changes. These issues (and others that could be added) make a tall pile of problems; in contract, the contribution of international trade to the US economic issues is pretty small. But it's always a lot easier to criticize the neighbors than to clean up the mess in your own front yard.

One of the stories that economists tell each other about the idea of comparative advantage (mentioned in a couple of these essays is from 1969 Presidential Address by Paul Samuelson, The Way of an Economist," published in International Economic Relations: Proceedings of the Third Congress of the International Economic Association Held at Montreal (and available via the magic of Google Books, quotation is from p. 9):
"[O]ur subject puts its best foot forward when it speaks out on international trade. This was brought home to me years ago when I was at the Society of Fellows at Harvard along with the mathemetician Stanley Ulam. Ulam, who was to become the originator of the Monte Carlo method and a co-discoverer of the hydrogen bomb, was already at a tender age a world-famous topologist. And he was a delightful conversationalist, wandering lazily over all domains of knowledge. He used to tease me by saying, `Name me one proposition in the social sciences which is both true and non-trivial.' This was a test that I always failed. But now, some thirty years later, on the staircase so to speak,  an appropriate answer occurs to me: The Ricardian theory of comparative advantage; the demonstration that trade is mutually profitable even when one country is absolutely more -- or less -- productive in terms of every commodity. That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them." 
It is of course a little disheartening to me that Paul Samuelson, one of the greatest economists of the 20th century, had difficulty coming up with an economic idea that was both true and nontrivial! But it does make a better story that way. I sometimes say to students that understanding the idea of comparative advantage--both its strengths and its limitations--is one of the dividing lines separating those who actually know some economics from those who don't.