“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.
Courtenay email -
Welcome to the November edition of Ask the Professor. We are pleased to once again have with us Steven Horwitz, Charles A. Dana Professor of Economics at St. Lawrence University in Canton, New York.
Please remember to regularly refresh your browser throughout the discussion to see the latest comments.
Steve Hogan email -
I'm curious to know if you've ever debated Paul Craig Roberts, Pat Buchanan, or other anti-free traders. How did come out?
Dr. Horwitz writes:
I have never debated either of those two. I don't think I've ever debated free trade issues in a public forum like that and certainly not with a major name. I've done it in college classrooms and I'm giving a talk on the topic for two classes on my campus on Tuesday. So the answer is no.
Sam Phillips email -
If a small country imposes a tariff on an imported good, domestic sellers will gain surplus, the government will gain tariff revenue, and the domestic consumers will gain consumer surplus. True or False.
Dr. Horwitz writes:
False, at least as presented. It's true that domestic sellers may well gain surplus as they can now raise prices to just under the imported good's tariff-augmented price (assuming that's above the domestic sellers' prices, which is the whole point of imposing a tariff after all). It will depend upon the elasticity of demand for the good of course: if the good is inelastic, surplus will increase. If the good is elastic, or has many substitutes, then the higher price/tariff could cause a loss in surplus.
The government's gain is subject to the same calculation. If the imported good has substitutes (imagine a tariff on butter - people will just buy margarine), people will buy those non-tariffed substitutes and gov't could well lose revenue.
Domestic consumers will surely be hurt. The tariff denies them access to a cheaper good they'd prefer to have, so either they must buy the more expensive domestic version or they must switch to a less preferred substitute. In either case, domestic consumers lose surplus as a result of the tariff.
Bottom line: tariffs concentrate benefits in the hands of a few and disperse the costs among many.
Matt Gordon email -
You talk about how 'diversity' benefits trade in the form on comparative advantage, however wouldn't the specialization that comes from comparative advantage reduce diversity within each country?
With countries specializing, that seems to inherently reduce the diversity of professions within that country.
Also, industries in different countries may do things differently- and some of that difference may be beneficial. But with the destruction of that industry in a country those beneficial differences may be lost because of something as simple as rising labour costs have made that country uncompetitive. Still, the beneficial 'technology' differences may be lost when the industry folds in that country.
Dr. Horwitz writes:
An excellent point Matt. In fact, we see exactly what you are noting: countries don't specialize in just one or two things, especially large and diverse ones like the US or Canada. The simple sort of examples used historically (as well as in my essay) are just designed to make the point as clearly and basically as possible. In the real world we certainly see countries and even regions engaging in a diversity of productive activities. That said, we still see patterns that reflect comparative advantage: the US devotes many fewer resources to agriculture (in percentage terms) than do smaller countries where such activity really is a comparative advantage.
Also, industries in different countries may do things differently- and some of that difference may be beneficial. But with the destruction of that industry in a country those beneficial differences may be lost because of something as simple as rising labour costs have made that country uncompetitive. Still, the beneficial 'technology' differences may be lost when the industry folds in that country.
Maybe, but if that technology difference really is one that matters, wouldn't competitors in other countries have every reason to try to adopt it in their own activity? Of course, it could be that the technology in question was
Matt Gordon email -
A country's production is nothing more than the sum of its people's production. I concede that industries that truly rely on geography like the two you mentioned, cotton and wine, should be specialized by the country/region with comparable advantage. However the world today is filled with service jobs - making movies, teaching students, engineering new technology etc. - and although there are infrastructure requirements for these jobs, it is the knowledge, creativity and training of the labour force that drives these industries.
Dr. Horwitz writes:
Sure, but don't different countries still have different comparative advantages at such things? For example, the US seems particularly good at producing movies, while Japan seems relatively better at certain types of high-end technology. The move to services and human capital doesn't change the fundamental point.
Matt Gordon email -
In the world today, free trade does not mean the free movement of labour. So someone with the ability and desire to enter into one of those 'knowledgeable service' may not be able to if they are born outside the countries that specialize in their industry and if that student lacks the capital to train for that career internationally.
Dr. Horwitz writes:
Well, if it were up to me, free trade *would* mean the free movement of labor. People who argue for the free movement of goods and services across national boundaries but deny the same freedom of movement to people are being inconsistent and missing the real point, which is that trade is mutually beneficial, including the exchange of labor for wages.
As for lacking the capital to train, yes that can be an issue, but that's always been a potential problem even domestically. It's not clear to me why adding the international dimension matters that much. There are all kinds of ways we might talk about enhancing the ways in which students get better access to training, but I don't see how that problem invalidates free trade.
Matt Gordon email -
If, however, there were protective taxes in that persons country to keep the industry that he has the ability and desire to join, then the company can train him and that person could be more productive than if he had given up and taken a local job that he had no desire for. What I'm trying to say is that geographic/country specialization may not be efficient when the driving factor is individuals who need to be nurtured. Mind you, with globalization in the form of international work teams and e-commuting, firms do seem to be capitalizing on this.
Dr. Horwtiz writes:
Perhaps, but here's two sets of questions:
1. How will governments know which industries require "protective" taxes (and how high a tax), and what's to prevent such a process from becoming politicized, where those firms with the best access to politicians get the protection, regardless of their objective need? See the bailout in the US for just such a case.
2. What about consumers? The protective tax you propose would raise the costs of those industries' products to consumers. Aren't you just redistributing wealth from a large group of consumers to a small group of workers and firms? What justifies that?
What I'm trying to say is that geographic/country specialization may not be efficient when the driving factor is individuals who need to be nurtured. Mind you, with globalization in the form of international work teams and e-commuting, firms do seem to be capitalizing on this.
Indeed. E-commerce and tele-commuting has dramatically reduced the barriers to the movement of labor.
Great questions Matt.
Jason Kneely email -
What is your opinion of the Auto industry's pleas for a bail out? Doesn't this suggest that they are not competitive enough to stay profitable? I read an article in a newspaper recently that said new car sales are actually doing better this year than in previous years - so I'm assuming they meant FOREIGN car sales. Any thoughts?
Dr. Horwitz writes:
Lots. :) Bailing out the auto industry would be a horrible mistake. And I say that as a native Detroiter, with many family members still living there. It would, in the short run, devastate my city, but bailing them out would be far worse - sort of like giving free drinks to an alcoholic uncle. There's no doubt that the US car companies make an inferior product at a much higher cost than their foreign competition. If any or all of the big 3 went into bankruptcy, their physical assets and their workers don't disappear. Instead, the factories and workers would likely get bought up by another manufacturer, presumably at a cheaper price for the machinery and at lower wages for the labor. That is exactly how to make the industry profitable again.
Yes, workers will suffer losses in wages, but the alternative is to make the rest of the country suffer with higher taxes, misallocated resources, and lousy cars. The bailout is primarily an attempt to save the jobs of auto execs and keep the much higher than the competition benefits for auto union workers. Letting those companies fail will not destroy the North American economy. In fact, it will help it by reallocating those resources into more capable hands. It is, after all, a profit AND LOSS economy we live in. If we keep trying to prevent the losses, we're going to really do damage.
Scott Weldon email -
So if we know that free trade creates lower prices for consumers (aren't we all consumers after all?) then what's with the remaining trade barriers today? Is it purely the result of protectionist politicians trying to buy lobbyist votes? Or is there a more complex answer? Thanks.
Dr. Horwitz writes:
I think it's more or less that simple! There *are* specific groups who benefit from protectionism: all those associated with the firms in the protected industries, from owners to managers to workers. They all have a strong incentive to ask for protection and politicians think they can get votes by giving it to them. I also think there is economic ignorance that accounts for support for protectionism more broadly. People just don't understand the issues and see jobs disappearing from "their" country (and don't see the ones being gained, nor the lower prices) and want to save them. It's an understandable, if wrong, perception.
The other point I'd make is that even though "we" are all consumers, the problem is that the gains to us from free trade (or the harm from protection) is relatively small per person, subtle, and accumulates over the long run. By contrast, the gains from protectionism (or the losses from free trade) tend to be concentrated in the hands of a few, more visible, and more short run. The result is that the concentrated beneficiaries of protectionism have a larger incentive to argue their case and can seem to point to more obvious evidence on their side. As a result, they tend to win the day politically not because their case is objectively better, but rather that the very nature of the gains and losses are such that they have a larger incentive to plead their case to Ottawa or DC and their voice carry the day. The incentive each consumer has to argue for free trade is much less because our per-person gain is less than the per-person loss on the much smaller group harmed by free trade.
That asymmetry between costs and benefits explains a lot of government intervention.
Jason Kneely email -
What about bailing out the financial sector? Is there a difference? I figured it would be important to improve the public's confidence in this sector by having the US government backing the bad loans. National and local banks don't *compete* with other national banks after all, right? So the concept of comparative advantages would not apply here, correct?
Dr. Horwitz writes:
No difference. I have a long piece arguing that the whole financial mess in the US is the result of government intervention and that the bailout only makes things worse. I'll give the link below. You might note that the original plan for the bailout has been abandoned, expanded, reworked, expanded again etc several times. And the demands from the car companies are part of that. Once you put a pot of money out there, everyone's going to want some and politicians will find it tough to say no, as they can get votes that way. So even the best designed bailout will get blown up by the political process.
That said, there was no need for it in the first place. Again, let them fail. This was not the whole US financial system in trouble, rather a small number of banks, yes many of them large, who were tied up in the mortgage market mess. Most US banks were/are fine, and credit, contrary to reports, continues to flow. My own view is that the bailout represented an attempt to save a small group of bankers who had political influence (concentrated costs/benefits again) and knew they had friends in DC. The credit crunch arguments were/are overblown but they did make an effective tool for convincing people to get on board the gravy train.
If several larger banks had failed, it would not have led to a catastrophe. Those banks DO compete with each other, and they too have to exist in a profit and loss system. Protecting banks from losses only makes them more likely to take bigger risks next time.
My thoughts on the crisis are here: http://myslu.stlawu.edu/~shorwitz/open_letter.htm.
Praveena Singh email -
Is it possible to fake a competitive advantage by keeping the value of your currency artifically low like China does? What do you think the economic result would be (notwithstanding the current economic crisis) if China let the yuan float? Would established industries crumble?
Dr. Horwitz writes:
I'm not sure I'd describe it as faking a comparative advantage (note you said "competitive" - I"m assuming you meant "comparative"). Keeping your currency artificially low certainly distorts the economic well-being of your country and will specifically throw off imports and exports. If they allowed the yuan to float, China would have to make a whole bunch of changes in resource allocation as a floating yuan would likely reduce their net exports. That would mean some industries would lose out and others would gain. In the absence of freer markets there, knowing which ones would be a real challenge for the government.
Courtenay email -
Great chat so far, everyone! Just a reminder that we only have 15 minutes left in this session, so please post any remaining questions for Dr. Horwitz now. Thanks :)
Econ Sean email -
What do you think about the whole environmental/global warming movement and its effects on free markets and allowing comparative advantages to evolve naturally? What effect do you think caps on carbon emissions would have on the ability of certain domestic industries to compete internationally when less-developed countries could continue to pollute as much as they like (such as China)?
Dr. Horwitz writes:
Complex questions Sean. Here's just a few thoughts on this very broad topic:
1. One need not deny the existence of global warming to believe that large-scale government programs are needed to deal with the consequences. As we've seen in the current crisis, governments and others love to use fear as a way to make people ask the government for "help." Much of the environmentalist movement has, in my view, overblown the real risks involved and thus created a climate (no pun intended) of fear around the issues, especially among the young. We need to do much more sober science and figure out what we do and do know now. Then we need some equally sober *social science* to think about how to resolve the problems.
2. The danger of overreacting is exactly as you say. One reality is that no country is going to get out of poverty without creating some pollution and other environmental effects. Attempts by the developed world to push our standards on the developing world are a recipe for continued poverty there.
3. Overly constraining our own industries will impoverish us as well, at least in relative terms. One of the interesting bits of history is that private firms have been at the forefront of figuring out how to use their byproducts productively. If firms really are such greedy profit-seekers, why would they just "throw things away"? Why wouldn't they figure out a potential use for them? There's lots of evidence that historically, they've done just that. The trick now is to not prevent firms from finding ways to reduce their emissions and/or find uses for them and other waste products. Gover
Courtenay email -
A big Thank You to Professor Horwitz for joining us today. This concludes our discussion on Comparative Advantage.
Join us next time on Friday, December 19th at 11:00am Pacific to discuss Consumption, Savings, and Economic Growth. An introductory article will be posted shortly.
