Paul Samuelson, nobel laureate and author of what was for many years the best-selling economics textbook (Economics, first published in 1948), was challenged in 1969 by mathematician Stanislaw Ulam to name one proposition in the social sciences that is both true and “non-trivial” (i.e. it’s not obvious, and has useful applications). It took Samuelson some years, but in the end he stated that the theory of comparative advantage met this test.
This theory “demonstrates” that the best outcomes for all countries will be achieved if they all follow a policy of free trade. The theory was formulated by English economist David Ricardo (1772-1823) and published in On the Principles of Political Economy and Taxation (1817), though the name was subsequently coined by John Steward Mill.
As to the theory being “true”, Samuelson believed that the mathematical formulation of the theory “proved” that it was true.
For this, we can go back to Ricardo’s original formulation. He used a simple example of a world economy consisting of two countries, Portugal and England, producing 2 goods, wine and cloth. In his example, Portugal can produce both goods with less labour (i.e. more efficiently). Thus, Portugal has an absolute advantage in the production of both goods. But this difference is greatest in the production of wine. Ricardo shows mathematically that the best outcome for both countries is if England produces only cloth and Portugal only wine – the two economies will produce the greatest combined value of goods in this scenario, and thus consume the greatest quantity of both wine and cloth. Although Portugal has an absolute advantage in the production of both goods, England is said to have a comparative advantage in the production of cloth.
Followed through to its logical conclusions, this theory means that every country benefits from free trade, even if it has no advantage in the production of any good.
There are known to be various flaws in the theory and its assumptions, yet this example is cited ad nauseam in economics textbooks and the theory of comparative advantage is trotted out like a religious catechism whenever an economist needs to justify free trade. In a single post I can only cover some of the most relevant flaws. For examples of detailed academic critiques see this paper by Professor Steve Keen, or this one by Professor Matthew Watson.
First of all, the theory ignores the problem of “sunk costs”. If Portugal has businesses that have already invested heavily in cloth production, and England in wine production, it is a false economy to scrap these investments and move into the industry of comparative advantage. One of the assumptions underlying the theory of perfect competition, which is the basis of mainstream economics, is that there is “easy entrance and exit into a market”. In other words, if it is seen that there are higher profits in one industry, it is easy for producers to close down their current production and enter this new production. The reality is that if a region has invested in the infrastructure to support a specific industry, and has a large workforce trained and experienced in the relevant skills, it cannot simply suddenly switch across to the new one. The problems of allowing a “non-competitive” industry to decline are detailed at length in the previous section of the blog on Distribution, but particularly in this post on coal mining in South Wales.
Secondly, it is a simplistic model that ignores the diversity of costs of production within any country. Ricardo made up a simple example with two countries producing two goods. But it would be reasonable to assume that, say, the land for wine production in Portugal in this example is the best available land for this purpose. If production is expanded it would have to extend to less ideal land, and thus the man hours required will go up and/or the quality will go down. In his book How Rich Countries Got Rich… and Why Poor Countries Stay Poor, Erik Reinert gives numerous examples of this dynamic in developing countries that were encouraged to focus on the production of raw materials in which they supposedly had comparative advantage, but who subsequently saw increasing costs and therefore declining profits as production extended to marginal land (see, for example, pages 156-7 for a discussion of the banana industry in Ecuador, or Appendix III).
And this leads onto the most important point – one that is at the heart of Reinert’s own theory – this simplistic example supposes that the economy reaches an equilibrium of optimal production. But innovation is continuously happening. We have already seen that Britain had to protect its textile industry from cheaper cotton imports, otherwise that industry would have been wiped out. And if it had been wiped out, it could not have made the technological innovations that placed that industry at the heart of the industrial revolution.
We have also noted that this is a pattern in industrialisation across the world – it begins with textiles, an industry which requires a plentiful supply of cheap and docile labour, but as this raises skills and industrial capacity within that region it proceeds onto more technologically advanced industries, such as household electronics. Economies are not static, and today’s leading technology might be tomorrow’s obsolescent one. Any country therefore needs a diversity of industry to spread its risks, and in particular needs industries that provide opportunities for innovation and technological development.
It turns out that the “comparative advantage” of the West has been in advanced technological industries, while that of developing nations has been in raw material production. Obviously, any country that hasn’t yet developed industrial capacity is not going to have a comparative advantage in this area. The application of the theory of comparative advantage, as promoted by the Washington institutions of the US Government, the IMF and the World Bank, told developing nations to “specialise” in their area of comparative advantage – raw material production. Such an approach condemned these countries never to develop industrial capacity.
Meanwhile, those countries at the forefront of technology continued to innovate and develop new technologies – the gap between the most and least technologically developed simply grew wider and wider, because those at the back of the race were being told that there was no point even attempting to compete and, as mentioned 2 weeks ago, were not granted access to aid unless they agreed to play by the rules set by the richest nations.
One fact that is absolutely ignored in mainstream economic thought is the vast difference in price between raw materials and the goods manufactured out of those materials. In technical terms, the value creation of processing raw materials vastly exceeds that of extracting raw materials. The most intelligent path for all developing nations would have been to develop the industry to process the raw materials in which they were abundant, using various protectionist methods, just as Western nations did in previous centuries. Instead, the political dominance of the Washington consensus forced them to focus on their “comparative advantage”, preventing them from treading the path that would have lifted them out of poverty.
As stated last week, I am not advocating protectionism over free trade. In that post I presented List’s theory, that protectionist measures need to be used judiciously, for a limited time, on a path to regional and then global free trade. It is not a simplistic advocacy of protectionism, but rather a well thought out approach, based on empirical evidence.
The theory of comparative advantage stands in stark contrast – a simplistic theory that can be logically demolished quite easily. And yet, it dominated mainstream economics for generations. It was the only theory that Samuelson could present as being provably true, and yet see how easily it is disproved. How did economists, and then politicians, and then the general public, allow themselves to be so misled?
Comparative advantage provided a spurious argument for free trade that can only satisfy those who don’t actually want to think, but merely want to feel that the wealth they have gained from the global economic system is justified. And this need for those who benefit from an unequal distribution of wealth and opportunity to feel justified in their privilege is at the heart of why the myths described in this section of the blog are able to prevail with such dominance.
Next week we will look at the political and moral philosophy that is at the heart of this justification.