Understanding Comparative Advantage

Although the principle of comparative advantage is at work in our lives every day, people often misunderstand it - if they have heard of it at all. Perhaps this is one reason why the vast flows of international trade can seem mysterious, even threatening, and fill people with anxiety about the global economy.

Why do human beings trade with each other? The reality has been around as long as civilization itself - trade was already ancient when Phoenician merchants began their daring voyages through the Mediterranean in the second millienium BCE. Combine this with another observable fact - that countries differ widely in their climate, fertility, and the skills of their populations - and a puzzle was set for the pioneers of formalized political economy in the late 1700s. They came into conflict with a view - common at the time, and indeed still common - that a given nation would be better served by consuming goods of local manufacture, discouraging imports with tariffs or other measures.

The most famous early economist, Adam Smith, attacked this view vigorously in his seminal book The Wealth of Nations (Book IV, Ch. II):

What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. 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....It is certainly not employed to the greatest advantage when it is thus directed towards an object which it can buy cheaper than it can make.

Here, Smith correctly points out that it would foolish to produce at home what can be bought more cheaply in the marketplace, drawing an analogy between the small economy of a household and that of an entire country. Should a family of shoemakers, for example, take the time to make their own clothing? Or would it be wiser for them to spend that time making and selling shoes, and using the earnings to buy clothes from the tailor? Both the tailor and the shoemaker will be better off under the latter arrangement, since they can both specialize in doing what they do best. Likewise, in the case of nations, should a cold country such as Canada try to grow its own bananas? It would be technically possible - Canada could build large greenhouses to provide a warm environment for the fruit - but economically foolish. What Canada would have to spend millions of dollars creating - the right, warm environment for bananas - is enjoyed by tropical countries for free. It would make much more sense for Canada to focus on producing something it's good at (such as grain, beer or manufactured goods) and exchange that for bananas.

Adam Smith assumed that "absolute advantage" is possessed by both parties to a trade. The shoemaker is better at making shoes than the tailor; Canada is better at producing grain than its tropical trading partners. What happens, though, if a person (or a country) isn't better at anything than its potential trading partners? Suppose the tailor is very talented - better at making both clothes and shoes than the shoemaker. Does this mean that the shoemaker is doomed, unable to trade with anyone else?

When translated into the macro-level of national economies, this view seems even more dire. In the mid-1990s, the famous Yale historian Paul Kennedy issued this warning about the perils of globalization:

If the pace of change and intensity of the challenge is too severe, the number of those unable to compete might, in certain parts of the world, be dangerously large and lead to a political and ideological backlash.

(Paul Kennedy, BBC "Analysis Lecture", May 1996)

Kennedy's fear of people or nations being "unable to compete" is analogous to the outclassed shoemaker above. Could not whole countries be forced into poverty, to starvation even, by competition from the hyperproductive West?

Two centuries earlier, this question had been pondered by the British economist David Ricardo. His surprising conclusion was that trade does not depend on both parties having an absolute advantage in some product. The less productive can also benefit from trade - in fact, having more productive trading partners can actually help them. As the French journalist and politician Frederic Bastiat would put it a few decades later, "In war, the stronger overcomes the weaker; in business [trade], the stronger imparts strength to the weaker." (Economic Sophisms, S II, Ch.17)

Unfortunately, these benefits of trade cannot flow to a country's population if its government either blocks commerce or practices some form of corrupt "crony capitalism." As too often happens today, a corrupt regime may permit trade or access to natural resources only to political allies or influential multinational corporations. The regime may grow rich from such deals, but at the cost of neglecting its own population. The country as a whole would be much better off if all of its people had the right to engage in commerce, protected by an impartial and fair legal system.

If you would like to learn more about comparative advantage, investigate the links below. Full texts of many of the cited works are available online, thanks to the Library of Economics and Liberty.

Further Reading - Books

Bastiat, Frederic, Economic Sophisms, Second Series, Chapter 17, "Domination Through Industrial Superiority." The Foundation for Economic Education, Inc. 1996. Trans. and ed. Arthur Goddard. Library of Economics and Liberty.

Hazlitt, Henry, Economics in One Lesson. New York: Harper Brothers, 1946.

This book has stood the test of time because it refutes common economic fallacies in clear, jargon-free language. Chapter 12, "Who's 'Protected' by Tariffs?" deals with many themes of comparative advantage in the context of international trade.

Mill, James, Elements of Political Economy. Henry G. Bohn. 1844. Library of Economics and Liberty.

Mill, John Stuart, Principles of Political Economy.  Longmans, Green and Co., 1909. Ed. William James Ashley.  Library of Economics and Liberty.

Ricardo, David, On the Principles of Political Economy and Taxation. John Murray. 1821. Library of Economics and Liberty.

The famous text in which David Ricardo presented the theory of comparative advantage. He was not in fact the first person to grasp the concept - that honor belongs to Robert Torrens in an 1815 essay - but Ricardo gave it its name and explicated it more fully.

Roberts, Russell. The Choice: A Fable of Free Trade and Protectionism. Updated Edition. Upper Saddle River, NJ: Prentice Hall, 2000.

A highly entertaining "economic novel" that addresses trade issues with logical rigor but without complex formulas. You can read the first few chapters for free here.

Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations.  Methuen and Co., Ltd. 1904. Ed. Edwin Cannan. Library of Economics and Liberty.

The foundational text of economics. Full of insights still useful today, although Smith thought that an "absolute advantage" was necessary for successful trade.

Websites and Organizations

The Center for Trade Policy Studies at the Cato Institute

The Digital Economist's page on comparative advantage.

A more mathematical approach to comparative advantage.

Suranovic, Steven. "The Theory of Comparative Advantage - Overview."

From the International Economics Study Center maintained by the author.