Working Paper WP-1148-E September, 2016 COMPARATIVE ADVANTAGE Antonio Argandoña IESE Business School University of Navarra Av. Pearson, 21 08034 Barcelona, Spain. Phone: (+34) 93 253 42 00 Fax: (+34) 93 253 43 43 Camino del Cerro del Águila, 3 (Ctra. de Castilla, km 5,180) 28023 Madrid, Spain. Phone: (+34) 91 357 08 09 Fax: (+34) 91 357 29 13 Copyright 2016 IESE Business School. IESE Business School-University of Navarra - 1
COMPARATIVE ADVANTAGE Antonio Argandoña 1 Abstract This is an entry for the second edition of Sage's Encyclopedia of Business Ethics and Society. It provides a brief explanation, with examples, of the nature and significance of the concept of comparative advantage in economics and its ethical implications. Keywords: Comparative advantage; Trade; International economics; Ethics 1 "La Caixa" Chair of Corporate Social Responsibility and Corporate Governance IESE Business School-University of Navarra
COMPARATIVE ADVANTAGE Introduction The theory of comparative advantage states that trade between two countries can benefit both if each country exports the goods for which it has a relative comparative advantage. David Ricardo coined the term in 1817. The principle explains the benefits of free trade and has a clear ethical significance. This entry will explain the content of the theory and its economic and ethical implications for a nation s economy. IESE Business School-University of Navarra
The Economics of Comparative Advantage Let us assume that, given the endowment of factors of production (labor, land and capital), a worker in Foreignland is able to produce one unit of cloth or one unit of wine per day, whereas in Homeland a worker is able to produce four units of cloth or two units of wine of the same quality per day. On the face of it, Foreignland seems likely to be excluded from trade, as Homeland has an absolute comparative advantage in both products. However, the inhabitants of both countries will be better off if the workers of Homeland specialize in producing cloth and export part of their output to Foreignland, while the workers of Foreignland concentrate on producing wine and sell some of it to Homeland. In Foreignland, the opportunity cost of wine in terms of cloth is 1 (to produce one unit of wine a worker in Foreignland has to forgo one unit of cloth), whereas in Homeland the opportunity cost is 2 (four units of cloth for two of wine). It is more profitable for the Homeland workers to produce only cloth, in which they are relatively more productive, even though they are also more productive than the Foreignland workers in producing wine. Trade between two countries benefits both if each specializes in the products in which it has a relative comparative advantage the ones it can produce at a relatively lower cost. This argument can be applied to many countries, factors, and products. The main conclusion remains the same, though the details get more complicated. For example, the existence of more than one factor of production reduces the tendency toward specialization, and transportation costs may interfere with trade and specialization. Several theories of international trade derive from the theory of comparative advantage. Examples include the Heckscher-Ohlin theorem, which states that, under certain conditions, an economy will tend to be relatively effective at producing goods that are intensive in the factors (labor, land, capital) with which the country is relatively well endowed. The Stolper-Samuelson theorem states that trade benefits the scarcest factor because its price is higher, while the Lerner-Samuelson factor price equalization theorem states that, under fairly restrictive conditions, trade leads to the equalization of factor prices internationally, even if factors are not mobile. (That is, wages in emerging economies tend to approach the level of wages in developed countries.) The theory of comparative advantage is also applied to the international strategy of the firm, distinguishing between its comparative advantage based on the lower cost of factors (labor, for example), which determines the decision of where to source and market and its competitive or firm-specific advantage, which influences the decision about what activities and technologies a firm should concentrate on. Implications for Labor The theory of comparative advantage leads to some important conclusions for the welfare of nations. One country s comparative advantage affects the specialization of production, the volume and direction of trade, prices paid for imports and received for exports, and the income generated for the nation s factors of production. Comparative advantage thus affects the standard of living and the growth and distribution of wealth among a nation s people and these income and wealth effects have economic, social, and ethical consequences. 2 - IESE Business School-University of Navarra
The theory of comparative advantage is a positive theory: it seeks to explain the direction of trade (what each country produces, exports and imports) and the relative prices of goods and factors. However, sometimes it is presented as a normative theory: countries must specialize in the products in which they have a relative comparative advantage, provided the country s goal is to maximize the value of the goods and services produced and consumed. Comparative advantage is, therefore, an argument in favor of free trade: under certain conditions, both countries are better off, although any improvement may not be distributed in accordance with predetermined criteria. In the example given earlier, both countries will be able to consume more wine and cloth than if they tried to satisfy their demand for both products using exclusively domestic production. The establishment of trade barriers (tariffs, quotas, taxes, etc.) is therefore undesirable. In practice, what is at issue is not the theory but its normative implication: the defense of free trade. Discussions of these issues must be based on a proper understanding of the theory and its consequences. The theory has important consequences for wages because the competitive advantage of an industry depends not only on its productivity relative to the foreign country but also on the domestic wage rate relative to the foreign wage rate. In our example, Foreignland has a lower productivity rate than Homeland and will pay lower wages to make its wine production competitive. We can argue that this is not fair but the theory of comparative advantage does not address issues of justice it merely notes that, if Foreignland pays its workers higher wages, its wine will become less competitive, exports will decline, Homeland may even find it worthwhile to invest in wine production and stop buying wine from Foreignland, and the welfare of Foreignland will be damaged. It is often said that trade makes a country worse off if its workers receive lower wages than workers in other nations the exploitation argument. Obviously, there may be social reasons for that argument. However, from the economic point of view, the relevant question is whether the workers are worse off when exporting goods based on low wages than they would be if they refused to enter into such trade because then their wages would be even lower. Of course, it is legitimate to discuss issues of justice regarding relative wage rates between countries. In any event, the theory of comparative advantage suggests that we should take into account the consequences of any decisions made. The Foreignland government cannot ignore the consequences of a wage increase in its country and, if the Homeland government imposes any kind of labor standard on its imports, it should consider the negative effects that this measure will have on the employment of the Foreignland workers. Let us now look at the problem from the viewpoint of the country with higher productivity. Is the competition from the lower-wage country unfair? This is the pauper labor argument, which tends to be used by unions in the industries hardest hit by competition from cheap-labor countries. Yet the theory does not support that argument. In fact, in our example, Homeland is more productive than Foreignland in both industries and, although Foreignland s lower cost in wine production is due to its having lower wages, that wage is irrelevant to the question of whether Homeland gains from the exchange. For Homeland, the relevant fact is that it is cheaper, in terms of Homeland s own labor, to produce cloth and trade it for wine than to produce wine itself. This discussion highlights yet another dimension of the theory of comparative advantage: the impact on income distribution. Let us assume that the two countries in our example have been selfsufficient and closed to trade but now decide to open up their economy to free trade. Homeland s IESE Business School-University of Navarra - 3
higher productivity in cloth production means that the cloth industry in Foreignland will disappear, while wine production in Homeland will cease to be profitable. (In practice, specialization will not be absolute. There will be some production of wine in Homeland and of cloth in Foreignland, according to their endowments of resources, relative productivities, and demands.) Both countries will end up better off under free trade, which means that their aggregate income will be higher, although in each country there will be an industry that will suffer and so will oppose trade liberalization. From the economic point of view, the argument put forward by that industry its loss of income will be unsustainable in light of the benefits of free trade for the country as a whole. However, the social and ethical reasons must not be forgotten. For example, the productive resources devoted to wine making in Homeland and to cloth making in Foreignland will not be readily redeployable to other industries, and this will also have an impact on the relative income of different regions in both countries. In other words, each industry has specific factors: trade benefits the factors that are specific to the export sector but hurts the factors specific to the import-competing sectors. (Effects on mobile factors are ambiguous.) Again, the theory of comparative advantage must shed light on the discussions of policies. It is not a dogma but an invitation to consider all the effects of these policies. Other Implications of the Theory The theory of comparative advantage has sometimes been presented as an obstacle to economic development. If countries must specialize in the products in which they have a comparative advantage and if it is a mistake to try to break away from the pattern of trade dictated by the theory, does that not imply a form of economic determinism? The answer is no. A country s comparative advantages are determined by its factor endowment (land, climate, natural resources) and its history (labor, technology, physical and human capital) but they may change as a result of new investments in physical and human capital, population growth, openness to foreign capital, etc. Typically, a poor country starts by specializing in whatever it has in greatest abundance: natural resources and cheap, unskilled labor. Low wages attract investments, which generate employment and income. As a result, domestic savings start to grow. If the financial system works properly, those savings will be channeled toward the most productive industries, prompting a process of diversification of production. The growth of the capital stock will increase labor productivity and wages, worker training and education will intensify, and the new investments will be more intensive in physical and human capital and technology. Thus, as labor costs rise, the initial comparative advantages will gradually be forfeited, while new advantages will be acquired. This process is neither simple nor easy but it is the process that many countries have undergone. Naturally, there are winners and losers, and there will be political pressures to try to halt or divert the growth process to the benefit of the status quo. The ethical arguments will have to be taken into account too: about the justice of the situations and the changes that take place; about human rights and the freedom of the agents; about environmental protection and the rights of future generations, etc. The implications of the theory of comparative advantage for policy are not rigid. What was known years ago as the new theory of international trade raised the possibility of using active policies to create acquired or artificial advantages. For example, a tariff on imports may foster the growth of a domestic industry until it is able to exploit economies of scale, generate spillovers 4 - IESE Business School-University of Navarra
into other industries and acquire a sustainable comparative advantage. Essentially, this is a variant of the infant industry argument (the need to protect new industries from competition in their early growth phases), the economic rationality of which is seriously questioned. Lastly, ethics may help to rectify misinterpretations of the theory. For example, it has sometimes been argued that developing countries have a comparative advantage in their ability to absorb pollution, due to the nature of their technology, the lack of environmental awareness among their population, and the rigidity of their demand for environmental goods. Ethical arguments, however, may help to put in its rightful place what is basically a shortcoming of the economic model of man. Antonio Argandoña IESE Business School-University of Navarra - 5
See also Development economics; Environmental ethics; Free trade; Free trade agreements; Free trade zones; Globalization; Income distribution; Natural resources; Opportunity cost; Protectionism; Sweatshops; Trade; Transfer pricing; Unfair competition. Further Reading and References Choi, E.K., & Carrigan, J. (2004). Handbook of International Trade. London: Blackwell. Findlay, R. (1982). International Distributive Justice: A Trade Theoretic Approach. Journal of International Economics, 13(1 2), 1 14. Helpman, E., & Krugman, P.R. (1985). Market Structure and Foreign Trade. Cambridge, MA: MIT Press. Kogut, B. (1985). Designing Global Strategies: Comparative and Competitive Value-Added Chains. Sloan Management Review, 26(4), 15 28. Krugman, P. & Obstfeld, M. (2002). International Economics: Theory and Policy (6th ed.). Reading, MA: Addison Wesley. Ricardo, D. (1817). On the Principles of Political Economy and Taxation. In P. Sraffa (ed.). (1951 1973). The Works and Correspondence of David Ricardo, volume 1. Cambridge, UK: Cambridge University Press. Samuelson, P.A. (2004). Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization. Journal of Economic Perspectives, 18(3), 135 146. 6 - IESE Business School-University of Navarra