Law of Comparative Advantage

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by Alasdair Macleod, GoldMoney:

The debates about Brexit and President Trump’s trade machinations have demonstrated the blindness of otherwise intelligent people to the Law of Comparative Advantage. Let me attempt a contemporary definition:

“The Law of Comparative Advantage states that an entity maximises its resources by producing that which gives the best return, while delegating production of all other products and services to other entities more cost-effective in their production”

This is the justification behind the principle of the division of labour. But it is amazing how people ignore it when it comes to cross-border trade, particularly the Remainers in the Brexit debate, and Donald Trump with his trade policies.

The law has a long history and was usually associated with David Ricardo, who applied the principle to explain trade between two countries. It might have been better to have explained it in more basic terms, but we must remember that in 1817, when Ricardo published his Principles of Political Economy, in which he devoted a few paragraphs to it, that trade was a political issue.

International trade became overtly political when in 1806 Napoleon ordered a blockade of all trade with Britain from Europe, resulting predictably in anti-trade pamphlets, on the lines that British agriculture was what mattered, and commerce was less important.[i] James Mill, in his Commerce Defended in 1808 attacked these trade fallacies, eleven years before Ricardo’s Principles was published.

Today, we have the benefit of a better understanding of free trade, so we can explain the Law of Comparative Advantage in more relevant terms. There are two issues to address, economic and political. The economic issue is simply explained.

We can do this in two stages, first absolute and then comparative. Humans specialise and in all cooperative economies are not skilled in the production of most of the goods and services they require. Therefore, it makes sense to maximise productive output by doing the few things we are individually good at and acquire the supplementary things we require from others, who are better than us at producing them. It would be unproductive for a farmer to make his own cooker or washing machine. Likewise, it would also be nonsensical, and impractical for factory workers to go farming. Thus, the farmer has an absolute advantage in his specialisation over the factory workers, and they have an absolute advantage over the farmer in their production.

But it goes even further. Let us assume the farmer grows wheat. Let us further assume other farmers grow wheat of the same or better quality at a lower cost. In that case, the first farmer will consider growing something else, where his profits are likely to be greater. The other farmers have a comparative advantage over the first farmer, and if the first farmer finds a more profitable niche than producing wheat, he will gain a comparative advantage over other farmers already specialising in his new production.

In other words, an absolute advantage is the simple deployment of skills through the division of labour. The comparative advantage is the deployment of skills to maximise production. Comparative advantage is hugely important, because by recognising it, we deploy capital more efficiently, capital being money, equipment, labour and our own skills. In the process we maximise value and economic progress for all.

An aprioristic law that is true in economics, such as that of comparative advantage, knows no national boundaries. If Chinese businesses can produce steel more cheaply than businesses in the US, US steel businesses can benefit from the comparative advantage of buying in cheap Chinese steel. And if Chinese producers have so much steel stockpiled that they decide to offer it below cost, US manufacturers of products buying that steel get to benefit.

Obviously, a US steel producer will dislike Chinese steel being cheaper than the cost of production in the US. But by not admitting to the comparative advantage, the US steel company is merely deploying productive capital less efficiently than it otherwise might. The management, like our wheat farmer above, should consider changing its business focus, perhaps to producing speciality steels, buying in Chinese steel as a feedstock for more profitable lines.

This does happen. But because the cheapest steel comes from abroad, lobbyists for the steel industry see an advantage in playing on nationalism, pointing out that China could dump steel to bankrupt US steel producers before raising prices again. But if a US producer cuts prices to dispose of surplus stock, no one bats an eyelid. A foreign entity doing so is regarded as a different matter.

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