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Comparative Advantage

BY JAMES SCOTT 19/02/2015

Econ101 - Comparative Advantage 2

The theory of comparative advantage holds a particular place of pride within the economics profession. It is one of the first things that budding young students of economics learn, and this experience has been said to be akin to a rite of passage event – an initiation into the fold, differentiating trained economists from the uninitiated, the plebeians. As Nobel laureate Paul Krugman puts it:

“An understanding of the principle of comparative advantage, and an appreciation of the virtues of Free Trade, are key dividers between trained economists and the Gentiles; even brash young theorists are hesitant to risk excommunication by challenging these tenets directly,” (Krugman 1992: 424).

The theory of comparative advantage has, rhetorically at least, underpinned trade policy for close to two hundred years in the UK and draws broad support across the world today. Yet it is not without its problems and the extent to which it truly underpins trade policy is questionable. Here, I set out in basic terms Adam Smith’s and David Ricardo’s insights into the benefits of free trade before raising a number of objections to the policy prescriptions that flow from that theory. Finally, I situate the issue within the context of the current negotiations between the US and EU on the Transatlantic Trade and Investment Partnership.

Adam Smith’s central insight was that, rather than trying to produce everything, countries would be better off by specialising in producing those goods that they can make more efficiently than anyone else and then trading with other countries to gain access to everything else. That way, the country’s factors of production – its land, capital and labour – would be put to use in the most productive areas while, in effect, gaining access to more efficient production in other countries through trade. Through this mean each country could achieve a higher output and higher consumption for its given endowment of factors, making itself richer than in the absence of trade.

David Ricardo extended and generalised this theory to show that it would hold even for countries that could produce no goods more efficiently than its trading partners – that is, having no absolute advantage over its competitors. In this situation, by specialising in producing those things in which its disadvantage was at a minimum – those things in which it had a comparative advantage – a country could again realise efficiency gains from specialisation and trade. For proponents, a significant factor underpinning the growth in wealth seen since WWII is to be found in the broad trend toward trade liberalisation over this period and the massive increase in trade integration that this facilitated.

While comparative advantage theory implies that all countries will be made better off by specialisation and trading, this does not mean that all individuals within those countries are automatically better off. Those that were employed in the less efficient sectors are likely to lose out as their jobs disappear in the face of cheaper imports. While it can be expected that there will be new job opportunities created in the expanding, competitive sectors of the economy, it is far from certain that these will compensate either in quantity or quality. Smith and Ricardo escaped this issue by assuming full employment in their model, and by and large this ‘assuming away’ of employment concerns continues to this day.

However, economists tend to emphasise that what Smith and Ricardo show is that the total gains to the country as a whole outweigh the total losses. Thus it is in theory possible for the state to compensate those who lose out through taxing and redistributing the gains, leaving everyone better off. But increasingly questions are being raised about the extent to which this is achievable in practice. Can the state accurately identify who is losing out? Can it tax those who gain? For developing countries lacking the state capacity to implement effective tax regimes the impediments are even greater. Indeed, the best research suggests that in low-income countries for every pound lost in tariff revenue only 30 pence is recovered through simultaneous tax reform (Baunsgaard and Keen, 2005).

This problem might be worth bearing if the broader economic benefits are large. However, this too is increasingly subject to question, despite the claims of politicians and unwary (or ideologically driven) economists. The proposed Transatlantic Trade and Investment Partnership (TTIP) is a good case in point (see George forthcoming). David Cameron claimed that the TTIP “could add as much as a £100 billion to the EU economy,” (Office of the Press Secretary, 2013). This certainly sounds impressive and was touted by EU Trade Commissioner Karel De Gucht as adding 0.5 percent to GDP growth (De Gucht, 2013). He was, however, wrong. In fact, the £100bn refers to a one-off increase in GDP rather than a year on year growth. That is, it represents an addition not of 0.5 percent to growth but to the EU’s GDP, spread over approximately ten years. This equates to an increase in growth of more like 0.05 percent over ten years. Furthermore, the figure of £100 billion is at the generous end of the calculated benefits. The least optimistic scenario predicts only around £20 billion addition to GDP, equating to a 0.01 percent boost to growth.

To achieve even this gain comes at a potential large social cost. As noted above, efficiency gains rely on shifting factors of production out of certain sectors and into others. Dani Rodrik (2011, p.57) has estimated that for every pound of efficiency gains released, around £50 worth of income would have to be shuffled among different groups. This implies a large bout of social upheaval as people move between jobs, to achieve very slight economic benefits.

The theory of comparative advantage has been one of the most influential ideas in economic thought. The benefits that it predicts from pursuing trade liberalisation have given this policy near universal support among economists and (rhetorically at least) politicians around the Western world. However, broader social and political considerations may give pause to the relentless drive for trade liberalisation. While nobody would advocate throwing up the barriers and pursuing autarky, it may be time that the pursuit of ever further liberalisation through the likes of TTIP is rethought.

 

Dr. JAMES SCOTT is a Lecturer in International Politics at King’s College London. His research focuses on global governance, particularly trade governance, with a primary interest in the effect this has on developing countries. He is co-editor of the forthcoming book “Expert Knowledge in Global Trade”, which will be published this year by Routledge. 

 

Bibliography:

Baunsgaard, T. and Keen, M. (2005). ‘Tax revenue and (or?) trade liberalization’, IMF Working Paper WP/05/112 (Washington, DC: IMF).

George, C. (forthcoming). ‘Numbers: the role of computable general equilibrium modeling in legitimizing trade policy’, in E. Hannah, J. Scott and S. Trommer (eds), Expert Knowledge in Global Trade, (Abingdon: Routledge).

De Gucht, K. (2013). ‘The Transatlantic Trade and Investment Partnership’, speech to the European American Chamber of Commerce, New York, Brussels: European Commission, 21 May 2013.

Krugman, P. (1992). ‘Does the New Trade Theory Require a New Trade Policy?’, World Economy, 15 (4), pp. 423-442.

Office of the Press Secretary, (2013). ‘Remarks by President Obama, U.K. Prime Minister Cameron, European Commission President Barroso, and European Council President Van Rompuy on the Transatlantic Trade and Investment Partnership’, Lough Erme, Northern Ireland, 17 June 2013.

Rodrik, D. (2011). The Globalization Paradox. (Oxford: OUP).

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