Absolute vs Comparative Advantage

In any discussion of international economics, you are bound to encounter the principle of comparative advantage. Comparative advantage has been the underpinning of international economics since it was first expounded on by David Ricardo in 1817. Despite its importance, it is surprisingly not commonly known outside the circle of those educated in economics. This makes it especially difficult to evaluate the benefits of free trade - I have attempted to do this in the past without delving in depth into this topic (see Misunderstanding the Free Market and On Economic Freedom), but since it seems to me that I will refer to this principle in the future, a somewhat detailed explanation is in order.

If you have the time, the Wikipedia article I linked to in the first paragraph should be sufficient and quite interesting. If you do not, however, then I shall try to sum up comparative advantage as concisely as possible. I believe the principle of comparative advantage can be stated as:

As long as the ratio of the prices of two or more goods relative to each other differ, it is beneficial for a country to engage in trade.

To anyone who has studied international economics, this undoubtedly seems like a very simplistic definition. However, it is the best that I can think of.

Now, the proof of the principle: let us say Malaysia produces petroleum and computers. The United States also produces petroleum and computers. However, the United States can produce more computers than petroleum, while Malaysia can produce more petroleum than computers. As a result, the Malaysian cost of mining petroleum is $1 per barrel and the price of building computers is $10 per CPU (shall we say), while in the US, the price of petroleum is $10 per barrel and the price of a CPU is $1. Each country has $1000 to allocate to its economy. Malaysia can produce 1000 barrels of petroleum or 100 computers, while the US can produce 100 barrels or 1000 computers.

To recap, both Malaysia and the US combined can produce $1000 worth of petroleum and $1000 worth of CPUs, $2000 worth of petroleum, or $2000 worth of computers. In addition, they can also produce any combination of goods that fits the parameters we have just defined. Malaysia, for example, could produce one CPU and 990 barrels of petroleum. (Recall, the prices represent the allocation of resources within the economy to the production of each good.)

Now, should Malaysia and the US try to be self-sufficient, producing 500 barrels of petroleum and 50 CPUs (Malaysia) and 50 barrels of petroleum and 500 CPUs (the US)? According to the principle of comparative advantage, no. Trade is beneficial to both sides. If the US and Malaysia each specialise in one good, then they will have 1000 barrels of petroleum and 1000 computers. Then, each country can have 500 barrels of petroleum and 500 computers - or any other possible combination of these goods that they desire, as long as it is less than 1000 of each.

Now, this seems pretty simply. It's a no-brainer, right? But what if the US kicked Malaysia's ass in both petroleum mining and CPU production? What if they could produce petroleum at $0.01 per barrel and CPUs at $1 per computer, while Malaysia stagnated and did not innovate enough to lower its costs? Would trade still benefit both countries?

Under absolute advantage, which is the typical principle used by non-economists to evaluate the benefits of trade, the answer is no. After all, it seems to be common sense that Malaysia should struggle along by itself while the US reaps the benefits of its innovation. But under comparative advantage, we reach a different conclusion: trade must continue.

The reason is simple. The US can now produce 100,000 barrels of petroleum or 1000 CPUs, while Malaysia remains stuck at 1000 barrels and 100 CPUs. If they go it alone and the US produces 50,000 barrels and 500 CPUs, while Malaysia makes 500 barrels and 50 CPUs, the combined output of both countries will be 50,500 barrels and 550 CPUs. If Malaysia specialises and trades some of its CPUs with the US for petroleum, however, then the same figures will be 50,000 barrels and 500 CPUs (the US) and 0 barrels and 100 CPUs (Malaysia). Combined output of oil is slightly lower, but it has been compensated for by the increase in CPU output. Malaysia can now take 50 of its CPUs (worth $50 in the US) and trade them to the US for $50 (US prices again) worth of oil, or 5000 barrels worth of oil. End result: Malaysia has the same number of CPUs it started with under the no-trade scenario, but now has 4500 more barrels of oil. The US has 5000 barrels less than it started with, but it has 50 CPUs, so it has lost nothing.

You can play this scenario out with different parameters, but no matter what, comparative advantage holds as true as 1 + 1 = 2. Even if the terms of the trade deal are less advantageous to Malaysia, it remains beneficial for Malaysia to trade with the US. The worst case scenario under comparative advantage is that only one party gains while the other stays the same (in the scenario above it is the US that ends up with the same value of goods it originally had), and this is an extreme. Often, you find that both parties will benefit from some trade arrangement because they can produce more combined than by attempting to be self-sufficient.

If this has you befuddled, you can try working it out on pen and paper. But even if you don't get it, take heart. Nobel Prize-winning economist Paul Samuelson has remarked that the principle of comparative advantage is one of the most difficult to grasp:

That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.

Nevertheless, it is a mathematical surety that the principle of comparative advantage holds. Unless the countries involved in the transaction are perfectly homogenous (same costs of production, same amount of resources, etc.), it is always better for countries to trade than to go it alone.