The law of comparative advantage shows us that people can consume more than they would be able to produce on their own. Increasing specialization implies increasing productivity, and our ability to enjoy gains from specialization and trade is one factor that helps explain our high standards of living today. Here is another example that illustrates the logic of comparative advantage.
Suppose there are two planets, Hoth and Mustafar. Hoth is an ice planet, and Mustafar is a planet covered in lava and volcanos. On Hoth, ice is everywhere while it requires the construction of special freezers on Mustafar. On Mustafar, conditions allow them to produce steel in abundance while it is much more difficult to produce steel on the ice planet of Hoth. These planets have the following production possibilities for steel and ice: residents of Hoth can produce ten tons of steel or 100,000,000 tons of ice in a given year while residents of Mustafar can produce 100,000,000 tons of steel or 10 tons of ice per year.
Notice that for both planets, self-sufficiency is incredibly expensive. Every ton of steel that Hoth residents produce themselves costs them the opportunity to produce ten million tons of ice. Every ton of ice Mustafar residents produce themselves costs them the opportunity to produce ten million tons of steel. Conversely, every ton of ice that Hoth residents produce only costs 1/10,000,000 ton of steel, and every ton of steel that Mustafar residents produce only costs 1/10,000,000 of a ton of ice.
Trade can make residents of both worlds better off. To see this, suppose that each planet devotes half of its resources to steel production and half of its resources to ice production. Hoth produces five tons of steel and 50,000,000 tons of ice per year, and Mustafar produces 50,000,000 tons of steel and 5 tons of ice per year.
Now suppose they completely specialize and trade at a price of one ton of steel for one ton of ice. If Hoth trades until it has as much ice as it had before and Mustafar trades until it has as much steel as it did before, they each end up with 50,000,000 tons of steel and 50,000,000 tons of ice. Complete specialization and trade allows Hoth residents to enjoy as much ice as it did while spending half of its time on ice production but 49,999,995 more tons of steel. Complete specialization and trade allows Mustafar residents to enjoy the same amount of steel as they enjoyed while spending half their time on steel production but 49,999,995 more tons of ice. For Hoth residents, the ice price of steel has fallen to a tiny fraction of what it was before trade. For Mustafar residents, the return to steel production in terms of ice has increased enormously relative to what it was before trade.
But won’t trade destroy the steel industry on Hoth and the ice industry on Mustafar? Yes, but it is anything but clear that Hoth and Mustafar need steel and ice industries, respectively. Consider their comparative disadvantages of each. If leaders on Hoth were to close off trade with Mustafar to protect the domestic steel industry, they would increase the price of a ton of steel from one ton of ice to ten million tons of ice.
Further, an old cliché says that God never closes a door without opening a window. Through trade, God closes one door but opens two or three others. The contraction in the Hoth steel industry is offset by an expansion in the Hoth ice industry and the contraction in the Mustafar ice industry is offset by an expansion in the Mustafar steel industry. Opportunities to earn income by producing steel on Hoth will be eliminated, but they will be replaced by opportunities to earn income by producing ice. Since trade increases the returns to ice production, these new opportunities will be more remunerative. The same logic applies to Mustafar’s ice industry. The integration of this market also provides opportunities in the interstellar shipping industry, which I have left out of this analysis for simplicity’s sake (here’s a tongue-in-cheek treatment of “The Theory of Interstellar Trade” by Paul Krugman).
Think about it this way. If residents of Hoth agreed to give residents of Mustafar ice without asking anything in return, Mustafar residents would be much better off because they can use their resources to produce other things, like steel. Even if they don’t get it for nothing, the next best thing is to get the ice really, really cheap. Similarly, if residents of Mustafar agreed to give residents of Hoth steel without asking anything in return, Hoth residents would be much better off. “Cheap steel” from Mustafar is the next best thing.
This raises an interesting strategic objection: if Hoth loses its steel industry, won’t the planet be vulnerable to invasion? Would Hoth be unable to defend itself without a steel industry? First, increased trade is likely to reduce the potential for conflict while protection is likely to increase the potential for conflict. As Frederic Bastiat is reputed to have said, “if goods don’t cross borders, armies will.” Second, even if aggression is imminent we can expect to see profit-seeking entrepreneurs stocking up on resources like steel that are needed to make war materiel on the expectation that they will be able to sell it to the government for a higher price if a war starts[1]. Of all the ways to prepare for possible war, protectionism is probably the most expensive.
Estimates suggest that protectionism is amazingly expensive. In the United States, the costs of protectionism are truly astounding. According to some estimates, steel protectionism in the United States was estimated to cost $750,000 per year per job saved[2]. This means that if we completely eliminated restrictions on international trade in steel, the government could pay every steel worker who loses his or her job $700,000 per year not to work and we would still come out way ahead.
The law of comparative advantage is one of the most important ideas in economics. One of the most deceptive and pernicious myths in the world is the idea that increased market liberalization systematically makes people worse off. The law of comparative advantage shows that it is just that: a myth. Trade allows us to take advantage of our differences and cooperate to mutual advantage. In short, it allows us to produce much more wealth with the resources we have at hand.
1-I first remember hearing this point from Bob Murphy, I think.
2-Miller, Roger LeRoy, Daniel K. Benjamin, and Douglass C. North. 2005. The Economics of Public Issues, 14th Edition.Boston: Pearson/Addison-Wesley, p. 210.
{ 13 comments }
Wouldn’t something like this have been better off as a Daily? Just sayin…
Nicely done! You have an ability with words to fairly easily explain complicated ideas in fairly simple terms.
What about the booming Taun-Taun safari industry? And the poaching of the Wampa Ice Creatures?
Interesting, but this is in a perfect situation. That is the hang up with the entire theory. I regard this theory as akin to socialism. Looks great on paper, but would never work in practice.
Economics is an inexact science. The theory does not take into account many variables that occur daily in economics. It is time that Austrian economics come up with a viable plan that does not occur in perfectly created worlds.
Proving mainstream economics wrong does not make Austrian economics right. It just proves mainstream economics is wrong.
Please, stop writing these articles. I’ve had enough of theory. Show me practicality. I’ve had enough of mainstream economics and Austrian economics. Show me something viable.
Here what is viable. Human’s are inherently evil, therefore greedy. Financially speaking one needs to save, and not spend. The majority of Americans do not save. That is why I am better off than most Americans. Stop coming up with theory and get an honest job. Build a savings and just deal with human greed. It’ll be here till the ends of time.
It’s not “just a theory,” you tard, it’s something very real which applies every time you pay somebody else to do something for you.
Embrace evil and save money. Sounds great.
Huh? What? Variables? Of course there are variables, but these variables sit on the foundations of Economic rules, just like a house. You can build it in unlimited ways, but they all sit on a foundation.
Also, The existence of evil does not change anything in the use or application of economic “law” either. Does evil make the working of the system less efficient? Of course? Does it change the way it works? no.
That is an incorrect and generalized statement Daniel.
So why didn’t you do it yourself then?
Money isn’t the only thing you save. Is it really that hard to see?
Just to be clear, I mean “why don’t you do everything yourself?”
This article does gloss over some very glaring aspects which argue against total specialization. First off, it is assuming long-term, continuous, uninterrupted trade between two equals. They briefly toss in the possibility of a war, but what about a natural disaster? Haiti was roundly criticized after the earthquake for having completely dismantled it’s rice-production capability in the name of specialization, meaning they were forced to rely on charity imports, which, due to the disruption to their economy, they had to go further into debt to pay for. Total specialization leaves you completely at the mercy of whichever nation is providing the resource you need, and leaves the economies that rely on export terribly exposed to market fluctuations in prices (this is especially on display in commodity export heavy economies. The nations involved are usually barely-developed, and prone to booms and busts).
In addition, it is not so easy to transition people from one industry to another. While the author is correct that in the larger sense, free trade makes many people better off, the benefits accrue disproportionately to low-wage third-world nations at the expense of jobs in first-world nations. Steelworkers cannot all retrain to become nurses. The author’s theoretical statement that we should all be better off is belied by the fact that indeed real incomes have been flat for decades while formerly well-paying middle-class jobs where shipped overseas and the costs of goods and services have risen enormously. Average families have had to go into massive amounts of debt and even bankruptcy just to pay for schooling or hospital bills. While correlation does not necessarily mean causation, correlations DO need to be explored and explained if they are to be discounted.
This article is not trying to make the case for “over specialization” it is using a simplistic example to convey the concepts of multiplication of trade though competitive/comparative advantage. Also, the words “free trade” do not appear in the article.
Benefits ALWAYS appear disproportionally, Geographic areas are blessed with different skills and resources. Trade restriction that try to protect against this are not effective, but for the immediately benefited group. Take this example, If you are 4′-4″, and I am 6′-2,” I have a natural disproportionate advantage over you in the “cleaning the top of the refrigerator without a chair” industry. There is nothing you can do about that, unless of course you choose to enact a trade restriction, in this case cutting my legs down to make me equal with you. (or sewing them onto the bottom of your legs). This is an absurd example at first glance, but few that think about trade restrictions, or import tariffs, see that this is the economic equivalent of cutting the tall guys legs off.
I’m sorry, but you mixed economic with military protection. It’s hard to tell what you’re talking about, especially when you make many references to war. From the military protection view, you seem to be saying it’s safer to have no military protection around a country or a planet for that would apparently lower the chances of an attack, but this would actually make the planet seem (and be) a lot more vulnerable, thus a more likely target. “Hey, look, these guys don’t have shields or weapons, let’s take their planet and rule it”. Even if the trade-friendly neighbors wouldn’t do this for fear of loss in their economy, more distant neighbors would seize the opportunity.
Comments on this entry are closed.