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Source link: http://archive.mises.org/3386/comparative-advantage-versus-absolute-advantage/

comparative advantage versus absolute advantage

March 25, 2005 by

I think Paul Craig Roberts gets it wrong when using the subject terms. Let me clarify according to my understanding:

An economic advantage is when one person or group can produce a given result with more economy than another. This is very general, and can be broken down into categories: labor advantage is when production can be carried out at lower labor cost (other things being equal); capital advantage, capital; rent/space advantage, rent. When aggregating costs in a group, we must be careful. The typical method for comparison is money accounting of wages, depreciation, and rent; this is appropriate when considering the subjective costs of the entrprepreneur/capitalist, since these are mainly aligned with money accounting costs.

The term absolute advantage emerges when considering multiple products. If A has an economic advantage against B at producing X, and A has an economic advantage against B at producing Y, then we say that A has an absolute advantage against B with respect to products X and Y. Notice that a claim such as “India has an absolute economic advantage against the US” is odd for two reasons. Firstly, such an advantage, unqualified, must refer to all goods and services. Since universal empirical claims are notoriously troublesome to prove, this raises a red flag. Secondly, aggregating costs within an industry (for instance, wages paid to workers per shirt produced) has meaning for businessmen in that line of business, while aggregating costs across an entire nation and over all goods is highly problematic, for the same reason that all aggregates of this sort are problematic — the subjective nature of cost. But, this is not the main issue. The main issue is:

The concept of comparative advantage emerges when considering trade. At first glance, there is no reason to think that A, with absolute advantage against B in goods X and Y, would wish to trade either X or Y with B. Another worry is that if B trades in either X or Y with A, he might harm his interests. These initial impressions are completely exploded by considering the nature of trade, and Ricardo’s discovery of the law of comparative advantage. It is not absolute advantage that is relevant when considering the gains to trade — it is comparative advantage.

Comparative advantage, when confined to considering goods X and Y, refers to the relative costs of a marginal unit of X per marginal unit of Y. That is, if A enjoys absolute advantage, he is still in a position such that the cost of foregoing production of enough units of Y to produce a unit of X means that he would be willing to trade X for Y at a ratio that is favorable to his position. The same is true for B, and if these ratios are not equal, then the direct benefits of trade emerge.

Indeed, the only condition for direct benefits of trade is that the substitution ratio for A be different from the substitution ratio for B. When the substitution ratio of X to Y for A is greater than that of B’s, then we say that A has a comparative advantage in X, and at the same time, B has a comparative advantage in Y. It then becomes mutually advantageous for A exclusively to produce X and B exclusively to produce Y — division of labor.

The existence of comparative advantage is always mutual and reciprocal.

While the law of comparative advantage was explicated and the benefits of free trade explained by Ricardo under a certain set of assumptions (mobility of labor, but not of trade) does not imply that the law of comparative advantage depends upon those assumptions — it does not.


Dennis Sperduto March 25, 2005 at 3:54 pm

Mr. Guillory, an excellent post and discussion. If I may, I would like to elaborate on one point that you mention. The discussion of the issues surrounding trade, exchange should always adhere to the principle of methodological individualism and, thus, be couched in terms of the economic entities actually involved in production and exchange, i.e., the individual or a specific firm. And methodological individualism should be employed no less when examining the issues surrounding “international trade” than with intra-national trade. The use of aggregates for conceptual analysis is wrong, and utilizing this methodology obfuscates the fundamental issues that need to be examined and understood. This is certainly the case when nations serve as the basis of analysis, as they do in mainstream international trade discussions. As the Austrian School, at least the Mengerian-Misesian branch, has demonstrated and emphasized, all economic activity must be traced back to and analyzed in terms of the purposive action of individuals.

In addition, where “international trade” is concerned, the use of national aggregates serves to inflame the ethnocentric/racial prejudice and bias that all too many individuals have when discussing economic issues. As is many times the case, economic analysis degenerates into an instrument of politics. And of course, politics cares virtually nothing about truth and scientific knowledge and understanding; politics is only concerned with power. It must be that the increased output made possible by the division of labor, or as I believed Mises termed the concept, the Law of Association, only exists when it is acknowledged to exist by the political system.

A related, but somewhat different, issue is that the protectionist, anti free trade argument, when consistently taken to its logical conclusion, indicates that virtually all trade, including intra-national trade, should be abandoned and we should all revert to the autarky of the primitive household economy. That is, those very few among us who manage to produce enough to stay alive.

P.M.Lawrence March 26, 2005 at 12:35 am

To some extent it depends what people are trying to bring out. For some questions, things like the mobility of labour do matter.

One of my favourite examples is the Highland Clearances. Free trade within the British Isles, changes in systems of ownership, and comparative advantage all combined to produce harm to Scots. This does not contradict comparative advantage at all; it’s just that more than 100% of the gains to Scotland went to newly landed Scottish aristocrats. Labour mobility problems – moe inertial than institutional – prevented evicted crofters from finding enough work quickly enough in the growing economy, so they suffered.

It’s a who/whom question, and of course it’s connected to undeveloped institutions in place before, so the evictees did not gain from increasing values of things in which they had property rights, which would have produced the right kind of automatic compensation (as would a slow transition, allowing for trickle down to work effectively).

Dennis Sperduto March 26, 2005 at 7:20 am

The following discussion by Mises in Human Action (pp. 162-164) hopefully will help clarify a portion of my previous posting on the matter of “international trade”:

“Besides, we realize that with regard to the determination of value and of prices there is no difference between domestic and foreign trade. What makes people distinguish between the home market and markets abroad is only a difference in the data, i.e., varying institutional conditions restricting the mobility of factors of production and of products….

It has been asserted that Ricardo’s law was valid only for his age and is of no avail for our time which offers other conditions. Ricardo saw the difference between domestic trade and foreign trade in differences in the mobility of capital and labor. If one assumes that capital, labor, and products are movable, then there exists a difference between regional and interregional trade only as far as the cost of transportation comes into play. Then it is superfluous to develop a theory of international trade as distinguished from national trade. Capital and labor are distributed on the earth’s surface according to the better or poorer conditions which the various regions offer to production. There are areas more densely populated and better equipped with capital, there are others less densely populated and poorer in capital supply. There prevails on the whole earth a tendency toward an equalization of wage rates for the same kind of labor.

…the teachings of the classical theory of interregional trade are above any change in institutional conditions. They enable us to study the problems involved under any imaginable assumptions.”

john Spiers March 26, 2005 at 7:56 am

In mid-1985 there were hundreds of small businesses in USA importing billions of dollars worth of garments from China… congress passed new trade laws and within a year or two these businesses folded or changed their mission.

I’ve been in int’l trade for 30 years, and have never seen a
“comparative advantage” in either Ricardo’s theoretical sense or any coherent sense. Certainly there are times and places where goods are best obtained, but these are more the result of the meddliing of politicians than any sense of pure market opportunity.

I suspect comparative advantage may have been in place in the garden of Eden, but it does not obtain now.

Small business buy from the only place that makes ‘it” (hardly “comparative advantage”) and big business like walmart are distribution-for-consumption machines that take advantage of govt policy to advance their total coverage. Hardly comparative advantage.

JS Henderson March 26, 2005 at 11:58 am

Mr. Paul Craig Roberts challenges us to deal with the new situation where foreign-domiciled peoples have absolute advantages over Americans. If true, this means that foreign peoples are superior to Americans at producing everything. The data does not bear this out. Americans are still producing roughly 85% of their own goods and services. If Americans are at an absolute disadvantage, how can they still dominate this much production?

Comparative advantage must always exist due to opportunity costs, which Mr. Roberts seems to assume away. Even if foreign peoples were to acquire absolute advantages in every productive activity, it would be highly inefficient to try to produce everything. Foreigners would naturally specialize in producing the higher margin goods and services, leaving lower margin production to others. If foreign producers, with their absolute advantage, produced low margin items, they would have to divert time and resources from production of the highest margin items. It is because of opportunity cost that absolutely more productive individuals trade with (outsource from) the absolutely less productive. Mr. Roberts is making the dubious assumption that foreigners have unlimited time and resources.

Mr. Roberts seems to be challenging libertarians to solve a problem which does not yet exist, and likely cannot ever exist.

Dennis Sperduto March 28, 2005 at 8:17 am

If anyone sent an e-mail to me beginning March 25, 2005, could you please, if possible, resend it. My computer at work crashed for some reason, and 18 to 20 messages were evidently lost. I’m sorry for any inconvenience.

John Bigelow March 28, 2005 at 1:59 pm

Capital Exports and Free Trade by J.G. Hülssman is the Daily Article that cleared up the issue for me. Mr. Roberts should read it.

shuolingdong September 17, 2005 at 3:37 am

I think trade is trade,comparative advantage theory is used as a trade theory,then it should just follow goods prices.Is it ok that we do not connect the factors of production with goods? we often consider specialisation,technology and trade are the three motives of economic growth, so we can not research the trade reasons and principles by specialisation principle or production scales or other standards.

micheal July 13, 2006 at 5:22 am

am a student of economics in university in Nigeria and will need your help in understanding what COMPARATIVE COST ADVANTAGE & ABSOLUTE COST ADVANTGE is all about.

Olatunji BUHARI March 11, 2008 at 5:06 am

Please your expert contribution is needed on this question. It is obvious tha If one country has an absolute advantage over the other in one line of production and other country has an absolue advantage over the first in a second line of producion. Both country can gain by trading. But what if one country is more productive than another in all lines of production, Does it still pay for both country to trade. Argus your case with vivd table, schedule, notation and diagram

David C March 11, 2008 at 6:11 am

Buhari said:

Please your expert contribution is needed on this question. It is obvious tha If one country has an absolute advantage over the other in one line of production and other country has an absolue advantage over the first in a second line of producion. Both country can gain by trading. But what if one country is more productive than another in all lines of production, Does it still pay for both country to trade. Argus your case with vivd table, schedule, notation and diagram.

Suppose country X makes product A and B, and country B also makes product A and B

Country X is more productive in making A, and less productive in making B .

Country Y is less productive in making A and more productive in making B .

HOwever, country X is still more productive in making B, than is country Y.

SO – Country X has absolute advantage in product A and B

Country X also has comparitive advantage in product A.

Country Y has no absolute advantage , but has a comparitive advantage in product B, by virtue of th efact that country A can generate more value per dollar invested in making product A than it can making product B.

this is because even though country X is more efficient in product B than country Y, if product B is available for import from country Y, it would be more productive for country A to allocate resources to what it is best at doing – making more product A than it needs, and exporting the surplus to country Y, where they can get more of product B in exchange than they would have been able to produce themselves.

In this case, the optimum balance will setlte where country Y’s demand for A is satisfied, so country X makes enough product A for both nations, country Y makes enough product B to both satisfy its own demand for it and to pay for its imports of product A, and country X tops up and makes only so much of product B as will satisfy its own demand for B as is not covered by the imports from country Y.

Overall, everybody ultimately gets more of A and B than they would get individually if they didn’t trade and instead manufactured for themselves.

Im sorry, I dont have time for elaborate diagrams and tables etc, but this is the upshot – hope it helps.

DINESH AGRAHARI April 24, 2008 at 1:40 am

Please your expert contribution is needed on this question. Recardo agreed with the analysis of Smith that international trade would be of mutual advantage if one country has absolute advantage over another in one line of production and the other country has an absolute advantage over the first country in another line of production. But Recardo went further and argued that any two countries can very well gain by trading even if one of the countries is having an absolute advantage in both the goods over another, provided the extent of absolute advantage is different in the two commodities.

Up to this is undestandable but whether the principle of comparative advantage is a satisfactory explanation of the trade pattern of a developing economy like Nepal?


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