Comparative Advantage – Upgraded

Future-Proof Foreign Trade Based on Relative Price Advantages

An Article in the Compendium of Market-Based Social-Ecological Economics

Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?

Click here for the list of all articles: Compendium
Click here for the German-language version: Komparativer Vorteil — aufgewertet

Table of Contents

  1. Abstract
  2. David Ricardo: Originator of »Comparative Advantage«
  3. The Basic Message of the Theorem
  4. This Articles’s Concern on Economic Policy
  5. Practical Implementation of »Comparative Advantage«
    > Step 1, Step 2, Step 3
  6. Summary
    > The Lesson for the European Union
  7. The Dangers Posed by Trade Based on Absolute Advantages
    > Absolute Advantages under the Neoliberal Doctrine
  8. Prospects

1. Abstract

The theorem of comparative advantage is still regarded as the only outstanding economic discovery. However, it is misjudged, misunderstood and wrongly used like no other proposition. Especially the representatives of the neoliberal economic doctrine abuse it with false claims to justify their selfish approach. Given the social and environmental devastations caused by the neoliberal regime, it is appropriate and even imperative to demonstrate the potential of the theorem in overcoming the present decline.

2. David Ricardo: Originator of »Comparative Advantage«

The economic phenomenon of comparative advantage was first described by economist Robert Torrens in 1815. David Ricardo, 1772 – 1823, one of the outstanding representatives of classical economics, formalized Torrens’ findings in his major work »On the Principles of Political Economy and Taxation«, published in 1817. Since then, the phenomenon is known as the Theorem of Comparative Advantage or the Ricardian Model, and is considered a central element of international economics.

Note: To avoid confusion between relative and absolute advantages, I will use the term »relative comparative advantage« throughout this article instead of »comparative advantage«. In economic literature, however, the term »comparative advantage« generally refers to relative cost or price advantages. The difference between relative and absolute advantages is set down below.

Relative advantages only become visible, if the production cost ratios or price ratios between a number of products from one country are compared with the ratios of identical or similar products from another country. Relative comparative advantages must not be confused with absolute cost or price advantages, arising in single currency areas like the euro zone or in supranational areas committed to a key currency as is the case in today’s neoliberal world trade based on dollar prices. Since only cost or price ratios are crucial for comparative advantages, but not the absolute costs or prices, they can be used profitably in foreign trade between all countries without exception, that is, independent and regardless of the differences between countries in their absolute productivity levels. In short, even an extremely backward country can profitably trade with an extremely advanced country, and vice versa, if both countries bilaterally use their relative comparative advantages.

The economist Paul Samuelson, Nobel laureate of 1970, was convinced that the theorem of comparative advantage was the only great idea that had originated from economics. There is nothing more to be said today except that the significance of the theorem can only fully be demonstrated by deploying it as a cornerstone of a post-neoliberal economic system.

3. The Basic Message of the Theorem

KomparativerVorteilJPG01In principle, all countries can achieve sustainable gains from trade regardless of their individual level of productivity, if they use the differing cost ratios in the production of goods and services, that is, the differing relative costs or differing relative prices in comparison to their trading partners. In short, a country has a relative comparative advantage in products it produces at lower costs than a trading partner relative to the average domestic costs of all traded products. Products having a relative comparative advantage are potential export products. Conversely, a country has a relative comparative disadvantage in products it produces at higher costs than a trading partner relative to the average domestic costs of all traded products. A country should import these products.

The above cartoon hints at the devastating consequences of today’s neoliberal free trade governed by absolute instead of relative price advantages.

For comprehension: The average production costs of all products traded in a bilateral relationship can be indirectly determined from the prices by summing up the domestic prices of the products in each country and dividing each country’s sum by the number of products. Trading partner A would then for instance have a relative comparative advantage in a product over trading partner B, if A’s product is lower-priced in relation to its domestic average price than the same product in relation to the domestic average price of B.

Relative comparative advantages invariably emerge between all countries at all times and in large numbers. Therefore they are a uniquely promising basis for beneficial trade. Excluded are only the rare cases in which two countries coincidentally have identical cost ratios in the production of a product or identical relative prices for a product. But even in this case mutual trade can be reasonable, if functional differences can enhance the variety of supply on both sides.

In economic literature the basic message of the theorem is often explained using the economic term of »opportunity costs«. Accordingly, a product’s relative comparative advantage is equivalent to low opportunity costs, meaning that countries have to abstain from relatively fewer units of other products in producing such a product in comparison to their trading partners. Conversely, products with relative comparative disadvantages are accompanied by relatively high opportunity costs, meaning that countries have to abstain from relatively more units of other products compared to their trading partners.

For comprehension: With respect to production, opportunity costs are to be understood as loss of revenue to be taken into account, if not the most profitable production alternative is selected from the available opportunities. I this sense, a relative comparative advantage means that a country disposes of a relatively profitable production alternative in international comparison.

4. This Articles’s Concern on Economic Policy

In this article, it is my main concern to explain …

  • why the theorem of comparative advantage is so often misjudged and misunderstood,
  • why the existing World Trade Organization makes false and misleading claims for its policies which are allegedly based on the theorem, and
  • why the theorem has the potential to add to the overcoming of the devastating neoliberal doctrine and to act as a keystone of a post-neoliberal economic order.

5. Practical Implementation of »Comparative Advantage«

Step 1
I begin with a presentation of the theorem similar to the one published by David Ricardo in the early 19th century: Assumed are two countries, England and Poland, both of them producers of cloth and hops, but with different cost ratios. The two countries want to make use of the differences for a profitable barter. Moreover, it is assumed that the productive factors labor and capital are freely exchangeable between the productions of cloth and hops within each country, but both countries refrain from international capital movements and labor migration in order to protect their economies against external interferences so as to optimally exploit and independently develop their own resources. After all, Ricardo had already recognized the disturbing effect of uncontrolled capital movements on relative comparative advantages and profitable trade.

The following table shows the total absolute production costs per unit of products to be traded. Simplistic, one could imagine the total costs as working hours to be spent for every produced unit of a product:

Absolute production costs per unit thought of as working hours spent

Cloth Hops
England 5 6
Poland 10 8

We equate the working hours with total production costs and calculate the relative costs to identify the relative advantages and the absolute gains from trade. Each relative value represents (as a quotient) the proportion of costs between one and the other product within a country. England, for example, can produce only 0,83 units of hops with the costs incurred for the production of one unit of cloth:

Relative production costs per unit

Cloth Hops
England 5/6 = 0,83 6/5 = 1,2
Poland 10/8 = 1,25 8/10 = 0,8

When comparing the two countries, England has a relative cost advantage in producing cloth (0,83 compared to 1,25 in Poland), Poland has a relative cost advantage in producing hops (0,8 compared to 1,2 in England).

If each country fully specializes in the product having a relative cost advantage, and each country imports the product it no longer produces itself from the other country, the following gains from trade will be realized:

England could originally produce only 0,83 units of hops with the costs incurred for one unit of cloth, and can now import 1,25 units of hops for each unit of exported cloth: a profit from trade of 0,42 (1,25 minus 0,83) units of hops per exported unit of cloth. Poland could originally produce only 0,8 units of cloth with the costs incurred for one unit of hops, and can now import 1,2 units of cloth for each exported unit of hops: a profit from trade of 0,4 (1,2 minus 0,8) units of cloth per exported unit of hops.

I should emphasize that, despite the profits made, the total absolute production costs remain unchanged in both countries, and: the trading profits are mutually realized although Poland has absolute cost disadvantages in the production of both products.

In its original form however, the Ricardian Model only forms the theoretical basis for mutually profitable trade, but reveals two essential drawbacks when implementing it under present-day trading conditions:

  • Firstly, the bilateral barter as proposed by Ricardo is virtually not applicable to dynamic and complex trade relations with more than two trading partners, and
  • secondly, the Ricardian Model generates an inevitable tendency towards complete international specialization for all products having a relative competitive advantage, thus provoking the risk of declining domestic diversity and increasing dependency on imports.

Step 2
In the second step, I go beyond Ricardo’s approach and add an essential condition for sustainable and profitable international trade. In so doing, I can demonstrate that the theorem is also applicable in dynamic and complex multi-bilateral trade relations being subject to constant change and including any number of products. For this purpose I expand the table by a third country and a third product. Now, the relative costs of products can not be determined pairwise anymore, but must instead be determined in relation to the average costs of all traded products of each country. Furthermore, the inflexible barter is replaced by settling trade movements against currency, so that each country is free to control its trade flows at any time as required and independent from its trading partners. Ultimately, it follows that in trading products for foreign currency not the relative costs are to be settled against one another, but the relative prices are to be settled against foreign currency, and the bilateral exchange rates have to be derived from the two average domestic prices of all trading products. Therefore, the conceived working hours representing total production costs in the above example are now replaced by prices in domestic currency:

Absolute prices per unit in domestic currency

Cloth Hops Potatoes Averages
England 5 6 4   5 pounds
Poland 10 8 3   7 zlotys
Bulgaria 19 15 5   13 levs

The exchange rates result directly from the average prices: between England and Poland the exchange rate is 5 pounds = 7 zlotys, between England and Bulgaria 5 pounds = 13 levs, between Poland and Bulgaria 7 zlotys = 13 levs. As a side effect of exchange rates based on average prices, average bilateral purchasing-power parity is established between countries. That is, citizens crossing the border and exchanging their money into the foreign currency retain their average domestic purchasing-power (which does not mean that citizens in the two countries involved have equal income and equal purchasing power).

The relative prices of products are calculated by dividing the absolute price of each product unit by the average price of all traded products of a country:

Relative prices per unit (unit prices divided by average product price)

Cloth Hops Potatoes
England 1,0 1,2 0,8
Poland 1,42 1,14 0,42
Bulgaria 1,46 1,15 0,38

The table of relative prices shows that England has a relative comparative price advantage in cloth compared to the other countries, whilst Poland has a relative comparative advantage in hops and Bulgaria in potatoes. To achieve a maximum of total profits (gains) from trade, the trade flows should be determined by the three products showing a relative comparative advantage. This means, each country should export the product in which it has a relative price advantage, and it should import the other two products in which it has relative price disadvantages.

Now, all profits from trade can be calculated from the above data, for example for England and Poland: If Poland imports English cloth, an import price of 7 zlotys results from its relative price advantage when applying the exchange rate (1 pound = 1,4 zlotys, 5 pounds = 7 zlotys). Since the Polish domestic price of cloth is 10 zlotys, Poland achieves a profit of 3 zlotys for each and every unit of imported cloth. If England imports Polish hops, an import price of 5,58 pounds results (1 zloty = 0,71 pounds, 8 zlotys = 5,68 pounds). Since the English domestic price is 6 pounds, England achieves a profit of 0,32 pounds for each and every unit of imported hops.

Utilizing the relative comparative advantages, all three countries can mutually achieve profits from trade, even with products having an absolute price disadvantage. If we equate Bulgaria’s absolute domestic prices shown in the table with absolute costs, the fact would be revealed that Bulgaria has absolute cost disadvantages in all products. But the country could nevertheless participate in the trade based on relative comparative advantages and profit from it.

Step 3
In the third step, I add another crucial condition to the Ricardian Model, one that counteracts the threat of complete international specialization: To begin with, countries need to maintain and further develop their own economic diversity and their unique skills to avoid unbalanced export-oriented value creation including complete specialization and structural unemployment, and to protect themselves at the same time against import dependencies, external incidents (shocks) and attempted extortions by other countries.

The goals of national economic diversity and international specialization are only to be reconciled, if countries govern their foreign trade with the highest degree of autonomy.

In particular, this implies that countries need to conclude bilateral trade agreements specifying not only exchange rates, as mentioned above, but also trade quotas as well as mutually granted autonomy on trade tariffs and duties. These conditions guarantee that trade in multi-bilateral environments can be concentrated on products having maximum relative comparative advantage in order to maximize profits, and furthermore, that every country can limit its import volume and adjust import prices by imposing tariffs to avoid ousting of domestic value creation and to constructively expose domestic players to international competition. Under these conditions, international competition induces productive and qualitative progress — complementary to domestic competition.

6. Summary

ComparativeAdvantagePNG05

ComparativeAdvantagePNG03

The Lesson for the European Union

The inexhaustible potential offered by foreign trade based on relative price advantages gives the EU the historic opportunity to overcome the euro crisis quickly – a crisis that is incorrectly and for selfish reasons referred to by its profiteers as a sovereign debt crisis.

The untapped trade potential is proof that

  1. the extremely inhomogeneous euro zone has been a faulty design from the start,
  2. that it’s impossible for countries to achieve mutual gains from trade based on absolute prices (in Euro and US Dollar likewise) given different levels of productivity,
  3. that economically strong countries dominate the weak ones and destroy their economic structures, and
  4. that strong countries finally fall short due to their extreme export dependencies when the weak ones face insolvency.

The European crisis can be overcome by reintroducing national currencies, calculating exchange rates, conceding duties and quotas, controlling movement of capital and labor migration, and abandoning the illusion of a uniform federal superstate. Europe’s future lies solely in building a confederation of states with common values ​​and objectives, and in establishing trade based on relative prices. For further details see the articles EU: Federal Superstate or Confederation? and Sustainable Social Welfare.

For a particularly practical demonstration of foreign trade based on relative comparative advantages I recommend the article Future-Proof Foreign Trade.

7. The Dangers Posed by Trade Based on Absolute Advantages

Adam Smith, 1723 – 1790, who is regarded as the founder of classical economics, was convinced that countries can achieve the greatest profits from free trade, if each country exports products and specializes in products, which it produces with the absolute lowest costs in comparison to its international competitors. Smith’s conviction was later, in the truest sense of the word, relativized by the Ricardian Model, as shown above, in particular with respect to free trade as an apparent condition for mutually achievable profits. The reason for this is simple: Ricardo’s theorem conclusively states that potential trading partners must first identify their relative comparative advantages and subsequently agree on trade flows and specialization to mutually achieve profits.

In Smith’s defence it must be said that he was not able to fully recognize the negative effects of uncontrolled free trade based on absolute advantages under the prevailing conditions of his day. These effects only fully show up under the regime of the present neoliberal doctrine.

Absolute Advantages under the Neoliberal Doctrine

In addition to the aforementioned trade within the euro zone based on absolute prices in Euros, I describe below today’s neoliberal world trade based on absolute prices in US Dollars. The two trading areas differ in one respect: The euro zone is a completely uniform area with respect to its currency, whilst the US dollar area is still distressed by fluctuating exchange rates between national currencies (including the supranational Euro) and the US Dollar as the de facto reserve currency:

The negative effects within the US dollar area originate in unregulated and uncontrolled financial markets: The exchange rates initially come under the influence of currency speculation and currency dumping, in particular against the Dollar. Exchange rates thereby lose their original function, namely to neutralize the natural differences between national economies in costs and prices, and in productivity and wages respectively. Without this neutralization a direct competition arises in goods, services and labor markets based on globally relevant absolute prices and globally relevant absolute wages. As a result, the evolutionary developments of individual domestic productivities are ousted by short-term apparent advantages of distorted exchange rates, uncontrolled capital transfers, disorderly labor migration, intense capital concentration, extreme territorial specialization and externalization of economic costs. Externalization of costs meaning that private business costs are passed onto the general public for lack of economic policy.

In the desperate struggle for industries and jobs, national economies have no choice but to counter the threat of complete specialization and deconstruction of their economic structures with cost-effective locational conditions, causing locational competition. Nevertheless, the systemic de-industrialization can not be averted by taking this measure, not even with the greatest effort. Unemployment, poverty and environmental damage spread inexorably. Countries having no absolute advantages from the beginning, are either completely excluded from trade or guided by the dictates of powerful industrial countries, in case they have valuable natural resources.

It is a scandal that the World Trade Organization (WTO) dishonestly justifies the present neoliberal free trade with gains from relative comparative advantages. You can read about the background of this scandal in the article World Trade organization (WTO).

8. Prospects

The Ricardian Model must also be described as outstanding and pathbreaking, because it provides evidence of the fundamental difference between a domestic economy and external economic relations (foreign trade). The evidence is derived from the different meanings and effects of absolute versus relative productivity and price advantages: Competition based on absolute advantages can, if it is not to turn anarchic and chaotic, only be held under the uniform conditions and rules of a generally mandatory economic system – and such a system is inherently limited by tradition and culture and hence limited in geographic scope. If economic productivity is therefore closely linked with country-specific conditions and also stands for diversity and progress in the world, then it can not and should not be subject to absolute global competition. Because absolute competition across national boundaries naturally quests for a policy-free sphere provoking monopolization by eliminating competitors irrevocably and disturbing domestic balances between productivity, wages and prices.

Relativizing the naturally occurring differences between productivities and prices is the key to bridge the gap between differently developed economies.

Constructive foreign trade based on relative comparative advantages and reasonable international specialization originates from local, regional and national activities. Only when democratically legitimated economic policies are enforced, the opportunity arises to understand and shape economic productivity and specialization as solely aimed at the well-being of society and environment. Only then can domestic economies form a solid foundation on which to build a profitable trade and a sustainable economic globalization.

For a genuine application this means: On the theoretical foundation I lay here, countries can build a sustainably profitable foreign trade by restricting themselves to an economically homogeneous currency area and subsequently agree on exchange rates and autonomously determined import tariffs and import quotas.

__________________________________________________________________________________

Click here for the German-language version: Komparativer Vorteil — aufgewertet

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