Common Sense looks at the law of comparative advantage
It has often been said that there is nothing in economics which is both insightful and true. Supply and demand? Intuitively obvious. Marx’s labor theory of value? Not true. But there is one exception, the theory of comparative advantage developed by David Ricardo in 1817. Ricardo’s ideas are directly relevant today to such diverse topics of debate as Bob Geldof’s Live 8 concerts and the calendar for selecting US Presidential candidates.
Imagine, as Ricardo did, a world with only two countries and only two products. Let us call the countries, as Ricardo didn’t, America and Ethiopia, and imagine that their products are computers and grain. As America is more developed than Ethiopia, it can produce both computers and grain more efficiently. Let us say American grain costs $10 a ton and Ethiopian grain $20. Imagine that American computers also cost $10, but Ethiopian computers cost a staggering $100.
Since America can make both products more efficiently than Ethiopia it has no need to import anything, and Ethiopia cannot expect to sell anything to Americans, right? Wrong!
The reason is that America’s comparative advantage in computers is greater than in grain. It therefore pays America to focus on producing computers, even though this means importing more expensive grain from Ethiopia.
The figures back up this surprising conclusion. If, before trade, each country produces $1000 worth of each commodity, then America will produce 100 computers and 100 tons of grain. Ethiopia will produce 50 tons of grain and just 10 computers. But if Ethiopia focuses on grain and exports its surplus (50 tons) to America then America can switch half its grain production to computers and produce an extra 50. Result, the world has the same total grain production but a net gain of 40 cheap computers a year. Both countries are better off.
But what happens if America’s presidential calendar gives disproportionate influence to a grain producing state, say, Iowa. Then, the chances are, that America’s computer manufacturers will have to pay taxes to fund a subsidy to farmers. America starts to focus on the industry where its advantage is least.
America produces fewer computers and has a grain surplus. Cheap grain floods the Ethiopian market, and Ethiopian farmers start producing expensive computers instead. As land in Ethiopia falls out of use it is absorbed into the encroaching desert, and Ethiopian agriculture is wiped out completely. Unable to sell its expensive computers, Ethiopia can no longer afford to pay for American grain.
But the Iowa subsidy machine cannot be stopped. There’s another Presidential election coming. So America has to lend money to Ethiopia to buy American grain. With no industry, no exports, and no income, Ethiopia cannot repay the loans. No need to worry: the debts must be cancelled, and new loans made. Iowa needs its subsidies.
The Ethiopian government takes on responsibility for distributing grain throughout the country and there is a coup – the generals want to make sure that soldiers get fed first. The areas which remain loyal to the ousted government are all deliberately starved to death . . . Where will it all end? Probably, with ageing rockstars passing round a begging bowl.
But there is another way. Western countries could stop subsidising agriculture and textiles, and so allow the developing world to actually develop. As Ricardo showed, everyone would be better off, except politicians scrabbling for votes in Iowa.