Celebrating 200 years of a deeply unintuitive idea: Comparative advantage

This past week marked the 200th publication anniversary of David Ricardo’s On the Principles of Political Economy and Taxation. Despite the somnambular title, this book marked the first dissemination of an idea that the mathematical economist and Nobel laureate Paul Samuelson referred to as “the only idea in the social sciences that is both true and non-trivial.” It is also deeply counterintuitive.

It is the Principle of Comparative Advantage, the fact that a more efficient person (or country) can gain from trading with a less efficient person (or country), even if the more efficient party is more efficient at everything. This is because the more efficient person, though better at everything compared to the less efficient person, is nonetheless even better at some things than at others. Dividing the labor and allowing the more-efficient person to specialize in what they are best at, and the less-efficient person to specialize in what they are best at, makes everybody better off.

Got it? Even the most intelligent people find this idea difficult, and if it hasn’t yet been explained to you ten different ways, then perhaps let’s try again, using a simple example. Suppose Jane is starting a computer repair shop. Jane has been taking computers apart and putting them back together since she was in diapers, and on top of that she’s now completed a degree in electrical engineering from a top university. Jane is also good with people and quick at adding up numbers.

Jane only has so many hours per day that she can work. One possibility is that she could spend half of her time fixing computers and the other half of the time dealing with the customers. She is, after all, great with people and good at adding up numbers, and she probably couldn’t find anyone better at either job. Nonetheless, I think we can see that Liz would be better off hiring another person – say, Alice – to do this job, even though Alice is not particularly skilled with people, gets involved in long conversations with customers, and is downright slow with a calculator. While it might take Jane only 3 hours per day to deal with customers, it would instead take Alice 5 hours, with her lack of social graces, her chatty personality, and her stubby fingers. It is nonetheless better for Jane to hire Alice for this job because Jane can then spend more time working on computers, for which her skill greatly exceeds Alice’s (or pretty much anyone’s). If both people specialize, they can both be better off – Jane can make more money by fixing more computers, and can use some of the extra money to pay Alice. Jane is said to have a comparative advantage at fixing computers, whereas Alice has a comparative advantage at dealing with customers. This is so even though Jane has an "absolute advantage" at both tasks.

That example is designed to give the intuition, but it is imprecise. Let’s now take a quantitative example, this time for trade across countries rather than between individuals. Suppose that France, because of its tamer climate, requires fewer resources to produce wine, compared to England. Perhaps it takes 20 hours of work to produce a barrel of wine in France, compared to 40 hours in England. Let’s also suppose that France requires fewer resources than England to produce a barrel of gin – say, 40 hours in France versus 50 hours in England. Clearly, France is better in absolute terms at producing both products. But England nonetheless has a *comparative* advantage in producing gin – it is *less* inefficient at gin production. Consequently, both England and France can benefit from exporting wine from France to England and exporting gin from England to France.

To see this, set the wholesale price of a wine barrel at $400 and a gin barrel at $700. Then if some French people spent 40 hours producing wine, they could produce 2 barrels, which could be exported to England for $800. These people can then use the $800 to purchase a barrel of gin for $700, and will still have $100 left over to spend on other things. (Tequila, anyone?!) In contrast, if the French instead made their own gin, they would spend 40 hours making a barrel of gin, and would have no proceeds left over for tequila. So even though French people are better at producing gin compared to the Brits, they are nonetheless best off specializing in wine because they are even better at wine. They can make as much wine as they want to drink, and then make some more wine to pay for their gin.

This trade is also beneficial to the Brits. If the Brits spend 50 hours making a barrel of gin worth $700, this can be traded to France for 1.75 barrels of wine. If they instead produced wine directly, 50 hours would produce only 1.25 barrels of wine. So even though the Brits are worse at producing gin compared to the French, they are better off specializing in gin because they are even worse at wine. Both the stronger and weaker trading partners benefit from trade. This is the power of Ricardo’s argument and it is one of the reasons that economists are so worried about political interruptions to free international trade.

Yet, the more examples I write down and the more I explain this, the more difficult I realize this idea really is. Why is comparative advantage so damned counterintuitive? Here are five (not mutually exclusive) speculations.

First, comparative advantage requires an understanding of the division of labor, as a preliminary. As I've discussed before, people seem to systematically underestimate the value of specialization, which can in turn lead people to underappreciate the benefits of trade. If people's cognitive biases make them think they will do better as hermits than as agents embedded within a broader network of trade, they will hardly find it intuitive that a weaker trading partner can gain from exchange with a stronger partner.

Second, it seems, at first blush, to violate the simple and intuitive heuristic that to produce more output, you have to work more. It is not difficult to imagine where this idea comes from, and it is usually true. If you own a winery, you will indeed produce more wine if you plant more grapes, work more hours, hire more employees, and so on. But you will not produce more gin by substituting some of the wine-production for gin-production – you will produce less gin than if you simply specialized in wine and traded for gin. Indeed, if you specialize in wine (rather than diverting some labor to gin), you can even work less hard and earn yourself more gin. Compare the following two cases for the French: (A) Working 200 hours to produce 5 barrels of gin, or (B) Working 180 hours to produce 9 barrels of wine. The 9 barrels of wine can be sold for $3600 and traded for 5 barrels of gin (= $3500), plus $100 left over. Option (B) results in greater output, even though it involves less work. Undoubtedly this is counterintuitive – it almost sounds like magic.

Third, it is easier to appreciate comparative advantage if we think of other people as machines or robots – a seemingly dehumanizing thought pattern that may be both unnatural and aversive. To take a more familiar industrial problem, suppose you want to produce paper clips. You could bend the metal by hand, but it would be more efficient to use your labor to obtain electricity, which can be input into a paper clip machine. If paperclips are anything like pins, we can bet that you (even if you are a paperclip expert) will produce a vanishingly small number of paperclips even after many many hours. But if you instead divert your labor toward producing electricity – even if your only method of doing so is riding an electricity-producing bicycle – an hour of work will produce enough electricity to manufacture thousands of paper clips. That is, it is far more efficient to use labor to produce the intermediary rather than the final product.

It is the same logic for other forms of trade. If the French person produces gin directly, she will require 40 hours to produce 1 barrel of gin. But if she instead aims at the intermediary of wine, she can spend 35 hours producing 1.75 barrels of wine (worth $700), which can be exchanged for the same barrel of gin. That is, in the latter case, she uses trade and the British gin industry like a machine that can input wine in exchange for gin. It is not so different if Jane, as a computer technician, swap skills with Nancy, her auto mechanic. Eventually Jane could figure out how to fix her car, but it would be far easier for her to fix Nancy’s computer and have Nancy fix Jane’s car instead. The “input” is fixing Nancy’s laptop, and the output is Jane’s fixed car. Nancy is the machine – and so is Jane.

Third, it is difficult to think at the level of a system rather than the level of an individual. I have taken pains to talk here about the gains to individual parties in these transactions rather than the gains to “society,” because I think it is more intuitive to think this way. But another way to see why trade is helpful, even when one trading partner is more efficient at producing everything, is to think about what maximizes the efficiency of both countries or trading partners taken together. For example, suppose the British people have a total of 800 hours to spend on wine and gin production, and the French people have another 600 hours, with each country dividing their production half and half between wine and gin. (The Brits haven’t yet adopted the French workweek, after all.) Then Britain will produce 10 barrels of wine (at 40 hrs/barrel) and 8 barrels of gin (at 50 hrs/barrel), and France will produce 15 barrels of wine (at 20 hrs/barrel) and 7.5 barrels of gin (at 40 hrs/barrel). Combined they produce 25 barrels of wine and 15.5 barrels of gin. It is lovely that both countries experience variety, but they would do better to obtain this variety through specialization and trade. If Britain specialized in gin, they could produce 16 barrels of gin, and if France specialized in wine, they could produce 30 barrels of wine – more wine and more gin. The world as a whole is richer, and both countries can be better off by trading at a mutually agreeable price.

Finally, I have argued in some of my own work that many people have the strong intuition that economic transactions are zero-sum – that one party’s gain is the other’s loss. As shown in the numerical examples above, this is demonstrably untrue. Yet there is a simpler argument, which comes back to Adam Smith. If two trading partners agree on a price, then they believe that the transaction benefits them both at that price. Jane fixes Nancy’s computer, and Nancy fixes Jane’s car. They surely would not have made this trade if Jane felt it was more work to fix Nancy’s computer than her own car, or if Nancy felt it was more work to fix Jane’s car than her own computer. We know that both parties are better off simply because Nancy and Jane are reasonable people. The basic logic is the same in international trade: When the French winery trades with the British gin distillery, they know what they are doing, and neither is winning at the expense of the other.

On the whole, consumers in both countries benefit from lower prices and the industrial sectors in both countries benefit from a larger market. (Though the greater these gains are overall, the more specialization is required and the more there are shifts across industries within each country). The fact that people and countries are different from one another is precisely what makes specialization possible and what allowed for the unimaginable escalation in wealth that society has experienced in the 200 years since Ricardo’s great insight.

#historyofideas #failuresofintuition #behavioraleconomics #cognitivescience #economics #divisionoflabor #comparativeadvantage #trade

University of Bath School of Management

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© 2018 by Sam Johnson