The SanityPrompt

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Tuesday, June 14, 2005

Comparative Advantage Encore!

A sure sign that you slept through most of your macro classes is when bits and pieces of it come back to you in the night. So I awoke Tuesday and recalled the discussion of comparative versus absolute advantage that Ben Bernanke presented in Macro 101. Differentiating between comparative and absolute advantage goes to the core of much that is discussed on Brad DeLong's website and probably wasn't very well explained by anyone.

Say, to make matters simple, you have a world economy consisting of three goods (how about - service, agriculture, and manufacturing) and three nations of similar size: LILLIPUT, BROBDINGNAG, and HOUYHNHNMS. And say that the Brobdingnaggians are the wealthiest, most educated people on your planet and they are endowed with superior productivity in all three goods markets -- they are more efficient producers in each market than the workers in the other two countries. This represents absolute advantage.

But in a world of the three nations, if they are going to trade with each other, and if the Brobdingnaggians are going to sell their goods to anyone, then the Lilliputians and the Houynhnmians will have to make something and sell something too. So who should do what? Obviously, if the Brobs do everything they won't sell much to the other countries. The idea of comparative advantage is that they should focus on what they do best -- on the industry in which they have the greatest advantage (relative to the other two) -- say it’s service. This doesn't mean they only have to do one thing, it just means that they should shift resources out of things that they do better than others (agriculture and manufacturing) into the area that they do much better than others, namely service, since the payoff is bigger.

So that’s the macro side of things -- as best as my sleepy head remembers it (sorry Professor Bernanke). But obviously in our simple example each nation is better off to focus on particular markets rather than trying to work in all three. So say in our stylized example that the Brobs decide to focus exclusively on service. This requires everyone in agro and manufacturing to shift out and into services. Some will be able to do this. But many will not.

Imagine that the service industry requires not only the highest levels of training but also the highest levels of ability. Now think back to your 5th grade classroom. Could everyone in that class room work at the same high level? If you went to a wealthy suburban school you may, (but the chance is slight) say maybe. But if you think across the spectrum of American society you know intuitively that many may not be able to work in this sector. In fact, this sector may not require many people at all. So the question I raise is – what do these people do?

Tim Worstall raises these issues and far more eloquently than I and rightly chides me for having simplified matters too much and failed to exactly specify the notion of comparative advantage. His heuristic is that each nation needs to do what it is least bad at. I hope this presentation does it better. The question really isn’t if comparative advantage is a myth, it’s if comparative advantage operates in the real world in a way to make enough of us better off to be sufficiently compensated for the shift to a free trade world. In other words, will the move into one industry over the others in our stylized example above be sufficiently lucrative to our society (macro says yes) that we can distribute the gains to everyone even those who cannot participate in the industry we decide to concentrate on.

I do not, unlike Worstall, however, believe it is the case that the wages of the Houyhnhnmians and the Liiluputians will rise up to meet the Brobingnaggians without any diminution of the latter’s wages. For one thing, international trade flows will never be completely free as long as migration is severely limited. Average wages may remain steady or rise slightly (the US case) but median wages could fall dramatically (telling you something about the spread rather than the mean).

Worstall rightly raises a profound question though. He asks if changes due to free trade are different from changes due to tastes or technological changes or changes in the weather. This really is the central question our society needs to consider. But is also a question for economists to consider because it asks us where do the rights of parties lie? If you are an internationalist and assume no special preferences for your own people than you are very likely to believe that free trade is no different than inventing a better way to build a widget. But if you are not of this mindset, then you may be inclined to view a shift towards free trade as more akin to the kind of injury that a polluter inflicts on his neighbors.

Coase being right here (which I think is the second thing in economics that is true and non-trivial) if property rights are well defined and markets exist, then parties can compensate each other for the injury and externalities minimized. But with regards to pollution, the question immediately arises who should have the property right and who should do the compensating. Does the polluter have the unfettered right to pollute and his neighbors need to pay him not too? Or does the neighbor have the right to a clean environment and the polluter needs to pay her to produce the pollution? What does this have to do with free trade? Well if you are less of an internationalist, you are more likely to see a free trade policy like pollution – an action creating costs on certain parties who need to be compensated than someone who says – “tough luck old chap, here’s a dime.” After all, free trade will result from a collective decision of the polity (while you may see free trade as the natural state of the world with protectionism as a gloss it seems in my mind to be more a matter of perspective) and as such, interpersonal compensation is likely to be merited and required. Now that’s just from a normative perspective.

What about a positive view? Well, the question I raise regards this more. It is theoretically possible (and this is my main concern) that a shift to free trade in some countries like the US will make more losers than winners but the winners will be better off in total than the losers are. The US operating as a democracy, however, voters are unlikely to be persuaded by those proffering Samuelson and saying but this is the only true and nontrivial thing in economics. Rather they are likely to resist the shift to free trade if they feel it threatens them And the emerging sense among the electorate (if the line up in the House on CAFTA is any indication) is that enough people feel sufficiently threatened to now be inclined to oppose free trade. Bringing us back to the question I left off on – do nations like the US move towards protectionism or do they move toward greater political integration as well. Recent developments in the EU bode poorly for the latter, raising the stakes about the former unless the compensation mechanisms can be worked out appropriately.