International trade debate: Installment I - Comparative Advantage

In a previous blog, I was speculating on why U.S. wages have not been rising while we have an unemployment rate that some economists would have dubbed as full employment. In that blog I didn't mention the growth of international trade. That's because it is an issue that deserves more attention than can be given in one blog post. So I've decided to tackle the "international trade debate" in a series of blog posts.

Photo: From U.S. Congressional Budget Office web site.

In this first one in the series, I'll cover the basic premise stated by David Ricardo 200 years ago, the theory of comparative advantage. A warning here. While I'll try to stay clear of economist jargon, a tad of that may slip out in this one.

By an overwhelming majority economists support freer international trade and believe it to be a force in raising the national income of all countries that engage in trade. This, in spite of new developments in the economics of trade theory that muddy the water somewhat because of the effect that trade may have on income inequality and because of the possibility of countries competing to get a leg up in industries that may be generating excessive rates of return stemming from increasing returns to scale and monopolistic advantage.

"The idea of comparative advantage -- with its implication that trade between two nations normally raises the real incomes of both ... seems simple and compelling to those who understand it. Yet anyone who becomes involved in discussions of international trade beyond the narrow circle of academic economists quickly realizes that it must be, in some sense, a very difficult concept indeed," Paul Krugman.

So in my first blog in a series on the international trade debate, I will attempt an explanation of comparative advantage by using a story.

It's a story of a man and a woman, Ricardo from Paris and Eva from Berlin, wanting for some adventure. They answered the same add and signed up for a cross Atlantic voyage out of Denmark on a 41 foot sailboat with an international crew of novice sailors. In a celebration in a local Copenhagen night club the evening before the sail was to begin, Ricardo and Eva clashed. Eva was seen slapping Ricardo across his cheek as she left the nightclub in a huff.

Nevertheless, Eva and Ricardo boarded the boat as it set sail. On the voyage they tried to avoid each other while they diligently performed their crewing tasks. Avoiding each other was difficult in the close quarters of a 41 foot sailboat.

Unfortunately, the boat went off course and encountered a fierce storm. The sailboat crashed on rocks broke in half and sank. Ricardo and Eva were the only survivors.

Fortunately, Eva and Ricardo, with life jackets on, reached an island they saw in the distance. Ricardo managed to save a stash of matches that were in a water proof pouch he had attached to his belt. He also had a pocket knife, some fishing line and some fish hooks in the pouch. These are the only resources Ricardo and Eva have when they reach the shores of this small remote island with semi-tropical vegetation and a sandy beach. They soon discover a plant which yielded a grain after much smashing between rocks. The grain, when mixed with a little rain water, made a dough that when baked in a makeshift oven of rocks produced a kind of green flat bread. The smashing of the plant also yielded a slightly sweet green liquid which was refreshing, especially when rain water became scarce between rains.

After Ricardo and Eva constructed a makeshift hut from the branches of palm trees that had fallen to the ground in some past storm, they get to work on harvesting the plant that yields the grain. They spend the days smashing the plant with rocks. They work separately and silently, still not able to get over their enmity. This in spite of their dire circumstances.

Since one cannot live by bread alone, Eva and Ricardo also spend part of their days fishing. Using the hooks and line from Ricardo's pouch. The fish aren't particularly plentiful off the beach on this island. The big fish are out in deeper water. But Eva finds a lagoon with entrapped fish. With patience and insects for bait, they can catch fish in the lagoon.

Eva turns out to be the more productive of the two. Making the grain and baking the bread is hard work. On an average working day Eva can prepare and bake two small loaves of flat bread, each loaf enough to make a small meal when paired with one small to medium fish. When Eva spends all day on fishing she catches an average of two small to medium fish. Of course, Eva can allocate her time differently. She can decide to fish for a half of a day and catch only one fish and prepare bread half a day to prepare one loaf of bread. The point is that Eva's productivity is such that she gets an additional loaf of bread for each fish she is willing to forego. By herself, she can exchange fish for bread on a one to one basis.

When Ricardo spends a day preparing and making bread, he can make an average of one and one-third loaves, i.e., four-thirds loaves of bread, and when he fishes all day he catches on average two-thirds of a small to medium fish. (Remember these are averages. He never really catches two-thirds of a fish. It means that for every three days that Ricardo spends fishing he catches two fish, an average of two-thirds of a fish per day.) You see he is much less productive, i.e., less efficient in both fishing and in making bread than Eva.

But note that if Ricardo gives up a day fishing in order to make more bread he, on average, foregoes two-thirds of a fish, but he can make four-thirds loaves of bread. That is a better than Eva who can only get one loaf of bread for every fish she were to give up catching. Economists say that Ricardo has a comparative advantage in baking. He is less efficient in both fishing and baking, but he does have a "comparative" advantage in baking compared to fishing. By himself, he can exchange bread for fish at a rate of two to one (four-thirds loaves of bread for every two-thirds of a fish. So let's see how this plays out.

Since they are still angry with each other, Eva and Ricardo do their own thing and keep their own fish and bread separately. Ricardo observes Eva from a slight distance while she goes about her work. Over a 30 day period he notes that Eva prepares 20 loaves of the flat bread and catches 40 fish and eats them all. She is looking pretty healthy, and more enticing to Ricardo even than when they were in Copenhagen.

Over that same 30 day period, Ricardo prepares 20 loaves of flat bread and catches 10 fish. He eats them all but is always hungry. Try as he might but he can't seem to do any better. He tries spending more time on fishing, but with each one more fish he catches he notes he has lost time on bread making and makes 2 fewer loaves of bread. He tries spending more time preparing bread, but notes that he is able to catch one less fish for each two more loaves of bread that he prepares. He decides 10 bread and 20 fish is the best he can do.

Ricardo does notice that when Eva decides to prepare an extra two loaves of bread, she has to be content with catching two less fish.

He thinks to himself, "What if I could concentrate on baking bread and Eva would do the fishing? Then I could trade bread to Eva for fish. I could easily give her one and a third loaves of bread for one of her fish and we should both be able to have the same amount of bread we have now while each of us will have more fish than we have now.

He starts drawing a table in the beach sand

Bread Fish

Eva 20 40

Rick 20 10

Total 40 50

"That's what we have now, each 30 days" he says to himself.

Bread Fish

Eva 0 60

Rick 40 0

Total 40 60

"That's what we would have if Eva does all the fishing, and I do all the baking."

Now, I could make Eva whole for her loss of bread. I could trade 20 of my loaves of bread to her for 15 of her fish. If she would agree, I would end up better off, since I would have 20 loaves of bread just as I have now, but instead of 10 fish, I would have 15. And Eva would be better off, since she would have 20 loaves of bread, the same as she has now, but she would have 45fishes instead of only 40.

He draws the table to show the result after the trade.

Bread Fish

Eva 20 45

Rick 20 15

Total 40 60

Ricardo decides to approach Eva. He calls her to view his scribbling in the sand. He is hoping for a rapprochement. Eva is hesitant but also curious about the writing in the sand. He begins by telling Eva how good she is at fishing, and says that he enjoys watching her climb the large rock near the lagoon where she goes fishing and he asks if she enjoys fishing from the rock. She looks at him quizzically and answers that she does enjoy it. Then he says, look Eva, if you were to forego the preparing of the bread and leave that to me and spend your time just on fishing I think we could both be better off.

He shows Eva the numbers in the sand and says if I bake and you fish, and then I trade you bread for fish, you could end up with 5 more fish per month and so would I, and we would both have the same amount of bread.

"Wouldn't you like to have five more fish per month? he asks.

"Yes, she answers, " But how can I trust you to make the trade."

"Well, If I were to renege and refuse to trade, I wouldn't have any fish would I? And I can't live on bread alone."

With that, they make the pact. It works out well, and Eva and Ricardo grow closer and learn to cooperate in many other little ways, even sharing meals of bread and fish together. These meals become more enjoyable when Ricardo learned to ferment some of the green liquid from the mashing of the grain plant into a wine they would enjoy together while sitting on Eva's fishing rock looking for rescue ships on the horizon.

Did Eva and Ricardo ever get rescued? Did they live happily ever after? That is another story.

For now, I hope the theory of comparative advantage, the basic tenet that leads a large majority of economists to support freer international trade is more clear.

For Eva and Ricardo, you could substitute country names like France and Germany and measure the units in tons of fish and thousands of loaves of bread or some such measurements. The point is that even when one country is more productive overall, say as measured in output per capita, they will not have a comparative advantage in all products. It's not possible. In fact, the better a country (or an individual) is at any one thing, the fewer things it or she will have a comparative advantage in doing or producing. This is because doing something else becomes very costly in terms of what it or she has to give up in order to do or produce the alternative. It is all about opportunity cost.

So ignoring complications like national monetary systems and accompanying exchange rates and economies with large entrenched industries and corporations that may or may not have monopoly power and diverse labor forces, and issues of large inequality of income, all of which may lead to caveats, the theory of comparative advantage points to free and freer international trade as a good thing that can increase the level of overall income in all countries.

References:

Paul Krugman, "Ricardo's Difficult Idea.

http://web.mit.edu/krugman/www/ricardo.htm

On economists' agreement on free trade

https://www.nytimes.com/2015/04/26/upshot/economists-actually-agree-on-this-point-the-wisdom-of-free-trade.html?_r=0

It's not possible for a country or an individual to have a comparative advantage in everything http://www.econlib.org/library/Topics/Details/comparativeadvantage.html

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