Tuesday, January 11, 2005

And now, another few stupid questions for economists, continuing on from last week. The subject of this week's stupid questions: comparative advantage.

To summarize briefly, comparative advantage is the idea that the world economy as a whole is best off when each country does what that country is best at doing, even if some other country could do it better. And furthermore, that this situation naturally comes about by free trade.

This notion was first put forward by David Ricardo, who came up with a numeric toy example of an economy with two goods and two countries: Portugal can produce either wine or wheat more efficiently than England, but the productivities differ. The details are like this:

Cost (Man-hours per unit)Total man-hours available

And we also make a few assumptions, just to keep the math easy:

  • There are no transport costs or tariffs.
  • All wheat and all wine are interchangeable.
  • The costs are static -- there is no progress in production, nor economies of scale.
And so forth. From there, a little simple arithmetic shows that if the countries don't trade, the economy as a whole produces 17 units of wheat and 11 of wine. But if England specializes exclusively in wheat, and buys wine from Portugal, the total output is 18 units of wheat, and 12 of wine. So even though Portugal can produce wheat more efficiently than England, it's still better off specializing in wine, and buying its wheat from the less productive English countryside.

And so, the argument goes, specialization in the good with the greatest comparative advantage is good for everybody. Even the toilers in English vineyards, who, according to the argument, should be just as happy to work on a wheat farm. (Part of the implicit background of economic arguments in this era -- or sometimes not so implicit -- is that market forces will act to keep workers' wages uniform and low. People who repeat the same arguments without qualification now, are arguing in effect that in the modern era, workers with IT jobs should take it with simple equanimity if they find that the Market, in its wisdom, has reallocated their labor to Wal-Mart).

Regardless, the effect on the scale of industries is clear: for comparative advantage to yield its benefits, the English vineyards, and Portugese wheat farms, have to get wiped out. And the operation of the market provides for that to happen. In Portugal, investing in vineyards yields greater returns than investing in wheat farms -- so that's where the money will go. In England, it's the reverse. (This happens through fluctuations in prices once goods start to travel; details here).

Or, to change the example slightly, suppose that Portugal is renamed "Nigeria", and its comparative advantage is now in oil. Once again, investing money in drilling oil wells will yield higher returns than just about anything else you could do with that money in Nigeria. With the result that oil drilling (or other extractive industries) would be seen to drive out investment in other kinds of industries in less-developed countries where it was found. As is found to occur -- a triumph for economic theory! Or is it?

Well, it's empirically true that oil-exporting third-world states are peculiarly slow to industrialize. There's even a name for the phenomenon -- the "oil curse". But, to judge from the economic literature, the cause is something of a mystery, and quite a few papers have been published searching for explanations. Here are pointers, for instance, to a few papers which attribute it to institutional factors -- the oil industry, for instance, is said to foster corruption. (One problem with that, as I pointed out here, is that China, the major current success story for ongoing third-world industrialization, is spectacularly corrupt, and industrialization there is going strong). These economists are puzzled, and I am puzzled by their puzzlement -- which brings me to my first stupid question for the week: Isn't the "oil curse" just comparative advantage at work?

More generally, let's consider the implications of this for a third-world "developing" economy which doesn't have any natural resources. In the absence of trade barriers, what should that country produce? The principle of comparative advantage would say that it should be whatever that country is best at producing. Or perhaps, in cases like this, it's more appropriate to say that the country's capital should go to whatever economic activity is the least comparatively disadvantaged, since countries like this don't do anything well. Either way, we can ask, what's that going to be?

Well, what do people there know how to do? They're able to do farming -- they have traditions in that going back millenia. And it doesn't necessarily require a whole lot of infrastructure beyond the ground itself, nor training; doesn't require workers to keep exact shift schedules; and so forth. If, on the other hand, you plop a factory in the middle of a country like that, you also need other facilities for that factory to succeed -- power and transportation infrastructure, and a trained work force -- which simply don't exist in the country, and which the factory is not likely to pay for on its own. So, our impoverished country has a very hard time making good use of a factory -- but it is able to get agricultural products out of a patch of dirt. Now, it may not do either of these things well, but it seems likely that its comparative advantage is going to be with agriculture.

And, in fact, you can see particular countries where things seem to be playing out just like that. All over Africa, for instance, people are dressing themselves in the cast-off T-shirts of Americans. In fact, Nigeria (where we'd expect things to be particularly skewed with the oil money) is now trying to ban imports of used clothing altogether, in order to preserve some kind of a local textile industry. Which might be a completely vain pursuit in the world of Comparative Advantage, just like the preservation of Ricardo's English vineyards, if the comparative advantage lies elsewhere.

What applies to textiles -- hardly high tech these days -- applies just as much to any other industry. African local industry is being starved out by first-world castoffs in everything from computers to mattresses to trucks. And the logic is the same in each case: the theory of comparative advantage seems to me to say that in the absence of trade barriers, industrialization cannot occur in a country if its comparative advantage lies in oil drilling or agriculture, because the lack of infrastructure dicates that you'll make more money running a farm in those countries, than putting up a factory there. And that's a good thing, because total world economic output is maximized by dedicating the continent to dirt farming -- in perpetuity.

The tricky words there are "in perpetuity". One of the assumptions of Ricardo's theory, as I mentioned above, is that the cost matrix stays the same -- that neither economies of scale, nor synergy, nor anything else is going to change it. It's a static theory. But an integral part of industrialization is doing things -- training the work force, building up transportation and energy delivery infrastructure -- which make it possible for a factory owner to get more bang for the buck. And these things take time. Longer than a decade. Longer than investors in the modern world are generally willing to wait.

To put it another way, a great deal comparative advantage in industrial goods comes from having a lot of industry, and the support structure for it, already in place. So, for countries that don't, what is to be done?

Well, one possibility is to put up trade barriers to force local people to invest in creating industries which would otherwise make no economic sense -- and in their share of a support structure which makes it cheaper to build the next factory. The idea here isn't that trade barriers are a positive good, to be maintained in perpetuity -- but rather, that for developing economies, they are a necessary evil, to be dropped when local industry can stand on its own. It's not a fairy tale to suppose that can happen. That's what South Korea did, for example, last century, pursuing mercantilist policies while building up its industry in the 1960s and 70s, and progressively lowering trade barriers after that. For that matter, it's more or less what the U.S. did in the nineteenth century. And it's what Mauritius, one of the few bright lights in the dismal African economic picture is doing right now. But this flies in the face of conventional "Washington consensus" advice to developing governments -- which is to drop all trade barriers immediately, and keep them down.

Another possibility is to have the government itself create and provide some of the support structure. To have it create electrical, water, and sewer systems, so that private industry doesn't have to shoulder that burden. But that again flies in the face of "Washington consensus" advice, which is to privatize, on the theory that "the competitive market" can provide more economical service. In practice, unfortunately, "privatization" all too often takes the form of first-world conglomerates getting monopolies, as in the case of Bolivian water utilities. The rationale was that the first-world monopolist, Bechtel, would serve more efficiently than the old public utility -- but in fact, it took advantage of its monopoly and the lack of competition to raise rates to levels that were literally killing Bolivians.

To recap: starting from a perfectly orthodox statement of the principle of comparative advantage, I've got the very heterodox position that in conditions of pure free trade, it's going to be extremely difficult for developing countries to industrialize. All of which goes way, way against economic conventional wisdom. So, the remaining dumb questions for the week: where are the countries where conventional wisdom has worked, and what's wrong with this argument?

Well, aside from the garbled version of the wine-and-wheat example that was originally posted up top. Repeat ten times: proofreading cannot be omitted. Proofreading cannot be omitted. Proofreading...


Anonymous Anonymous said...

The puzzle with oil is not that it drives out other traded goods (as you say, a standard application of comparative advantage) but that it seems to make countries worse off, probably because of corruption.

2:25 AM  
Blogger Guy said...

One problem with the idea that governments in the developing world should invest to shift comparative advantage to more favorable industries is that it's been tried many times in the past 60 years and has rarely been effective. Often it's made things worse.

It's hard to figure out in which industries comparative advantage should be "generated", to figure out exactly what kinds of investments are necessary to achieve this goal, and to get bureaucrats to give the proper incentives. There's also the question of, if comparative advantage is actually shifted, whether the costs of the initial investments will have yielded a positive return. Finally, you need to keep in mind that these kinds of "investments" are often captured by special interests and turn out to be little more than a boondoggle.

Given the quality of government in Africa, I'm dubious about this kind of policy advice.

11:01 AM  
Blogger Bruce Wilder said...

There's a corollary available, regarding the consensus Washington advice on accepting foreign investment. Massive foreign investment is recommended as a way to further industrialization. The consequence, when the investment has to be repaid in a recession, is an equally massive currency crisis, a la Argentina. East Asian countries, like Japan, industrialized on the back of very high domestic savings rates and highly restricted foreign investment.

1:52 PM  
Blogger Mike said...

This comment has been removed by a blog administrator.

5:27 PM  
Anonymous Anonymous said...

Comparative advantage, while real, must be considered (a) over the long term and (b) in historical perspective.

It must be recognized that every modern industrialized nation had, at some point in it's development, stiff trade barriers. Often these were the result of favored groups pressing for protection against imported good, but just as often served to shelter flegling domestic industries. Industry in the US benefitted greatly from the trade barriers erected as a result of the War of 1812. Sans that, it is questionable how rapidly the industrial revolution would have reached our shores.

The first point is a tad tricky, but I think more important. The micro-example of "comparative advantage" involves a lawyer and his secretary. The lawyer is a faster typist, but makes more money speaking to clients, etc... It is to both their advantages to to work in their respective specialties. Up to a point. For the secretary to increase his salary beyond a certain point he needs to improve his marketable skills beyond typing, an act which requires a debt-financed investment in training. The same holds true for countries.

Most non-industrial nations can see the comparative advantage trap for what it is, a few try to act accordingly. The problem with oil is that it is (a) so proffitable and (b) so crucial to far more powerful neighbors that it exerts a poli-social-econ pressure of it's own. It takes a great deal of vision, and even more guts, to move beyond that and act against so powerful a short-term interest.

The the House of Saud for example. The tacit agreement between them and their subjects is essentially buying governance: we use the oil money to pay for everything and you don't ask too many questions. This little farce is being played out to greater or lesser degrees of success in most of the oil-exporting countries. Many of these countries are in a trap, and their leaders respond accordingly by packing away billions overseas in case they have to airdale it out like the Shah. In these cases corruption (a correlate of normal industrialization) is an effect of the economic conditions, not the cause.

Any 18th century mercantilist could have spelled it out: a colony is a state which exports raw materials and imports finished goods. The history of these exchanges is instructive.

12:15 AM  
Blogger Ronald Brak said...

"If a country's comparative advantage is in dirt farming, how can it still industrialize under unrestricted free trade?"

This is a good question. Now unfortunately it's very hard to answer as there have never been any countries that have operated under unrestricted free trade. However we are fortunate in having the example of Nebraska which can serve as a proxy for such a country as it appears to have a comparitive advantage in dirt farming and has had free trade with other American states since its creation.

Nebraska appears to show that countries with an advantage in dirt farming don't industrialize. Sure there is some industry but it is mostly light and revolves around agricultural machinery and food processing. Compared to many other U.S. states Nebraska has very little industry.

Of course this doesn't mean Nebraska has remained dirt poor. Through education and and investment in farm capital Nebraska farmers have grown to become amoung the most productive in the world and while Nebraskans aren't the richest people in America they are certainly rich by world standards.

10:26 AM  
Blogger JoshSN said...

I am very interested in a user-friendly version of your comment that the _point_ of these comparative advantage theories was to keep wages low.

Manufacturing and Agriculture certainly do something different to the mentality than extraction.

A lot of the extractors (e.g. Haroldson Lafayette Hunt) have become very religious people. What other force can one (simpleminded) person possibly attribute to their good fortune? Why did they strike oil, and not another? God intended this. This is the way. Bow, now.

7:18 PM  
Blogger charles said...

It's not that the point of comparative advantage is to keep wages low. Comparative advantage just describes what will happen under certain conditions. There are cases in which it will actually keep wages high --- as in America in the '50s, when it probably was the case that the country's comparative advantage was in high wage industries, and so opening trade pushed low-wage jobs overseas. But those were unusual conditions; my point here is that in other cases, which may be more common in other parts of the world right now, the exact same theory may predict very different effects.

11:38 PM  
Anonymous Anonymous said...

"Of course this doesn't mean Nebraska has remained dirt poor. Through education and and investment in farm capital Nebraska farmers have grown to become amoung the most productive in the world and while Nebraskans aren't the richest people in America they are certainly rich by world standards."

While Nebraska didn't industrialize, highly productive agriculture was important for the industrialization of the country as a whole. This is an essential point that economists tend to miss. Subsistance farming means most of the manpower is tied up in producing its own food, and so little is left over for other productive endeavors. One reason Africa has remained so poor is that there has not been a revolution in agriculure such as occured in England in the 17th and 18th centuries, and Asia with the Green Revolution. This is partly because the crops are different and foreign aid and government policies have mistakenly emphasized big industrial projects.

In addition, African agriculture has been crippled by agricultural trade barriers in the developed countries.

8:32 PM  
Anonymous Anonymous said...

a good article that strikes directly at the heart of everything that's wrong with the washington consensus. trade barriers are an absolute pre-requisite for industrialization, period, end of story.

and the economists who preach the opposite are not stupid, they know exactly what they're doing. the goal is not to help poor countries industrialize, it is to *prevent* them from industrializing and make sure that they continue to specialize in the extractive industries - including oil drilling - that are necessary top fuel the existing industrialized economies.

it's sharecropping, on a global scale, and the IMF is the new company store. simple as that.

8:52 PM  
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