The young farmer who rents our pasture hasn’t studied economics, or he wouldn’t have offered to spell me doing hand-shoveling recently.
His offer was generous on a sweltering day, but it ignored the vital economic principle of “comparative advantage.” That principle, first identified by British economist David Ricardo two centuries ago, remains a foundational idea in economics. Its insights led to policies that have boosted trade and economic growth ever since, but especially since World War II. And yet it remains unappreciated by the general public.
To understand it, start with our ditch-digging. We are installing water lines and fences to divide the pasture into separate paddocks so Allan, the young farmer to whom we rent the pasture, can implement rotational grazing. His family has a tractor-backhoe and he is adept at operating it. I have hand tools and much miscellaneous experience. He digs trenches with the backhoe while I lay out pipe, glue it together and connect hydrants and valves in correct locations.
We had to put one hydrant in a tight corner between a fence post and one of the enormous earthmover tires that are used as livestock tanks nowadays. And we had to avoid nicking the already-buried drainpipe for the tank. Allan did what he could with the backhoe but someone had to hand-dig a 1-foot-square extension of the trench 7 feet deep in heavy yellow clay to get the hydrant in the right spot.
I grabbed my shovel and climbed into the trench. Allan continued to backhoe. But I am a portly college teacher who will be 60 in a few weeks. Allan must have noticed that shovels of clay emerged more and more slowly. He came over and offered to do the spade work.
In his late 20s, Allan is in better physical shape than I ever was. He could have dug the clay in half the time it took me. In economic terms, he is more productive and, considered alone, it would have been more efficient for him to have dug the clay.
The problem is that to shovel the clay, he would have stopped backhoeing. While I have run a lot of machinery, I am a novice backhoe operator. He is much more productive than I am at this task, too.
Now consider the economics. Prior to Ricardo, economists like Adam Smith thought that trade depended on “absolute advantage.” Suppose cool, wet Britain could produce wool cheaper, either in hours of labor or silver coins, than Portugal. And suppose sunny Portugal could produce wine cheaper than Britain.
With Portugal’s “absolute advantage” in wine and Britain’s “absolute advantage” in wool, the two nations should specialize, Britain in wool and Portugal in wine, and trade with one another. The two countries taken together would be better off because wine and wool would be produced where they could be produced most cheaply.
The problem was that, just as Allan is more productive with both a shovel and a backhoe-tractor than I am, there were some countries that could produce both of two goods cheaper than another. Yet they still engaged in trade. How could this be to their advantage?
The answer is that “opportunity cost,” the value of what you give up to pursue any alternative, is the relevant factor; not the absolute cost. The same is true for us digging trenches. Yes, Allan could take over the shovel and make the clay fly. But the backhoe would sit idle or, at best, produce 20 feet of trench an hour with me running it rather than the 120 feet it could with Allan.
The opportunity cost of Allan hand-shoveling is a trench that is not backhoed. While Allan has an absolute advantage in both hand and machine work, his comparative advantage is running the machine. I have an absolute disadvantage in both hand and machine work, but have a comparative advantage with a shovel. If we each specialize in the task at which we have a comparative advantage, me with the shovel and Allan on the backhoe, we get more total pipe installed in a day. Our two-person economy is more productive: We have more output for the same use of resources.
Portugal perhaps could produce both wine and wool more cheaply than Britain. But to get more wool would have meant turning vineyards into sheep pastures. The wine that could be produced on those same vineyards, if traded to Britain, would fetch far more wool than could be raised on those same acres.
Similarly, grapes could be cultivated in parts of England. But you could get more (and better!) wine by raising sheep on that land and trading wool for Portuguese wine. Under the right conditions, both countries could have more wool and wine than without trade. That principle of comparative advantage still underlies modern trade theory.
Despite agreement among economists that voluntary trade can benefit both nations, it remains politically controversial nearly everywhere. Government policies like China’s undervaluing its currency or the United States and European Union subsidizing agricultural production can warp true comparative advantage. But despite current handwringing about the recession, people in most countries of the world have far better standards of living than their grandparents did in 1945. And much of that is due to international trade.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.