An Economic Principle For Us All: Comparative Advantage

In an update to his popular A Concise Guide to Macroeconomics, David Moss explains how the state of the macro economy affects managers, executives, students—and all the rest of us. In this excerpt, Moss illuminates David Ricardo's theory of comparative advantage.

The first edition of A Concise Guide to Macroeconomics, by David A. Moss was published in 2007—just as one of the world's great economic downturns was taking off. The second edition has just been published, which includes an epilogue on the crisis and the contrasting actions taken by world governments to fight the downturn. "It seems likely that economic historians will look back at the years since 2007 as a grand natural experiment for assessing the effectiveness of alternative macroeconomic responses to a financial crisis," he writes.

In this excerpt, Moss discusses one of the great principles in economics: the concept of comparative advantage and how it influences everything from nations to house painters. —Sean Silverthorne

A Concise Guide to Macroeconomicsbook excerpt

A Brief Aside On The Theory Of Comparative Advantage

From A Concise Guide to Macroeconomics

By David A. Moss

One of the most important principles in all of economics is that of comparative advantage, first articulated by the British political economist David Ricardo in 1817. Intent on persuading British lawmakers to abandon their protectionist trade policies, Ricardo set out to prove the extraordinary power of trade to increase total world output and thus consumption and living standards. On the basis of a simple model with just two countries and two goods, he showed that every country—even one enjoying an absolute productivity advantage in both goods—would benefit from specializing in what it was relatively best at producing and then engaging in trade for everything else.

In his now-famous example, Ricardo imagined that Portugal was more productive than England in making both wine and cloth. Specifically, he assumed the Portuguese could produce, over a year, a particular quantity of wine (say, 8,000 gallons) with just 80 men, as compared with 120 men in England; and, similarly, that the Portuguese could produce a particular quantity of cloth (say, 9,000 yards) with just 90 men, as compared with 100 men in England. In other words, Portugal's productivity was 100 gallons of wine or 100 yards of cloth per worker per year, whereas England's was only 66.67 gallons of wine or 90 yards of cloth per worker per year. Given Portugal's absolute advantage in both industries, why would the Portuguese ever choose to buy either wine or cloth from England?

Ricardo's surprising answer was that both countries would benefit from trade, so long as both specialized in what they were relatively best at producing. In Ricardo's example, although Portugal was better at making both wine and cloth, its advantage was greater in wine. As a result, Portugal enjoyed a comparative advantage in wine, and, conversely, England enjoyed a comparative advantage in cloth. Ricardo concluded that if each country followed its comparative advantage—with Portugal producing only wine and England only cloth—and the two then engaged in trade with one another, each would be able to consume more wine and more cloth than if it had tried to produce both goods on its own.

“Most of us—even those who have never studied the theory of comparative advantage—tend to live by it in our own personal affairs every day”

To make this more concrete, assume that each country had 1,200 workers, and that each allocated 700 to wine and 500 to cloth. This would mean that Portugal produced 70,000 gallons of wine and 50,000 yards of cloth, whereas England produced 46,667 gallons of wine and 45,000 yards of cloth. However, if each country devoted all 1,200 workers to its comparative advantage, Portugal would produce 120,000 gallons of wine and England 108,000 yards of cloth. If they now traded, say, 48,000 gallons of wine for 55,000 yards of cloth, Portugal would end up with 72,000 gallons of wine and 55,000 yards of cloth, and England with 48,000 gallons of wine and 53,000 yards of cloth. Both countries, in other words, would end up with more of both goods as a result of specializing and trading. In fact, to have produced these quantities on their own would have required 1,270 workers in Portugal and 1,309 workers in England. It is as if, as a result of specializing and trading according to the principle of comparative advantage, both countries got the output of many extra workers for free.

Economists have since shown that Ricardo's result can be generalized to as many countries and to as many goods as one wants to include. Although we can certainly specify conditions under which mutual gains from trade break down, most economists tend to believe that these conditions—these possible exceptions to free trade—occur relatively rarely in practice. Indeed, the Nobel Prize-winning economist Paul Samuelson once acknowledged that "it is a simplified theory. Yet, for all its oversimplification, the theory of comparative advantage provides a most important glimpse of truth. Political economy has found few more pregnant principles. A nation that neglects comparative advantage may pay a heavy price in terms of living standards and growth."

Remarkably, most of us—even those who have never studied the theory of comparative advantage—tend to live by it in our own personal affairs every day. For the most part, we all try to do what we're relatively best at and trade for everything else. Take an investment banker, for example. Even if that investment banker were better at painting houses than any professional painter in town, she would still probably be wise (from an economic standpoint) to focus on investment banking and to pay others to paint her house for her, rather than to paint it herself. This is because her comparative advantage is presumably in investment banking, not house painting. Taking time away from her high-paying investment banking job in order to paint her house would likely prove quite costly, ultimately reducing the amount of money she could earn and, in turn, the amount of output she could consume. In order to maximize output, in other words, it makes sense for each of us to specialize in our comparative advantage and to trade for the rest.