William Watson: The hardest idea in economics—comparative advantage

I’m spending the weekend at the Fraser Institute in Vancouver with two American colleagues introducing 25 Canadian journalists to key ideas in economics. We’ve been doing it every May for three or four years now and this month we’ve done three separate sessions. At least something in Canadian journalism is growing!

Teaching journalists is lots of fun. They’re smart, informed about lots of things, and, unlike many undergraduate students, not shy about asking questions. One question they never ask, though, is “Will this be on the exam?” There is no exam.

The guys I teach with, Mark Schug, who’s an emeritus prof from the University of Wisconsin at Milwaukee, and Scott Niederjohn, who teaches at Lakeland College, also in Wisconsin, are terrific at working through the basics of supply and demand, the tragedy of the commons, the gains from exchange, and so on, often with interactive games. If I’d seen them in action 35 years ago, I would have been a much better teacher myself.

The one concept we introduce that always gives people the most trouble is comparative advantage. When Economics Nobelist #3, Paul Samuelson, was asked by an MIT colleague, a non-economist, to name something in economics that was true but not trivial, Samuelson came back with comparative advantage. Another Nobelist named Paul, Paul Krugman, who won the prize in 2008 (Samuelson’s was in 1970) has called comparative advantage “Ricardo’s Difficult Idea,” referring to British economist David Ricardo (1772-1823) who is credited with having discovered the idea.

What economists call “absolute advantage” is very easy to understand. It’s true but trivial. If someone else—whether a country or a person—can produce something more efficiently than you can, you should buy it from them and focus your effort on what you do most efficiently. (As Adam Smith put it in The Wealth of Nations: “What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.”)

But what if there’s nothing you can do more efficiently than anyone else? Many of us often have that feeling.

That’s where comparative advantage comes in. The example we use in our sessions is of Sidney Crosby and the kid who lives next door to him. (It’s actually an adaptation of an example from Scott using LeBron James.) Who should mow Sid’s lawn, Sid or the kid? As all Canadians know, Sid is a terrifically talented athlete. His exceptional endurance, discipline and hand-eye coordination make him a great hockey player but they also make him a tremendous lawn-mower. At mowing lawns, Sid can do a better job in a shorter time than almost anybody, certainly including the kid next door. He has an absolute advantage in lawn-mowing.

But what does it cost Sid to mow his own lawn?

In the couple of hours that mowing takes him he could be shooting commercials or working out or renegotiating his contract or any number of activities with a much bigger payoff. His time is extremely valuable. The cost to Sid of mowing his own lawn is very high. The kid, by contrast, might make $20 or $25 in a shift at Macdonald’s or play some videogames with his friends or hang out in the skateboard park, and so on. What he gives up to mow Sid’s lawn is much lower than Sid’s sacrifice to mow his own lawn. So the kid should mow Sid’s lawn even though he’s a worse mower than Sid.

After thinking about it a bit, people tend to get that example. But tell us about the real world, they then say. What about trade between countries? We have the idea that these days China can do just about everything more efficiently than anyone else. We assume, in effect, that China has an absolute advantage in producing almost everything. The only reason it doesn’t produce all the world’s goods is that there are only so many Chinese, even if there are a lot.

But the impression we have is just not true. Only this week the OECD produced its latest Compendium of Productivity Indicators (not the most alluring book title ever, admittedly!). Figure 2.9 of that study on p. 47, shows that in China output per person employed is only a little over 25 per cent of the OECD average while in Canada it’s actually a little higher than the OECD average. As a result, Chinese wages are much lower than Canadian wages. Chinese productivity just doesn’t permit higher wages. If China did have an absolute advantage in everything, its wages would be higher than everyone else’s.

What enables China to export as much as it does is not absolute but comparative advantage. In industries where we have a really big absolute advantage—agriculture is one—not even low Chinese wages can make its products competitive with ours. But in industries where China’s productivity is closer to ours, even if it’s not actually as high as ours, China’s low wages give it a decisive cost advantage. There may also be some industries, though probably not many, where China has an absolute advantage. If so, its higher productivity and lower average wages make that advantage decisive.

As productivity rises in China, so will average Chinese wages. Because productivity probably won’t rise by the same amount in every industry, the pattern of China’s comparative advantage will likely change, just as our comparative advantage has changed over time with changes in the industrial and sectoral pattern of our own productivity. But unless the pattern of Canadian and Chinese productivity becomes exactly the same, we’ll almost certainly still find things to buy from them and they’ll find things to buy from us.

As China becomes a rich country, will we stop trading with them? Very likely not. Despite common beliefs about low-wage advantages, most of the world’s trade is among its rich countries. If anything, a rich China will be more of a trading partner than it is now.