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Comparative Advantage: An Idea Whose Time Has Passed – Article by Michael Munger

Comparative Advantage: An Idea Whose Time Has Passed – Article by Michael Munger

The New Renaissance HatMichael Munger

The Division of Labor Is the Engine That Drives Prosperity

Many economists will tell you that the most important principle in economics is comparative advantage — the idea that it is expensive to grow oranges in Alaska or to flood rice paddies in Saudi Arabia, so Alaska and Saudi Arabia should import oranges and rice, respectively, and base local production on the advantages of local conditions. We got this idea from classical economist David Ricardo, who famously observed in 1821 that England and Portugal would both be wealthier if Portugal exported its wine and imported England’s textiles, and vice versa.

Ricardo’s principle even demonstrated the advantages of trading with those who are less productive at everything. For example, my wife is an attorney. She is also a fast and accurate typist. Yet she hires a secretary who is considerably slower at typing. Secretaries get paid less than attorneys, so if my wife specializes in law and the secretary specializes in typing, my wife can earn more for her firm and a secretary gets a job. Both end up better off. That’s true even though my wife is better at both jobs: comparative advantage means trade helps everyone.

Division of Labor Trumps Comparative Advantage

The problem is that fixed comparative advantage — derived from weather, culture, and location — is vanishing in the modern world. Ricardo’s classical formulation leaves no space for human creativity, no role for division of labor, and no room for innovation to affect the dynamics of cost.

So economists have it wrong, as my friend Russ Roberts argued in 2010. The most important principle in economics is opportunity cost. Here’s proof: you can define opportunity cost without resorting to comparative advantage. But you can’t possibly define comparative advantage without invoking opportunity cost.

The notion of comparative advantage is empirically misleading, because it sounds deterministic. There are few situations where fixed factors make the relative opportunity costs of different actions immutable. Instead, cost and productivity differences are endogenous, the consequence of human ingenuity and the division of labor. Today’s cost advantage for one country may disappear if another country finds a better, cheaper way to produce the product. And the way to specialize is to exploit the division of labor.

Sock City

What nation lost the most manufacturing jobs from 1990 to 2000? China. That may seem surprising, given the media stereotype of how we “ship US jobs overseas,” but it’s true (PDF). In 1990, Chinese manufacturing meant large sheds filled with hundreds of people working with sewing machines and other small tools. The scale was huge, with at least 100 million manufacturing workers. But productivity was terrible.

In the late 1990s, China began to automate, taking advantage of division of labor. A thousand women with sewing machines in a barn turned into 25 women running enormous machines in a factory, with a gigantic increase in productivity. A fraction of the workers produced 10 times as much output, increasing productivity a hundredfold and forcing 97.5 percent of the workers out. But those workers found new jobs, as China used the division of labor more and more effectively. The country’s advantage was not climate, not soil quality, but human action consciously designing production processes that were cheaper and faster.

Nowhere did productivity rise faster than in the city of Datang in Guangdong Province. Part of Datang is actually called “Sock City,” because more than a third of all socks sold in the entire world (yes, the world) are manufactured there. Datang boasts more than 8,000 hosiery makers ringing the city center, and they produced more than 11 billion pairs of socks in 2012. The socks you’ll find at Walmart — or even at Neiman Marcus or another more upscale store — were likely made in or around Datang.

The concentration of manufacturing at Sock City means this: there is a well-developed labor market for exotic sock-making specialties. The occupations that are well known in Datang don’t exist elsewhere, because no other location has been able to take such full advantage of the division of labor. What limits the division of labor in Datang? Only the extent of the market, just as Adam Smith said in The Wealth of Nations. And remember that Datang is producing at a rate of nearly two pairs of socks per year, for every human on the planet. Datang’s market is Earth.

It wasn’t always that way. Datang does not have any comparative advantage, at least not in the way Ricardo meant. The climate is not especially favorable, the city is not near an essential natural-resource base, and sock making is not part of traditional culture. Datang’s dominance is new and is overtaking historical frontrunners like Fort Payne, Alabama, the self-proclaimed Sock Capital of the World.

Fort Payne “began making stockings in 1907 and once boasted of producing 1 of every 8 pairs worn on the planet,” writes Don Lee in “The New Foreign Aid,” published April 10, 2005, in the Los Angeles Times. However, he explains,

China’s advantages in the global marketplace are moving well beyond cheap equipment, material and labor. The country also exploits something called clustering in a way that the United States just can’t match.… Industrial clusters are like one-stop production centers, achieving economies of scale and driving innovation by geographically bunching suppliers, manufacturers and contractors.…

Meanwhile, American producers, pummeled by imports from China and elsewhere, saw their share of the US hosiery market fall from 69% in 2000 to 44% in 2003, according to the latest industry data.

Comparative advantage is fixed and exogenous. Opportunity cost is mutable, the product of innovation. Datang’s Sock City itself may soon lose its dominance.

Who “should” produce socks? Comparative advantage here is no guide; the situation is more like comparing two street porters who appear to be quite similar. One of the street porters figures out ways to make socks much more cheaply. Over time, the advantage in opportunity cost grows because of the improvements in dexterity, tool use, and design of new production processes. Human ingenuity created an opportunity for nations to specialize in activities where their opportunity costs were lower. Specialization and trade are what produce prosperity, and opportunity costs guide the choice of what each country should specialize in. My comparative advantage today may be your comparative advantage next year. But all the street porters started out the same.

Focus on Opportunity Cost

Economists routinely act as if three related key concepts — division of labor, comparative advantage, and opportunity cost — are distinct.

They are not. Comparative advantage is not a separate concept at all. It is simply an explanation of the implications of the division of labor (the engine that drives prosperity) and opportunity cost (the concept that guides the choice of which activities a person, or a nation, should specialize in).

Admittedly, it was a significant intellectual achievement to show that the weaker trading partner benefits from trade, even if the stronger partner is better at everything. But those fixed differences have largely disappeared in many markets. The question of what should be produced, and where, is now answered by dynamic processes of market signals and price movements, driven by human ingenuity and creativity. The cost savings resulting from successfully dividing labor and automating production processes dwarf the considerations that made comparative advantage a useful concept in economics.

Let’s downgrade comparative advantage from our list of key concepts in economics, and recognize that the human mind is the mainspring of a market economy.

Michael Munger is the director of the philosophy, politics, and economics program at Duke University. He is a past president of the Public Choice Society.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution 4.0 International License, which requires that credit be given to the author.

The Importance of Subjectivism in Economics – Article by Sheldon Richman

The Importance of Subjectivism in Economics – Article by Sheldon Richman

The New Renaissance Hat
Sheldon Richman
October 3, 2012

After many years, Frédéric Bastiat remains a hero to libertarians. No mystery there. He made the case for freedom and punctured the arguments for socialism with clarity and imagination. He spoke to lay readers with great effect.

Bastiat loved the market economy, and badly wanted it to blossom in full—in France and everywhere else. When he described the blessings of freedom, his benevolence shined forth. Free markets can raise living standards and enable everyone to have better lives; therefore stifling freedom is unjust and tragic. The reverse of Bastiat’s benevolence is his indignation at the deprivation that results from interference with the market process.

He begins his book Economic Harmonies (available at the FEE store) by pointing out the economic benefits of living in society:

It is impossible not to be struck by the disproportion, truly incommensurable, that exists between the satisfactions [a] man derives from society and the satisfactions that he could provide for himself if he were reduced to his own resources. I make bold to say that in one day he consumes more things than he could produce himself in ten centuries. What makes the phenomenon stranger still is that the same thing holds true for all other men. Every one of the members of society has consumed a million times more than he could have produced; yet no one has robbed anyone else.

The Existence of Privilege

Bastiat was not naïve. He knew he was not in a fully free market. He was well aware of the existence of privilege: “Privilege implies someone to profit from it and someone to pay for it,” he wrote. Those who pay are worse off than they would be in the free market. “I trust that the reader will not conclude from the preceding remarks that we are insensible to the social suffering of our fellow men. Although the suffering is less in the present imperfect state of our society than in the state of isolation, it does not follow that we do not seek wholeheartedly for further progress to make it less and less.”

He wished to emphasize the importance of free exchange for human flourishing. In chapter four he wrote,

Exchange is political economy. It is society itself, for it is impossible to conceive of society without exchange, or exchange without society. …For man, isolation means death….

By means of exchange, men attain the same satisfaction with less effort, because the mutual services they render one another yield them a larger proportion of gratuitous utility.

Therefore, the fewer obstacles an exchange encounters, the less effort it requires, the more readily men exchange.

How does trade deliver its benefits?

Exchange produces two phenomena: the joining of men’s forces and the diversification of their occupations, or the division of labor.

It is very clear that in many cases the combined force of several men is superior to the sum of their individual separate forces.…

Now, the joining of men’s forces implies exchange. To gain their co-operation, they must have good reason to anticipate sharing in the satisfaction to be obtained. Each one by his efforts benefits the others and in turn benefits by their efforts according to the terms of the bargain, which is exchange.

But isn’t something missing from this account?

Austrian Insight

Indeed, there is: the subjectivist Austrian insight that individuals gain from trade per se. For an exchange to take place, the two parties must assess the items traded differently, with each party preferring what he is to receive to what he is to give up. If that condition did not hold, no exchange would occur. There must be what Murray Rothbard called a double inequality of value. It’s in the logic of human action–which Ludwig von Mises christened praxeology. Bastiat, like his classical forebears Smith and Ricardo, erroneously believed (at least explicitly) that people trade equal values and that something is wrong when unequal values are exchanged.

Perhaps I am too hard on Bastiat. After all, he was writing before 1850. Carl Menger did not publish Principles of Economics until 1871. Yet the Austrians were not the first to look at exchange strictly through subjectivist spectacles, that is, from the economic actors points of view. The French philosopher Étienne Bonnot de Condillac (1715-1780) did so a hundred years before Bastiat wrote:

The very fact that an exchange takes place is proof that there must necessarily be profit in it for both the contracting parties; otherwise it would not be made. Hence, every exchange represents two gains for humanity.

Bastiat Unaware?

Well, perhaps Bastiat was unaware of Condillac’s argument. That is not the case. He reprints the quote above in his book and responds:

The explanation we owe to Condillac seems to me entirely insufficient and empirical, or rather it fails to explain anything at all. . . .

The exchange represents two gains, you say. The question is: Why and how? It results from the very fact that it takes place. But why does it take place? What motives have induced the two men to make it take place? Does the exchange have in it a mysterious virtue, inherently beneficial and incapable of explanation?

We see how exchange . . . adds to our satisfactions. . . . [T]here is no trace of . . . the double and empirical profit alleged by Condillac.

This is perplexing. Clearly, the necessary double inequality of value is not empirical or contingent. Contra Bastiat, the double inequality explains quite a lot, and his questions all have easy answers.

Yet more perplexing still is Bastiat’s statement in the same chapter: “The profit of the one is the profit of the other.” This seems to imply what he just denied.

Consequential Failure

Bastiat’s failure to grasp this point had consequences for his debates with other economists. For example, he and his fellow “left-free-market” advocate Pierre-Joseph Proudhon engaged in a lengthy debate over whether interest on loans would exist in the free market or whether it was a privilege bestowed when government suppresses competition. Unfortunately, the debate suffers because neither Bastiat nor Proudhon fully and explicitly grasped the Condillac/Austrian point about the double inequality of value. As Roderick Long explains in his priceless commentary on the exchange,

[E]ach one trips up his defense of his own position through an inconsistent grasp of the Austrian principle of the “double inequality of value”; Proudhon embraces it, but fails to apply it consistently, while Bastiat implicitly relies on it, but explicitly rejects it. . . .

Proudhon’s case against interest seems to depend crucially on his claim that all exchange must be of equivalent values; so pointing out the incoherence of this notion would be a telling reply. But Bastiat cannot officially give this reply (though he comes tantalisingly close over and over throughout the debate) because elsewhere–in his Economic Harmonies–Bastiat explicitly rejects the doctrine of double inequality of value.

How frustrating! Bastiat has so much to teach. But here is one blind spot that kept him from being even better.

Sheldon Richman is the editor of The Freeman and, and a contributor to The Concise Encyclopedia of Economics. He is the author of Separating School and State: How to Liberate America’s Families.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.