Comparative Advantage

for ECON 376 “Rural, Urban, and Regional Economics”

by Prof. Kilkenny (last update/check: 8/18/2003)

original authors: Ricardo (died 1823)

Heckscher, Ohlin; and Samuelson (latter still alive today)

= a fundamental theory of the pattern of trade, and why free trade benefits everyone (IF factors are perfectly mobile among sectors, and goods are costlessly transportable among regions, among other assumptions). It is a “a-spatial” model because there is no explicit role of distance.

The Theory of Comparative advantage says that regions (or countries) tend to specialize in and export the outputs of industries

(i) that employ their relatively abundant factors relatively intensively

(ii) in which their resident workforce is relatively productive

(iii) in which they have relative economies of scale.

Aspects (i),(ii), and (iii) are each reasons why certain outputs from that region would be cheaper than from other regions. All customers can afford more (of everything) if they buy from the places that supply things cheaper. And all places can thus sell more of what they produce relatively cheaply. So, people/places who practice free trade tend to specialize in and exchange the things predicted by this theory, and both as customers and as workers, everyone gains.

Formally, the neoclassical model (i) compares two places (A,B) in a world with two factors of production (L,T);

place A is T-abundant iff:

For example, Iowa is relatively land-abundant, because Iowa has more acres (T) per worker (L) than the rest of the USA:

since there are 26,821,844 acres of cropland and a labor force numbering 1,610,000 in Iowa, compared to (431,144,896-26,821,844 =) 404,323,052 acres of cropland and a labor force of (136,297,000-1,610,000) = 134,687,000 in the rest of the USA. The T/L ratio in Iowa is 16.65 acres/worker. The T/L ratio in the rest of the USA is 3.0 acres/worker. Iowa has more than five times more acres per worker than the rest of the country.

The sources of this data are Census of Agriculture for 1997 cropland, and the Bureau of Labor Statistics for the 1997 labor force data. Notice that we use data from the same year, and 1997 is the latest comprehensive data on cropland. Notice also that we do not use the data on cropland planted or harvested, but on the total available. And we do not use the data on employed persons, but the whole labor force, employed or not.

Note that if place A is T-abundant, then place B is L-abundant. Verify:

By relative we mean both relative to the other places and relative to the other factors of production. Also: every place is relatively abundant in at least one factor of production. This is a real-world fact as well as a mathematical one. This is very important because, as we shall see, it suggests that every place has something it can sell relatively cheaply.

Back to the example: since Iowa is relatively land-abundant, then the rest of the USA is relatively labor-abundant. USA’s L/T ratio is 0.33, while Iowa’s L/T ratio is only 0.06.

Furthermore, for example, farming is relatively land-intensive, because farming requires has more acres (T) per worker (L) than all other industries:

Formally, comparing two industries (X,Y); industry X is T-intensive iff:

And again, if industry X is T-intensive, then industry Y is L-intensive. And, every industry is relatively intensive in at least one factor of production. This is a real-world fact as well as a mathematical one. Thus every place will have a comparative advantage in some industry. So the citizens in every place can gain from specialization with free trade.

Back to the example: since farming is land-intensive and Iowa is land-abundant, then Iowa will optimally specialize in and export farm products. By the same token, since the rest of the USA is labor-abundant and other industrial activity is labor-intensive, the USA will specialize in those other things, and both the USA and Iowa will be better off if they trade farm products for TVs and clothing and other things that are generally made cheaper elsewhere. (Better off than what? Better off than if Iowans purchased only “made in Iowa” non-farm things, and Iowa farm and non-farm industries produced only for the Iowa market. That is, better off than without free trade.)

The rest of the USA (and the world) is better off because it consumes nice inexpensive Iowa-produced food, and it produces other nice things that it sells to Iowans. Iowans are better off because they consume nice inexpensive non-farm things that are often made elsewhere, using the income they earned in farming and industries linked to farming like storage and transport, machinery, chemicals, food processing, etc.

BUT NOTE: A theory is a hypothesis that has not been contradicted by real world data. The Theory of Comparative Advantage is only as true as the axioms it relies upon. In its basic version, the Theory of Comparative Advantage assumes there are no costs of distance. Obviously that is not a realistic assumption. And if transport is more costly for some places than others (by virtue of their proximity or remoteness), the theory will not hold.

In ‘the real world’ a place could be land-abundant but so far away from the market for its land-intensive products that it would not be a low-cost supplier once transport costs were taken into account. It would not be able to gain from specialization and trade in the products that employ its relatively abundant factors relatively intensively.

Second, the Theory of Comparative Advantage assumes perfect mobility of factors of production across sectors. While it is not so farfetched to imagine a world where people are so well-educated that they could be just as productive in one career as another, it is very hard to imagine that this, plus the physical mobility implied to work in any industry, would be costless.

Maybe ISU graduates could be just as productive working as stockbrokers or farmers or anything else. And, nowadays e-commerce allows stockbrokers, for example, to live/work anywhere. But farmers still have to live in the countryside to farm. And only a portion of people can afford an ISU college degree. So it may be difficult for the whole USA to specialize in either farming, or stockbrokering, or any particular sector. And since people are not so mobile, even if the USA has a comparative advantage in stockbrokerage, for example, those who were in that profession would gain, and the ones who could never be stockbrokers would be stuck competing with the low-cost producers of the other things we trade.

Then free trade can make everyone better off only if there is a mechanism that redistributes gains from the lucky to the unlucky. The lucky ones supply factors employed intensively in the comparative advantage industry. They get to earn more with free trade, and pay less for the lower-cost imports (the comparative advantage goods of other places). The unlucky ones supply factors employed intensively in import-competing industries. In the USA, we tax income, and we subsidize primary and secondary education. That’s about all we do to redistribute the gains from free trade that we enjoy. It is not much compensation for workers competing with foreigners who are specializing in their own comparative advantage sectors.