Sunday, September 12, 2010

Ricardo's Hypothesis of Comparative Advantage - Imperialist Poison or Modern Panacea

During my time at B School I took up the course of International Economics. I still remember the first day when I was enthralled by that one theory that not only forms the bedrock of all Modern Trade theories and Mulitlateral trade treaties across the world but was also instrumental in pulling economics from the status of Social Science to a path more closer to Physics. It's the David Ricardo's "Theory of Comparative Advantage", it is one of those thoughts that had a lasting effect to the lives of mankind. I would not be exagerating if I say that in Economics it holds the same pedestal as perhaps the Einstein's relativity does.

A few days back on my flight back to Delhi I was sitting with a small time businessman engaged in the business of engineering goods. Our discussions moved to International Trade and as expected he was opposed to the idea of opening up of borders for goods. While his arguments were obviously centered around his concern of facing lot of competition but I started having second thoughts about this whole notion of Free Trade and if it is Good for the World. The main problem with textbook education is that it doesn't give you a chance to critique existing norms. Most of the theories taught to us are set in the Western World, the same place which developed by imposing heavy restrictions on the flow of goods.
As I thought deeper into the Ricardo's theory I found it to be surmounted with imperialist flavour, very similar to our archaic caste system in which a person of lower caste/work was not allowed to leave his/her profession. In essence both had the sole motto - "The poor should remain poor".
Ricardo theory only works if the productivity across sectors in a country is the similar, otherwise it's nothing more than a tool to create disparity in society. Think about it if a person has a comaparitve advantage in cobbling shoes while another in writing software then and according to the theory they both specialise in their fields of comparative advantage, wonder what would happen..... the gap between the cobbler and the software engineer would increase many folds in some years (Sounds familiar !!!)......
Let's take a numerical example. Please note that I believe that the explanation is intutive enough to understand, however since Ricardo's theory gains it's strength from numerical presentation, I feel it's appropriate to give a counter in the same way. The examples are simplified. Incase someone is interested in any detailed analysis, they can contact me through mail or this blog.
Let's assume the same simplified case of two countries, two products and single factor of production (labour).

In the example above the productivity of B in producing product X and Y is the same and so if the two nations specialise in their areas of comparative advantage the worlds output would expand. Country A would be richer than country B, however that has more to do with the fact that the labour in country A in both the sectors is far better than country B. Ricardo's theory fits in perfectly here.

However is it practicle to assume that the productivity in both sectors would be the same. I mean in the above case 1 unit of labour would produce $150 worth of X or Y, but in most cases this is not true. Usually productivity of skilled and educated labour is higher than the labour that is unskilled and illiterate. In most cases richer countries would always have a comparative advantage over the developing world in the work that involves skilled labour. This is because highly skilled jobs means that labour input involved for every unit of output is less.

Hence (x1 + ∆x)/ x1 > (x2 + ∆x)/ x2 ; x1 would lead to far higher labour productivity, so does that mean that the developing world should specialise in non-skilled work!!! Absolutely Not. Let's look at it numerically:

Here there are huge productivity differences between the two products. If Country B produces in the area of comparative advantage it's output would be worth just $60, however if it produces the more productive good (even though it's not in the area of it's comparative advantage) it's output would increase to $100. However the flip side is that the global output would reduce from $260 to $250.

So in essence

- Ricardo Hypothesis makes sense only when we deal with products from similar industry or sector and doesn't hold across sectors or industries.

- If the country produces a good in which it has higher productivity but not a comparative advantage, the country would benefit but the global growth would reduce as there is going to be some "Dead Weight Loss".

Economics is not just about growth and efficiency but rather about inclusive growth and if this introduces some redundancy then it's worth it as otherwise we risk social unrest. The focus on efficient growth equations with no redundancy that emanates from Ricardo's hypothesis has created a pseudo science within economics with is dangerous for our future (the classic example is the recent debt meltdown), focus on efficient growth with minimal redundancy not only widens gap between rich and poor but is also counter to nature. Think about it, what would happen if gmail, yahoo don't take backup of your data, or if you have to live with one kidney or lung. While free trade and specialisation has advantages but for a country to grow it's imperative that it increases it's productivity specially in products that have higher value.

Since large parts of our economic textbooks are written during imperialist or Cold War times, it's important that we critique every notion of conventional growth theories. Remember unlike Physics Economics is not a pure science and no matter what people say a Ricardo, Keynes or Friedman can never match up to Einstein, Feynman or Newton. So next time you read any economic article I would suggest you doubt; even this one..........