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Economics/Comparative Advantage


Dear Expert Miller:

Area of Concern:  Comparative Advantage

I am having some difficulty understanding certain aspects regarding comparative advantage and how it works.  I fully understand what absolute advantage means and what opportunity costs mean.  The point where I get confused is when the effects of specialization and how trade would be established.

I found a website that explained how comparative advantage works.

I understand how absolute advantage works and how opportunity costs are established, but the part that challenges me is when a country decides how much to produce and how much to trade.

I hope my questions are not too confusing.

Thank you for your time, patience, and feedback.

Dear Ashwin--

Thank you for a most interesting question. I wish everyone who sends me questions about economics were as articulate as you. You explain what you understand and what you don't; you even provide a great link. You make my work easier, Ashwin. I really appreciate that.

Let me begin by apologizing for taking so long to respond. I began a reply almost as soon as your question arrived. However, my workstation locked up. Once I rebooted, I got diverted, and then I forgot about this. I'm so sorry. Please forgive me.

Anytime one is dealing with aggregate data, as we are in this hypothetical case, please keep in mind that the data are after-the-fact. In point of fact, no country can know "how much to produce and how much to trade." More important, although the examples in the link are based on Ricardo's work, let's remember that, in free markets, "countries" don't produce or trade. Individual firms do that. Each one decides based on its own circumstances. Sure, economists can 'model' the choices and arrive at optimal decisions, but there is no assurance that the result of tens of thousands of decisions about production and trading will result in anything resembling what economists predict in a simplistic, two-country model such as the one in the link you so kindly provided.

To be sure, a country's government can provide incentives that affect output and trade, but that's about all. And, to the extent those incentives distort output and trade, thus missing the mark, then presumably output and trade will, too. In the absence of legal constraints, each producer decides how much to produce and how much to trade. It does so based on what it knows.

That knowledge is always incomplete. Moreover, the market is always changing, so decisions made on a given set of assumptions will always be wrong, either by a little, a lot, or somewhere in between. So all of this is highly theoretical. The real world is much less efficient than Ricardo and his pals would have us believe.

That does not, however, invalidate the idea of comparative advantage. It's a compelling construct, if for no other reason than it eviscerates the validity of ill-conceived notions such as protectionism. Consider the case of the United States and sugar. In the U.S., for instance, far too many Americans are obese. That obesity results in Stage 2 diabetes for millions of older Americans. This is a major reason that per-capita healthcare costs are far higher in the U.S. than they are in other countries.

Now, a person with an understanding of economics, if not nutrition, would say that a higher price for sugar, which is the primary contributor to obesity, might reduce obesity and the later onset of adult diabetes that often accompanies it. Makes economics sense, doesn't it?

Yet, for many decades, the United States government has subsidized a small group of domestic sugar producers through import quotas and tariffs. This has the effect of raising sugar prices. If that were all there was to obesity in the U.S., we'd be getting skinnier, not fatter. But raising the price of sugar also made it possible for a sugar substitute--high fructose corn syrup (HFCS)--to be manufactured cost-effectively; without the artificially high price for sugar, HFCS would not be feasible to manufacture because the cost would exceed the price for sugar in a free and competitive market (i.e., with foreign imports unaffected by quotas).

The food intake of the average American has very high levels of HFCS and relatively lower levels of sugar. The problem is that HFCS doesn't metabolize nearly as well as sugar, so Americans are much heavier than they would be if domestic sugar-producers were not "protected" by import quotas. Higher healthcare costs result.

But it's not just fat Americans who are getting whacked with this ill-conceived policy. By increasing the price of sugar in the U.S., foreign producers can't sell as much here. So growers of sugar beets in poorer countries of the world are much worse off. And what is the U.S. government's response to that: you guessed it, foreign food aid so people in those countries will have more to eat.

In sum, we have a policy that costs Americans, literally, hundreds of billions of dollars every year in avoidable healthcare costs while costing Americans the price of foreign aid to help feed overseas farmers harmed by the same policy. It's not win-win. It's lose-lose. Without this misguided policy, U.S. sugar-producers would probably go out of business, sugar prices would fall, HFCS would cease to be viable, Americans would get thinner, healthcare costs related to obesity and stage 2 diabetes would plummet, and overseas sugar-beets growers would not need our foreign aid due to the comparative advantage they have in sugar production.

Each grower would make its own decision about how much to produce and how much to trade based on one thing: the expected price the producer would get for its output. The U.S. economy would be more efficient, even though those U.S. sugar-beets producers that have been riding the gravy train of misguided and counterproductive sugar policy would have to go find honest work.

Please don't confuse simple two-country models with how things work in the real world. That world is a ton more complicated than economists' simple 2x2 matrices would have us believe.

I hope this is helpful, Ashwin. Again, I do apologize for being so slow to respond.  


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Warren D. Miller, CFA, CPA, ASA


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