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comparative advantage versus absolute advantage

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03/25/2005

I think Paul Craig Roberts gets it wrong when using the subject terms. Let me clarify according to my understanding: An economic advantage is when one person or group can produce a given result with more economy than another. This is very general, and can be broken down into categories: labor advantage is when production can be carried out at lower labor cost (other things being equal); capital advantage, capital; rent/space advantage, rent. When aggregating costs in a group, we must be careful.

The typical method for comparison is money accounting of wages, depreciation, and rent; this is appropriate when considering the subjective costs of the entrprepreneur/capitalist, since these are mainly aligned with money accounting costs. The term absolute advantage emerges when considering multiple products. If A has an economic advantage against B at producing X, and A has an economic advantage against B at producing Y, then we say that A has an absolute advantage against B with respect to products X and Y.

Notice that a claim such as "India has an absolute economic advantage against the US" is odd for two reasons. Firstly, such an advantage, unqualified, must refer to all goods and services. Since universal empirical claims are notoriously troublesome to prove, this raises a red flag. Secondly, aggregating costs within an industry (for instance, wages paid to workers per shirt produced) has meaning for businessmen in that line of business, while aggregating costs across an entire nation and over all goods is highly problematic, for the same reason that all aggregates of this sort are problematic — the subjective nature of cost. But, this is not the main issue.

The main issue is: The concept of comparative advantage emerges when considering trade. At first glance, there is no reason to think that A, with absolute advantage against B in goods X and Y, would wish to trade either X or Y with B. Another worry is that if B trades in either X or Y with A, he might harm his interests. These initial impressions are completely exploded by considering the nature of trade, and Ricardo's discovery of the law of comparative advantage. It is not absolute advantage that is relevant when considering the gains to trade — it is comparative advantage.

Comparative advantage, when confined to considering goods X and Y, refers to the relative costs of a marginal unit of X per marginal unit of Y. That is, if A enjoys absolute advantage, he is still in a position such that the cost of foregoing production of enough units of Y to produce a unit of X means that he would be willing to trade X for Y at a ratio that is favorable to his position. The same is true for B, and if these ratios are not equal, then the direct benefits of trade emerge. Indeed, the only condition for direct benefits of trade is that the substitution ratio for A be different from the substitution ratio for B. When the substitution ratio of X to Y for A is greater than that of B's, then we say that A has a comparative advantage in X, and at the same time, B has a comparative advantage in Y. It then becomes mutually advantageous for A exclusively to produce X and B exclusively to produce Y — division of labor.

The existence of comparative advantage is always mutual and reciprocal. While the law of comparative advantage was explicated and the benefits of free trade explained by Ricardo under a certain set of assumptions (mobility of labor, but not of trade) does not imply that the law of comparative advantage depends upon those assumptions  it does not.

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