Dec 8 2012
In a recent post in Evolving Excellence, Bill Waddell pointed out that the economic theory of comparative advantage was wrongfully used to justify outsourcing to low wage countries. The way Bill puts it: “…the theory is based on productivity – not hourly wages. It is driven by the idea that goods should be made wherever the collective combination of hours results in the overall minimum consumption of human effort…” (http://bit.ly/Uy8yfg)
In an earlier post, Bill cited the economic report of the president in 2010 as defining comparative advantage as the idea, “that nations specialize in producing the goods that they can produce cheaply relative to other goods.” (http://bit.ly/UsT0aA)
The comments by readers of Bill’s post seem to confuse Ricardo’s comparative advantage with the Adam Smith’s division of labor.
They also tend to confuse low labor costs with low wages, when increasing productivity achieves both low labor costs and high wages. In the 1910s, when Ford started paying workers $5/day, twice the going rate in Detroit, it still had lower labor costs than competitors because its workers on assembly lines were four times more productive.
Ricardo’s own words are easy to check, because the Kindle edition of his Principles of Political Economy and Taxation costs $0.00 and the discussion of comparative advantage starts on p. 92. It is more a case study than a theory, in which two countries benefit from free trade in two products, even though one is more productive at making both than the other.
Ricardo’s case is cloth and wine made either in Portugal or England. Both needed less labor to make in Portugal but wine required much less while cloth only slightly less. In this case England was said to have a comparative advantage on cloth even though Portugal has an absolute advantage on both wine and cloth. The practical consequence is that more wine and cloth are produced overall if England focuses on cloth and Portugal on wine.
It sounds like a hypothetical example, contrived for the purpose of illustration, and that is what I first assumed it was. It sounded particularly far-fetched, writing in 1817, that the production of cloth should take more labor in industrial England than in Portugal. But it is not a made-up case. It is a real one that unfolded in the century before Ricardo wrote, before the industrial revolution. If we believe the following excerpt from the Wikipedia article about the history of Portugal, it happened as follows:
“The 1703 Methuen Treaty between England and Portugal had both direct and indirect effects on the Portuguese wine industry. The treaty not only stipulated that the amount of duties on Portuguese wines was to never be more than two-thirds that of which was levied on French wines, it also allowed English woolen cloth to be admitted into Portugal free of duty. This second stipulation ended up having a devastating effect on the Portuguese textile industry, leading to huge numbers of shepherds and weavers becoming unemployed. In and around the Douro region, this segment of labor turned to the wine industry and encouraged a boom in vineyard planting.”
Three centuries later, while British textiles are not what they used to be, port wine from Portugal can still be found in liquor stores worldwide. It owes its unique taste to its fortification for sea travel to England, and it is sold under English brand names like Croft or Sandeman, from the British trading houses that used to ship it.
It is a great story, but hardly enough to prove that free trade always benefits all participating countries. It is not easily generalized from two countries trading two products to many countries trading many products, and it is not obvious that it can be used to justify outsourcing. On the other hand, I have applied it in production to the allocation of work among machines with overlapping capabilities.
Ricardo talks about “the labor of 100 Englishmen” as the main measure of the resources consumed in making a product. In the 1700s, labor was the main resource used in production, but, in 2012, labor is only one of many, the others including equipment, tooling, energy, and data, and a discussion focused exclusively on labor would not be appropriate.
So, what metric would you use to represent the total amount of resources used to make a product? The metrics used for this purpose are usually called “cost.” Their calculations involve debatable allocations that are not consistently made even within one country, and equally debatable exchange rates to make international comparisons. You would also use different metrics depending on whether you are deciding where to locate a new plant or how to allocate work among existing plants.
In using comparative advantage to allocate work among machines, the metric was the amount of machine time used per unit of product, which was relevant because we were trying to maximize production for a given mix of products. To minimize WIP instead, you would use a different metric, so as to penalize a machine for processing WIP-generating batches instead of single pieces.
When I first heard of comparative advantage, it was described to me as one of the few economic theories that is neither trivial nor false. And indeed it is, and I believe it makes Ricardo a precursor to today’s Operations Research and Game Theory, but we should be wary of jumping to overly broad conclusions about 21st-century globalization based on the trade of wine and cloth between England and Portugal 300 years ago.