by March 27th, 2015on
In 1815, after Duke of Wellington ends years of war between the United Kingdom and France by defeating Napoleon at Waterloo, the UK parliament passes the “Corn Laws” which prohibit import of cheap grain from France. The motivation is obviously to protect British land owner’s monopoly, but the argument for why the UK shouldn’t be buying French grain is based on Adam Smith’s principle of absolute advantage. British farmers can produce more grain than the same number of French farmers, so why would the UK be buying grain from France?
To refute this argument, a British economist David Ricardo described what is perhaps the most complex and counterintuitive principle in economics. It is called the theory of comparative advantage, and it feels more like a natural law than an economics principle. It is definitely worth studying in depth, but here we only have space for a brief example.
Imagine two castaways who must survive by fishing and gathering berries. One of them is competent, and it takes her 4 hours to catch a fish, and another 4 hours to gather 100 berries. The other castaway is anything but competent, and it takes him 6 hours to catch a fish, and another 6 hours to gather 60 berries. The competent castaway has an absolute advantage over the incompetent one in both fishing and berry gathering, and without considering opportunity cost it seems that she has nothing to gain from trading with him. But let’s see what happens if they specialize, and focus on what they each have a comparative advantage in. If she doesn’t have to fish, the competent castaway can gather 200 berries in her 8 hour workday. The incompetent one can catch 2 fish in his 12 hour workday. He will gladly trade one fish for 75 berries because he knows that he could gather only 60 berries in the time it took him to catch that fish, and she will gladly trade 75 berries for one fish because she knows that it would take her an hour longer to catch a fish than to gather 75 berries. They still work the same hours, each one still eats one fish per day, but he eats 15 more berries, and she eats 25 more berries each day. That’s the magic of comparative advantage. The extra 40 berries worth of value are created simply by specialization and trade. Read the rest of this post »