Tuesday, October 11, 2005

Comparative advantage ain't for dummies

If you haven't understood the doctrine of comparative advantage, you're in good company. It turns out a lot of the world's intellectuals - particularly those versed in anti-trade rhetoric - fail to understand it too.

In an old classic essay, Paul Krugman explains why. He draws a parallel between Ricardo's idea and Darwin's idea: both are simple, but profound; both run counter to everyday intuition.

In the case of evolution, it seems obvious that some rational Mind must be responsible for designing living organisms. Well, biology has no comment on the idea of a supernatural Mind; however it takes strong exception to the "must" of the foregoing sentence. Purely natural processes are sufficient to account for the forms and actions of living things. The main insight is that organisms reproduce; combined with natural selection, generations of organisms undergo successive modification (which also gets reproduced) to arrive at their current forms.

In the case of foreign trade, the intuition is that the amount of resources used to produce something ought to figure in its cost, and therefore in its price. Hence a country that needs more of every resource to produce a good, will not be able to sell that good in the foreign market. Nothing can be more obvious, it seems. In fact if every commodity requires more of everything - land labor, capital - than other goods produced abroad, then the country will not be able to sell anything at all in the world market.

The common sense view turns out to rely on a subtle misconception about the true nature of cost. Ricardo's insight is that cost is measured by what is given up to produce something, i.e. its opportunity cost. The normal way of reckoning cost (resources used x price of resources) is a reasonable enough approximation within a price system of a single economy; however when comparing two or more economies, the normal method breaks down and one must proceed directly to a comparison of opportunity costs.

As Krugman points out:

To a trained economist, the basic Ricardian model seems almost trivial. Two goods, two countries, one productive factor, perfect competition: what could be simpler? Indeed, one of the fierce joys of being an international trade economist is that so many seemingly sophisticated tracts can be revealed as nonsense, so many self-important men unmasked as poseurs, using such a minimalist framework.

And yet if one tries to explain the basic model to a non-economist, it soon becomes clear that it really isn't that simple after all. Teaching the model, to docile students, is one thing: they get the model in the course of a broader study of economics, and in any case they are obliged to pay attention and learn it the way you teach it if they want to pass the exam. But try to explain the model to an adult, especially one who already has opinions about the subject, and you continually find yourself obliged to backtrack, realizing that yet another proposition you thought was obvious actually isn't.

Furthermore:

In sum, while the concept of comparative advantage may seem utterly simple to economists, in order to achieve that simplicity one must invoke a number of principles and useful simplifying assumptions that seem natural and reasonable only to someone familiar with economic analysis in general. ("What do you mean, objects fall at the same rate regardless of how heavy they are -- if I drop a cannonball and a feather ... you're assuming away air resistance? Why would you do that?") Those principles and simplifying assumptions are indeed reasonable, but they are not obvious.

The reliance on simplifying assumptions to lay bare the essentially formal, quantitative relations is the essence of mathematical reasoning. However many intellectuals are deeply hostile to this type of reasoning, preferring to attribute trade to the shadowy designs of neo-colonialist conspirators. (Similarly anti-evolutionists prefer to trace life to a divine Designer.)

Krugman concludes with the following advice for the economist:
(i) Take ignorance seriously: I am convinced that many economists, when they try to argue in favor of free trade, make the mistake of overestimating both their opponents and their audience. They cannot believe that famous intellectuals who write and speak often about world trade could be entirely ignorant of the most basic ideas. But they are -- and so are their readers. This makes the task of explaining the benefits of trade harder -- but it also means that it is remarkably easy to make fools of your opponents, catching them in elementary errors of logic and fact. This is playing dirty, and I advocate it strongly.

(ii) Adopt the stance of rebel: There is nothing that plays worse in our culture than seeming to be the stodgy defender of old ideas, no matter how true those ideas may be. Luckily, at this point the orthodoxy of the academic economists is very much a minority position among intellectuals in general; one can seem to be a courageous maverick, boldly challenging the powers that be, by reciting the contents of a standard textbook. It has worked for me!

(iii) Don't take simple things for granted: It is crucial, when trying to communicate Ricardo's idea to a broader audience, to stop and try to put yourself in the position of someone who does not know economics. Arguments must be built from the ground up -- don't assume that people understand why it is reasonable to assume constant employment, or a self-correcting trade balance, or even that similar workers tend to be paid similar wages in different industries.

(iv) Justify modeling: Do not presume, as I did, that people accept and understand the idea that models facilitate understanding. Most intellectuals don't accept that idea, and must be persuaded or at least put on notice that it is an issue. It is particularly useful to have some clear examples of how "common sense" can be misleading, and a simple model can clarify matters immensely. (My recent favorite involves the "dollarization" of Russia. It is not easy to convince a non-economist that when gangsters hoard $100 bills in Vladivostock, this is a capital outflow from Russia's point of view -- and that it has the same effects on the US economy as if that money was put in a New York bank. But if you can get the point across, you have also taught an object lesson in why economists who think in terms of models have an advantage over people who do economics by catch-phrase). None of this is going to be easy. Ricardo's idea is truly, madly, deeply difficult. But it is also utterly true, immensely sophisticated -- and extremely relevant to the modern world.

1 comment:

pons said...

hi. you may want to check out http://paseoblur.blogspot.com/ or http://arkangel1a.blogspot.com/. Both deal in policy issues, the first focuses on trade.