Surplus wealth, specialisation and trade - everyone doing what they are good at and trading the output with others - are of course just as beneficial in international trade as they are in domestic trade. This led Adam Smith to set out his claim that countries should export those things that they can produce at less cost than other countries - i.e. where they have a production efficiency advantage, and import those things that other countries can produce at less cost than them. This makes sense because if country A can create wealth X at less cost than can country B, but country B can create wealth Y at less cost than can country A, then both gain if A produces all X and B produces all Y, and they trade their excess produce of X and Y with each other. This is known as the Theory of Absolute Advantage and is fairly easy to understand.
Less easy to understand but with much wider applicability is the Theory of Comparative Advantage, set out by David Ricardo (Ricardo 1817). He explained that for both trading countries to benefit it is not necessary for each to have an absolute advantage over the other in producing anything. Provided that country A can produce X at less cost than it can produce Y, and that country B can produce Y at less cost than it can produce X, then it still benefits them to have A produce all X and B to produce all Y and trade their excess, even if A can produce both X and Y at less cost than can B. In other words provided that each has a comparative advantage - not in comparison with other countries but in comparison with other products that it produces - then both can gain.
The easiest way to see why this is so is to consider an example, and the most famous is that used by Ricardo himself. Let's say that both Portugal and England produce both wine and cloth, and that to produce a given quantity of wine in Portugal takes the labour of 80 men for a year whereas in England it takes 120 men for a year. To produce a given quantity of cloth in Portugal takes the labour of 90 men for a year, whereas in England it takes 100 men for a year. Portugal therefore has an absolute advantage over England in producing both wine and cloth, but it is comparatively cheaper for it to produce wine, whereas it is comparatively cheaper for England to produce cloth. Let's now say that Portugal produces twice as much wine and exports half to England, and England produces twice as much cloth and exports half to Portugal. Now Portugal is better off than it was before because it has saved the labour of 10 men, and England is also better off than before because it has saved the labour of 20 men, but each still has the same quantity of both wine and cloth as before.
However, before applying the comparative advantage theory in the real world we would be wise to dig much more deeply rather than trust that it works in all circumstances.
Firstly we should examine the factors that give rise to differences in production efficiency, because if they can be reproduced in the country that doesn't already have them then we can increase the overall rate of creation of that type of surplus wealth, and just trade the types of wealth whose factors of production can't be reproduced.
Factors include:
· the natural environment - climate, resource availability, land quality;
· population - abundance, skill level, age distribution, health; and
· innovation and technology - production techniques, energy availability, transport infrastructure, communications, machinery sophistication.
Secondly we should scrutinise in detail what assumptions it makes, and determine whether or not those assumptions apply in real world circumstances where we are inclined to apply the theory.
Assumptions include:
· only two countries producing the same two commodities;
· tastes similar in both countries;
· no transportation costs;
· capital and labour can be redeployed within a country for use in any sector at no cost;
· goods bartered rather than being bought and sold using different currencies;
· no production costs other than labour;
· demand available for all that is supplied;
· all workers have the same output;
· no trade barriers;
· both countries equally capable;
· no changes over time;
· no economies of scale; and
· no labour or capital movement across borders.
This is a formidable list of assumptions, and shows how a simple and attractive theory can become immensely complex when attempts are made to apply it in the real world. How can we extrapolate from two countries with similar tastes trading two commodities to dozens of countries with widely different tastes trading thousands of products, and still be sure of mutual advantages all round? We can't. Two particularly dubious assumptions are the two before the last:
· No changes over time: In reality everything changes over time - labour supply, technological know-how, raw material availability, and exchange value ratios. Any country that devotes itself to producing a limited range of products where it currently has an efficiency advantage leaves itself very vulnerable to changes - not only in its own country but in its trading partners - that can seriously damage or even wreck its economy. This assumption also means that countries rich in raw materials must keep extracting them, and assumes infinite supply.
· No economies of scale: In reality all production is subject to economies of scale that are either positive (more than double the output for double the input = increasing returns to scale), or negative (less than double the output for double the input = diminishing returns to scale). At a stroke this significantly undermines the comparative advantage theory because with increasing returns to scale a single producer can come to dominate a market both domestically and internationally - as many multinationals can testify - and with diminishing returns to scale the efficiency advantage is soon lost with increased production.
If those two aren't bad enough the last assumption kills it stone dead!
· Even Ricardo himself admitted that his theory depends on labour and capital staying in the country of origin otherwise they will move to where the best wages and returns are to be had. The modern economic system does restrict labour movement but free capital movement across borders is one of the major tenets of neoliberalism. Ricardo felt that capital retention within the home country could be relied upon because of its great insecurity in those days when abroad. As John Gray said (Gray 2009 p82):
When capital is mobile it will seek its absolute advantage by migrating to countries where the environmental and social costs of enterprises are lowest and profits are highest. Both in theory and practice the effect of global capital mobility is to nullify the Ricardian doctrine of comparative advantage. Yet it is on that flimsy foundation that the edifice of unregulated global free trade still stands.
Using the above example, if I am an investor in England why should I invest in expanding cloth production in England when I can invest the same money in Portugal and import wine and make more profit? If I have enough money I might also invest in Portuguese cloth and import that. With free capital movement investors are always better investing in countries with absolute advantages. However this point is at best only ever glossed over by global free trade economic supporters, who continue to cite both comparative advantage and free capital movement as factors promoting international trade, without acknowledging the contradiction between them. Reinhard Schumacher has written a detailed paper entitled 'Deconstructing the Theory of Comparative Advantage', published in the World Economic Review, Issue 2 2013, pp83-105.[254] In this he very thoroughly debunks the theory, concluding with the statement:
After deconstructing the theory of comparative advantage and its assumptions, it cannot be endorsed any longer. Not only were the assumptions dismissed in this article, but it was also shown that the theory of comparative advantage is wrong on its own terms. The obvious suggestion is to dismiss the theory of comparative advantage after nearly 200 years in order to get a better and sounder understanding of international trade.
Thirdly we should consider what the long-term effects are on countries that are forced to trade on the basis of the theory, particularly poor countries that exploit natural resource availability. This has been the pattern for much of history. Rich countries manufacture finished goods from raw materials supplied by poor countries, very often in competition with other similar poor countries so that prices stay low. The theory allows no room for development - no changes over time - so poor countries continue to supply raw materials and rich countries benefit greatly from their availability. The poor country is indeed better off than it would have been without the trade, but it doesn't have a way to improve beyond that better off level, it and its workers are locked into that state. Also, the more that resources are devoted to producing raw materials for rich countries rather than to producing essentials for home consumption, the more dependent poor countries become on rich countries, both for the import of manufactured goods that make modern life possible and for continuing demand for exports. Their fortunes are tied very closely to the economies of rich countries, and they are therefore very vulnerable to downturns in those economies when demand for raw materials drops and manufactured goods become unaffordable. Not only that, dependence on natural resource exports limits prosperity to the rate at which resources can be extracted or harvested, and if extractable resources begin to run out or environmental conditions cease to favour harvestable resources then the economy plummets.
If a poor country wishes to become a rich country then it cannot do so by trading on the basis of comparative advantage (Chang 2008 p47).
Ricardo's theory of comparative advantage underpins the neoliberal approach to international trade. It has been developed in more recent times to include other factors of production as well as labour, and these models - Heckscher-Ohlin and its derivatives - are more sophisticated. Nevertheless they too incorporate many unrealistic assumptions and the success of these models in explaining trade patterns in the real world is poor.[255] It reflects the fact that there are always many more interacting factors at work in the real world than any mathematical model, however sophisticated it appears to be, is able to take into account.
Nevertheless such is the faith of neoliberalism in the theory that it ignores all these assumptions and has enforced its doctrines on poor countries through the International Monetary Fund (IMF), the World Trade Organisation (WTO) and World Bank, whose activities are examined in more detail in chapter 73.