Friday, February 8, 2013

Developing country status? Comparative advantage is a prerequisite for industrialization.

There are things we take for granted, like computers assembled in Asian factories, shoe imported from Italy, corn and sugar imported from the United States and CNN beaming the news into millions of homes. Have you asked yourself: what made all these possible? Why do some nations fail to copy the success of other nations, who decade after decade have specialized in producing particular products to the exclusion of other countries? If you come from a developing country background, why are you not getting industrialized like America, France, Germany and the BRIC countries?

Low standards of living are why children enter the labor force.
One concept behind these huge movements towards industrialization is comparative advantage. I was surfing the Internet when I found this article by Steven Hinson on I thought he did a disservice to the concept for the layperson, so I decided to reword it for the beginner reader who I presume are part of my readership.

His aim was to explain the concept of comparative advantage which was first proposed by David Ricardo (1772 -1823) in his “Principles of Political Economy and Taxation” (1817) . It has been used to explain mutual gains from trade, why specialization and division of labor works when workers are efficient and that the least cost of production is based on opportunity cost.

I’ll use Steven Hinson numeric examples.

Specialization and the division of labor in relation to comparative advantage

Imagine Sarah owns a small law firm. She is an accomplished attorney who earns $200 dollars per hour and she can type extremely fast at 120 words/hour without errors. Sarah believes she needs an assistant. She hires Andrea. Andrea is paid $20 per hour. He types at 60 words/hour without errors.

You can see that on every count, Sarah can do better than Andrea. She can type better than him and earns more. She has an “absolute advantage.” Does it mean she should do all the work and keep Andrea idle, but still receives his $20 at month’s end? According to the principle of comparative advantage, Andrea should be assigned a task between either typing or assisting in office filing and research, etc. Which would it be?

That is where the concept of opportunity cost comes into play. Opportunity cost, in simple terms, is the cost of the best foregone alternative. In this trivial example, if Andrea is assigned to typing, the best foregone alternative is office work. If he is assigned to office filing and research, the best foregone alternative is typing.

Since Sarah does 120 words/hour and earns $200 per hour, in simple terms, her 3 words of typing stands before $5 of earnings. Andrea does 60 words/hour and earns $20 per hour, therefore, his 3 words of typing stands before $2 of earnings. So, taking 3 words of typing as base, who has the lowest opportunity cost? You calculated rightly – Andrea. He will only be losing $2 for every 3 words of typing. We can rightly assign Andrea to typing while Sarah concentrates on office work like filing, researching etc and still carry out her duties as an attorney.

Efficient use of resources in relation to comparative advantage

Steven Hinson also made use of another example, Accountants and Attorneys. In an office, let there be two accountants and two attorneys. They have to specialize and divide between themselves the work of either producing tax returns or creating trusts. Accountants can produce 0.5 trusts per hour and 1 tax return per hour. Attorneys can produce 1 trust per hour and 0.5 tax returns per hour. Logically, accountants are better at doing tax returns and attorneys are better at creating trusts when absolute advantages are considered. I decided to simplify the relations; let us use the task of creating trusts as base. Accountants can, when the maths is simplified, produce 1 unit of trust for every 2 unit of tax return per hour while attorneys can produce 1 unit of trust for every half (1/2) unit of tax return. So, according to opportunity costs, attorneys have a lower opportunity cost of producing trusts while accountants have a lower opportunity cost for tax returns.

What happens if we let the accountants do all the tax returns and the attorneys all the trusts? Between them, there would be a maximum of 4 trusts per hour and 2 tax returns produced per hour. Remember the ratio of units!

Let’s play around a little. We think that there could be a way of rearranging tasks amongst these professionals so that they do not get redundant in either tasks while specializing and doing division of labor. Repeated tasks can result in boredom, can affect productivity and worker efficiency. Recall that for every 1 unit of trusts, accountants can exchange 2 units of tax returns while for every 1 unit of trusts attorneys can afford to give up half-a-unit (1/2) of tax returns. So, we’ll ask them to switch tasks once in a while based on comparative advantages. When the two accountants are asked to give up tax returns on the margin, they end up with two tax returns and one trust while if the attorneys give up trusts on the margin, they end up with 1 trust and half of a tax return making for a total of 2 trusts and two-and-a-half (21/2) tax returns on the margin.

The concept of giving up objects for another on the margin is behind the mutual gains nations receive by international trade. The casual reader can check up any good economics textbook for an in-depth understanding.

Why is comparative advantage very important?

These three reasons are what made Ricardo’s concept of comparative advantage ground-breaking.

  1. Necessary for industrialization.
  2. An economy with self-sufficient agents will produce within the constraints of the possible production boundaries taking into consideration its resources and manpower and for their own consumption. Economies that operate with comparative advantage can extend their productive possibilities by trading with other nations using least cost production methods, more efficient processes and highly specialized labor.
  3. Production using most efficient methods.
  4. Two prerequisites for industrialization is specialization and division of labor. This was well expounded by Adam Smith, the father of economics. Thus by trading based on comparative advantages, production is maximized much more than without comparative advantage. This is done using least opportunity cost.
  5. Increased standard of living.
  6. Specialization and efficiency translates into quality products, best use of resources, lower priced goods and services, high Gross Domestic Product (GDP) etcetera.

The concept of comparative advantage might seem trivial but it played a very important part in the industrialization process of many nations.

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