Ricardo’s Dilemma: 2 Big Problems With Comparative Advantage

The Limitations Of David Ricardo’s Theory of Comparative Advantage

Everybody and their dog’s heard of Adam Smith, John Maynard Keynes, and Milton Friedman—not only are they some of history’s most influential economic thinkers, they’re intellectual celebrities.  They’re household names.

But unless you’re a lonely economist, or you actually paid attention in took an economic class, you’ve probably never heard of David Ricardo (d. 1823).

David Ricardo, inventor of the theory of comparative advantage
David Ricardo (d. 1823) is best remembered for his theory of comparative advantage, which he explained in his book On The Principles of Political Economy and Taxation.

You should have—he’s the most important economic thinker of them all.

His big idea, the theory of comparative advantage, underpins economic globalization and international free trade.

It shaped, and built, the modern world.

It’s also (wrongly) been used to justify every bad trade deal from NAFTA to KORUS, and is one of the primary reasons why Great Britain’s economy collapsed during the late Victorian Period.

And it’s still doing damage today—its misapplication is mostly to blame for America’s endless economic problems.

This article explains why comparative advantage looks good on paper, but doesn’t always work in the real world.

What Is The Theory Of Comparative Advantage?

Before critiquing it, let’s first define comparative advantage.

Basically, it’s the idea that countries should trade stuff they’re relatively good at making for stuff they’re relatively bad at making. This improves economic efficiency, since everyone makes what they’re best at, which, in turn, means there’s more stuff to go around.

According to comparative advantage, trade is always a win-win that makes everyone richer.

David Ricardo’s Classic Example:

Ricardo explained comparative advantage with the following example in his book On the Principles of Political Economy and Taxation

Pretend it takes England 100 man-hours to make a roll of cloth, and 120 hours to make a barrel of wine.

Next, pretend it takes Portugal only 90 hours to make the cloth, and 80 hours to make the wine.

In this example, Portugal’s absolutely better at making both products (meaning they can make them faster).

But, they are comparatively better at making wine (it takes them less time to make wine than cloth), and England is comparatively better at making cloth.

Ricardo used Portuguese wine as an example to explain his theory of comparative advantage
Portuguese wine has become synonymous with free trade in the minds of generations of economists, all because of Ricardo’s rather arbitrary example.

Ricardo then argues that both countries would be better off if they specialized their production (Portugal only makes wine, England only makes cloth), and traded with each other.

In doing so, they will divide their labor more efficiently, and therefore benefit from a surplus of goods.

That’s the logic; here’s the math.

If both countries worked alone, and each made 1 of each products, then in total, 2 wine barrels and 2 rolls of cloth would be made.

But, if they specialized and traded, they’d have more (together they’d make 2.125 barrels of wine and 2.2 rolls of cloth).

That additional surplus equates to more global wealth, which they could either consume, or trade to France for pearl necklaces, or fur hats.

Of course, this overstates the case a little, since the hours they worked weren’t equivalent (220 in England, 170 in Portugal), but even so, the theory holds up.

That’s it.

It’s an elegant theory.

Sadly, it’s been hijacked by people with ideological agendas and applied on a global scale—first to Britain’s, and now to America’s detriment.

Globalists, like Milton Friedman and Henry Kissinger, argue that if every region on earth specialized, and maximized their comparative advantage, then the global economy would be as efficient as possible, and the world would be richer.

They also claim that because the world would be interconnected and interdependent, that there would be global peace (I guess they’ve never been in a crowded train before—more interaction breeds more tension, and conflict).  For them, free trade is literally a panacea.

All in all, it’s a nice theory, but it’s wrong.  The reality is that global free trade has winners and losers.

And America is one of the losers.

Why Doesn’t Comparative Advantage Always Work?

Although I could make a very compelling case against comparative advantage by simply relying on exogenous critiques, I’ll limit my discussion to debunking the theory of comparative advantage using its internal logic.

Comparative advantage has two faulty premises.

Comparative Advantage’s 1st Problem: People Are Greedy

The greatest critique of comparative advantage comes, ironically, from David Ricardo himself.

In his book, he acknowledges that his theory contains the seeds of its own destruction.

He writes comparative advantage necessarily implies that:

…it would undoubtedly be advantageous to the capitalists [and consumers] of England… [that] the wine and cloth should both be made in Portugal [and that] the capital and labour of England employed in making cloth should be removed to Portugal for that purpose.

Ricardo explicitly states that, under his theory, it makes sense for England to import both cloth and wine from Portugal (since Portugal’s better at making both), and that England’s cloth-making industry should be offshored to Portugal.

Ricardo’s not a stupid man, and knows full well that this would be a losing strategy for England—if they imported everything and made nothing, they would have no economy.

Furthermore, they would be vulnerable to foreign suppliers, in the same way that the US depends upon Saudi Arabia, and other members of OPEC for its oil.  This can have disastrous repercussions, such as the 1973 Oil Shock.

Therefore, Ricardo adds an intellectual buttress to ensure that the temple of trade will not collapse.

He argues that:

most men of property [will be] satisfied with a low rate of profits in their own country, rather than seek[ing] a more advantageous employment for their wealth in foreign nations

And  there you have it.

the fact that people are greedy, like gordon gekko in wall street, completely undermines the theory of comparative advantage
David Ricardo loses because Gordon Gekko wins: and “greed is good” is the name of the game, whether you like it or not.

Ricardo’s entire argument—the theory of comparative advantage, global free trade itself—is premised on the belief that most people love their country more than money, and will invest domestically out of the goodness of their hearts.

Of course, this doesn’t happen: money is like water, it always flows to the lowest possible point.

Nowadays, that’s China—they soak up American money like they’re a giant sponge.

Comparative Advantage’s 2nd Problem: Capital Is Mobile

Ricardo also used a more technical defense to defend comparative advantage from this rather obvious, and roundly admitted, flaw.

He argued that because capital was functionally immobile, offshoring was impossible.  In his example, England’s cloth-making factories could not be moved to Portugal even if Portugal was way cheaper.

And as it turns out, this was largely true in Ricardo’s time: not only was international shipping relatively expensive, but it was also illegal to export machinery, or industrial plans, out of Britain.  Furthermore, Britain imposed a 50% tariff on all manufactured goods during the Industrial Revolution—not that it really needed to, since warfare was so endemic that import dependency was practically impossible.

Therefore the hypothetical problem caused by offshoring remained purely hypothetical for Ricardo.

Of course, this is no longer true, and it’s why comparative advantage fails on an international scale.

capital is mobile in today's global economy
It’s a small world, especially for things that can be bulk-shipped.

Capital is incredibly mobile today—a factory can be relocated from America to China in the blink of an eye, and transportation for bulk goods is incredibly (almost hilariously) cheap.

Furthermore, there are almost no restrictions on technological exports to many countries (China included), which means that advanced American manufacturing processes can be given to foreigners at no cost—the 3rd world is literally time-travelling into the future.

Even in the decades following Ricardo’s death (1823) capital grew increasingly mobile; his hypothetical problem soon became very real.

Throughout the 1800s, there was a steady increase of capital outflows from Great Britain (British investors built projects abroad seeking higher returns).  In 1815, £10 million were invested abroad.  In 1825 this climbed to £100 million, and by 1870 it was £700 million.

By 1914 (the peak) over 35% of Britain’s national wealth was held abroad.  Consequently, Britain suffered a severe, decades long shortfall in domestic investment.

This left their infrastructure decrepit, and their factories outdated.  Unemployment was relatively high, wages stopped growing, and Britain lost her place as the world’s superpower—all because Britain abandoned its mercantile policies in favor of Ricardian free trade.

The same thing is happening to America: between 2000 and 2015 we invested almost $4 trillion abroad (in terms of FDI), and accumulated $10 trillion in trade deficits.

The Theory Of Comparative Advantage Is Domain-Specific

David Ricardo was a smart man who recognized his theory’s limits—comparative advantage was never meant to be applied on a global scale, between countries with very asymmetrical economies.

Ricardo recognized that comparative advantage is domain-specific, meaning that it only applies when certain conditions are met.

One such condition it that capital is immobile, because otherwise one country could suffer a loss of industry, and long run economic growth, to another.

For example, England could lose it’s cloth-weaving industry to Portugal, since Portugal’s cheaper than England.  This isn’t an idle fear: it’s exactly what’s happening to America’s manufacturing industry today.

This begs the question: when is capital immobile?  There are three possible situations:

  1. Capital can be naturally immobile due to restrictions inherent in geography, technology, or the type of product or service offered.  For example, mineral deposits are immobile, because they cannot be relocated to another country without extracting and selling them.
  2. Capital can be artificially immobile because of protectionist policies, such as imposing tariffs, capital controls, or import quotas.  Of course, imposing capital immobility undermines any efficiency advantage gained from comparative advantage, so this situation is moot.
  3. Capital immobility may be irrelevant, because the mobility occurred within a nation’s borders: if a factory is relocated from Arkansas to Oklahoma for cost reasons, this benefits America as a whole, by making the domestic economy function more efficiently.

This understanding of capital immobility sets the stage for defining the domains in which comparative advantage works.

Simply put: comparative advantage works when capital is naturally immobile, or when mobility is irrelevant.

In the first case, comparative advantage allows countries to specialize their production on products that cannot be done abroad.  For example, if one country is better at mining Zinc, and another is better at growing wheat, it makes sense for them to specialize (concerns about the food supply aside), since the Zinc deposits and wheat fields aren’t going anywhere.

In the second, capital mobility is irrelevant within a nation’s borders—even if said asset moves, it would be to the net benefit of the country.  This just means that free trade within a country (between states or provinces) is good, since it enriches the country as a whole.

On the other hand, Ricardian comparative advantage does not work when capital is artificially immobile, nor does it benefit everyone when capital is mobile.

This is because offshoring creates winners and losers—rich countries will bleed capital to poorer ones until the economies are equal (much like water).

Although this may enrich the world as a whole, most rich countries would benefit more from simply reinvesting their wealth domestically, as was the case historically in America, and elsewhere.

At the end of the day, economic globalization isn’t always a win-win.  Some countries win, others lose.

Did Comparative Advantage Work Historically?

The greatest test of any theory is the test of time.

Comparative advantage failed this test.

In an ironic twist, the histories of Portugal and England, the very countries from David Ricardo’s famous example, show that he was wrong.

In 1703 England and Portugal signed the Treaty of Methuen, which, among other things, exempted English cloth from Portuguese tariffs.

In the space of a few decades, Portugal’s entire cloth-making industry was cannibalized by cheaper English imports. To compensate, Portugal actually did specialize in exporting wine.

However, not all industries are equally valuable: cloth-weaving could be scaled up (the more cloth England made, the cheaper the cloth got), meaning that English merchants soon gained a fabric monopoly in Portugal.

Over time, England’s merchants used their greater profits to buy up Portugal’s vineyards—eventually England controlled both industries.

And of course, England’s textile industry gave birth to the Industrial Revolution, and explosive economic growth (needless to say, Portugal missed that boat entirely).

Select Sources:

Chambers, J.D. The Workshop of the World: British Economic history from 1820-1880. London, Oxford University Press, 1961.

Lance, Davis E. and Robert E. Gallman. Evolving Financial Markets and International Capital Flows: Britain, the Americas, and Australia 1865-1914. Cambridge: Cambridge University press, 2001.

Ricardo, David. On the Principles of Political Economy and Taxation. London: John Murray, 1821.

Reinert, Eric. How Rich Countries got Rich and Why Poor Countries Stay Poor. New York: Carroll & Graf, 2007.

About Spencer P Morrison 62 Articles
JD candidate, writer, and independent intellectual with a focus on applied philosophy, empirical history, and practical economics.Author of "America Betrayed" and Editor-In-Chief of the National Economics Editorial.

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11 Comments on "Ricardo’s Dilemma: 2 Big Problems With Comparative Advantage"

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Brendan Carruthers
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So in addition to a tarriff on trade from off-shore factories, Trump would need to implement a tarriff on the outflow of capital since a company that has off-shored its production can still make a lot of money from exporting its products to other countries beside the United States.

Jorge Morales Meoqui
Guest

Dear Mr. Morrison,

I’m sorry to tell you that you have also been a victim of those who have misinterpreted Ricardo’s numerical example.
Here is a short list of the misinterpretations:

1. The numbers in Ricardo’s original numerical example are not unitary labor-time costs but the number of men working for a year necessary to produce unspecified amounts of cloth and wine traded between Portugal and England; 
http://etdiscussion.worldeconomicsassociation.org/?wea_paper=ricardos-numerical-example-versus-ricardian-trade-model-a-comparison-of-two-distinct-notions-of-comparative-advantage;

2. the purpose of the numerical example was not to offer an argument for free trade but to illustrate that his labour theory of value is not valid in international exchanges;

3. Ricardo’s case for free trade is very much based on Smith’s insight on the positive effect of an extension of the market on the division of labor – and not on comparative advantage. 
http://et.worldeconomicsassociation.org/files/WEA-ET-3-2-MoralesMeoqui.pdf

4. The classical case for free trade is not affected by the international mobility of capital, nor by the creation of winners and losers; after all, any technological change creates winner and losers, but very few argue in favour of banning technical progress.
http://epub.wu.ac.at/2952/


But I agree with you that the political support for free trade is very much affected by greed. The greedy ones are those who want to protect their investments from foreign competition, and also those who deny the funds to provide assistance to displaced workers who are in desperate need of retraining.

You can be sure that Ricardo’s insight will continue to attract the attention of scholars for many more years.

Allen
Guest

What good is it to retrain displaced workers if there’s not enough new jobs being created?

Jorge Morales Meoqui
Guest

The needs of people are constantly growing, so there is no limit to the amount of work required to satisfy these needs. People just lack the necessary skills to do it.

Jorge Morales Meoqui
Guest

Dear Mr. Morrison,

I’m sorry to tell you that you have also been a victim of those who have misinterpreted Ricardo’s numerical example.

Here is a short list of the misinterpretations:
1. the numbers in Ricardo’s original numerical example are not unitary labor-time costs but the number of men working for a year necessary to produce unspecified amounts of cloth and wine traded between Portugal and England; 
http://etdiscussion.worldeconomicsassociation.org/?wea_paper=ricardos-numerical-example-versus-ricardian-trade-model-a-comparison-of-two-distinct-notions-of-comparative-advantage

2. the purpose of the numerical example was not to offer an argument for free trade but to illustrate that his labour theory of value is not valid in international exchanges;

3. Ricardo’s case for free trade is very much based on Smith’s insight on the positive effect of an extension of the market on the division of labor – and not on comparative advantage. 
http://et.worldeconomicsassociation.org/files/WEA-ET-3-2-MoralesMeoqui.pdf

4. The classical case for free trade is not affected by the international mobility of capital, nor by the creation of winners and losers; after all, any technological change creates winner and losers, but very few argue in favour of banning technical progress.
http://epub.wu.ac.at/2952/


But I agree with you that the political support for free trade is very much affected by greed. The greedy ones are those who want to protect their investments from foreign competition, and also those who deny the funds to provide assistance to displaced workers who are in desperate need of retraining.

I can assure you that Ricardo’s insight will continue to attract the attention of scholars for many more years.

Apollonius
Guest

Good stuff, and you touched on the mistake at the core of Ricardo’s 2 state, 2 industry conceptual model. He assumed constant returns to the scale of production (probably for analytical convenience) but this results in a comparison of apples to oranges instead of apples to apples.

Industrial production is characterized by increasing returns to scale (as you note), while wine pruduction faces decreasing marginal returns – the opposite property. His recommendation that Portugal specialize in a decreasing returns sector and that England specialize in industry would almost inevitably lead to a rich England and a poor Portugal. Although the positive sum gains from trade are there, that is not the whole story as the relationship his highly asymmetric. England’s relative gains will be greater until it wins the game and acquires control of Portugal’s wine industry. Relative gains matter, as the realist school of international relations teaches, and neoclassical economists would do well to pay attention to before giving bad advise based on an incomplete model.

Jorge Morales Meoqui
Guest

Ricardo for sure did not assume constant returns to scale, nor any other of the many unrealistic assumptions of the textbook trade model. This international trade model has been wrongly attributed to him. It has been developed by other scholars based on crucial misunderstandings of Ricardo’s original numerical example.
I have explained this in greater detail here: https://www.worldeconomicsassociation.org/files/journals/economicthought/WEA-ET-6-1-MoralesMeoqui.pdf

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