David Ricardo’s Theory of Comparative Advantage
Everybody and their dog’s heard of Adam Smith, John Maynard Keynes, and Milton Friedman. They’re household names.
But unless you’re an economist or a dabbling dilettante, you’ve probably never heard of David Ricardo.
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’s economic structure.
It’s also (wrongly) been used to justify every bad trade deal from NAFTA to KORUS. In fact, its misapplication is mostly to blame for America’s economic problems.
What Is It? Comparative Advantage Defined.
Comparative advantage is pretty straightforward.
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.
Ricardo’s Classic Example:
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 do both faster). But, they are comparatively better at making wine (since it takes them less time to make wine than cloth), and England is comparatively better at making cloth.
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. They will make a surplus, because their labor is used more efficiently.
Here’s the math.
If both countries worked alone, and each made 1 of each products, then 2 wine and 2 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).
Of course, this overstates the case a little, since the hours they worked wasn’t equivalent (220 in England, 170 in Portugal), but even so, the theory holds up.
It’s an elegant theory. Sadly, it’s been hijacked by people with ideological agendas and applied on a global scale—to America’s detriment.
People, like Milton Friedman or 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.
It’s a nice theory, but it’s wrong. The reality is that global free trade has winners and losers.
Why Doesn’t It Work?
I have written previously on America’s economic decline, and documented it all with hard data. I won’t cover that here.
Instead, I’ll limit my discussion to debunking the theory (and thus everything that depends upon it). It has two faulty premises.
Faulty Premise One: People Aren’t Greedy
The greatest critique of comparative advantage comes from David Ricardo himself. It contains the seeds of its own destruction.
He writes that his theory 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).
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. 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.
Sadly, Gordon Gekko won, and “greed is good” became the name of the game.
Faulty Premise Two: Capital’s Immobile
Ricardo also used a more technical defense to defend comparative advantage from this obvious flaw.
He argued that capital was functionally immobile (England’s cloth-making factories could not be moved to Portugal, regardless of cost differences).
In Ricardo’s time, this was largely true because transportation was so expensive, it was illegal to export machinery from Britain, Britain had 50% import tariffs, and endemic warfare prevented import dependency. Therefore this hypothetical problem remained purely hypothetical for Ricardo.
This is no longer true.
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.
In fact, in the decades after Ricardo’s death (1823) capital grew ever more mobile, and 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—Britain suffered a severe, decades long shortfall in domestic investment.
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.
These two facts, that (i) people are greedy and (ii) capital is mobile, completely destroy comparative advantage by invalidating its underlying premises.
Let Ricardo’s Theory Rest In Peace
David Ricardo was a smart man who recognized his theory’s limits, and it is unfortunate that his ideas have been bastardized to justify global free trade in a world where his theory was never meant to apply.
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.