Weak Links in the Theory of Comparative Advantage: Missing Markets

0:00First of all, I'm very happy to be here, this is my first time here, I'm grateful to Professor Salerno for giving me this opportunity to present some of my work. This paper is actually an extension of one of my chapters from my recently completed PhD thesis that I did under the guidance of Professor Glenn Fox at the University of Guelph in Ontario, Canada. I'll first start with a little bit of context how I ended up dealing with this question. And sometime in 2004, the province of Saskatchewan, political authorities of the province of Saskatchewan demands a reassessment of the national allocation of, in that case, poultry production, according to the principle of comparative advantage.

1:01Now, you may ask, why would provincial political authorities ask for such a thing? Well, because that's the only way it can be done, because some of the agricultural commodities in Canada, like poultry, milk and eggs, are under a specific system called Supply Management. And what that basically means, it's a quota system. If you're a producer, you have a license to produce a certain quantity of output. If you want to expand your output, you have to obtain a license from another producer so you can buy it, but it goes through the provincial marketing boards.

1:48Another thing here is that you can buy from producers in your own province, but not from the producers in other provinces, so you can see that the total quantity of quota within a province can only increase if the national or in some cases provincial agencies allow that. That's why they go through the political means. Now, why comparative advantage? Why would they want this? Well, at the time of the forming of this policy in the 1970s, this term comparative advantage was put in the policy and it said in one of the articles in the law that the national supply management agencies will take into account the principle of comparative advantage when allocating production to different provinces.

2:47So that's where the question comes from. So the Canadian government officials ask economists how to allocate this production according to this principle. So economists start working and they started working in 2005 and they're still working and they give some advice and it's generally contradictory advice and it's different statistics, different aggregate statistics, you should use this number or you should use that number. So when I kind of started with this literature I started wondering is there something in our theory that sort of points us in this general direction in looking for these statistics but doesn't really answer the question which one, so we have lots of them.

3:40So, then I went back and looked at the theory and I started with Adam Smith. There are some earlier references to division of labor and that would come from the principle of comparative advantage, but since Adam Smith is the most well known, I started there and onward in the history of economic thought. And what I found, and this is my thesis, is that while in the 1920s and the 1930s the focus of international trade theory, which is based on this principle of comparative advantage, theory was slightly sidetracked by attempts to cut a perceived tie to Ricardo's labor theory of value, but maintaining the emphasis on modeling using aggregate variables from 1940s onward has left out important aspects of the principle of comparative advantage and what are those aspects, heterogeneity of capital including human.

4:47Austrian theory maintains that heterogeneity of capital is one of the major factors that leads to the coordination and calculation problems. So in the calculation problem we have questions like how much of what we should produce and consume and in what way. In the coordination problems we have questions like who does what, where and when. And these questions, when we assume away heterogeneity of capital, become of tertiary importance. Now, the implication of this is that this has blurred the limits of economic policy with the meaning of who and how can implement this principle of comparative advantage.

5:38To the people in this room it's probably more clear to begin with why this would blur the limits of economic policy. But if we start with a model that begins with homogeneity, that may not be as obvious. Now I decided to start with Adam Smith and he was one of the first economists who points out the benefits of division of labor and he says, division of labor, however, so far are as it can be introduced, occasions in every art are a proportionable increase in the productive powers of labor. The separation of different trades and employments from one another seems to have taken place in consequence of this advantage.

6:29This separation too is generally called furthest in those countries which enjoy the highest degree of industry and improvement. So I wanna highlight two things that come out of this is that he talks about individuals and says, Individuals within a country specialize, and as a result, there's an increase in total productivity, so some benefits of individual specialization. Now, the next major figure that talks about division of labor at the national level is David Ricardo. And I highlighted one of his quotes that says because it would be advantageous to her, meaning Portugal, he's talking about Portugal and England deciding whether to trade or not.

7:20Rather to employ her capital in the production of wine for which she would obtain more cloth from England, then she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth. And I want to highlight a few things here. First, he uses a metaphor, an anthropomorphism, where countries sort of look like they decide to specialize in exchange as single entities. But the language that he uses had a specific purpose, to provide a rational argument to political authorities of that time in favor of opening borders, not necessarily a watertight description of reality.

8:07Now, it seems that this literary metaphor, it seems that it has initiated a process of translating this broad literary metaphor into the Language of Exact Aggregate Mathematical Variables. And the first major figure in this process is Bertil Olin. Actually, he uses some of the earlier findings of Heckscher, who was working on the factor endowment theory of comparative advantage. But Bertil Olin also thought that Ricardo's theory of comparative advantage was based on wrong theory of value and the labor theory of value and he says the classical theory of value has long ceased to be a satisfactory solution to the problems of price determination, nevertheless it continues to form the basis for the theory of international trade even in contemporary exposition, even in contemporary exposition.

9:19This is clearly an anomaly. So he does two things. He attributes Ricardo's labor theory of value to the theory of comparative advantage. And in his subsequent work, he thinks he can solve this by replacing Ricardo's fixed proportion technology with variable proportion technology, but maintains Ricardo's country person metaphor. has a reasonable abstraction in, but now a description of reality. His attempt is not just to give a reasonable argument, but to provide a description of reality that is reasonable. Now Gottfried Haberler, one of the Austrians, thought that the theory of competitive adage is not necessarily logically based on the labor theory of value, but it may appear to to be, and he was more correct.

10:18He says the theory of comparative costs, that's the synonym that some theorists use, was developed on the basis of labor theory of value and all theorists who have accepted have indeed assumed that it rests also logically on the labor theory of value. So he seeks ways to separate the theory of comparative advantage from the perceived link to the labor theory of value. He said, fortunately, however, it is possible to reformulate theory in such a way that its analytical value and all conclusions drawn from it are preserved, rendering it at the same time entirely independent of the labor theory of value. This may be most readily be shown in a diagrammatic representation of our theorem.

11:04And this is the introduction of the production possibilities frontier in economics. Now, Mises didn't use diagrams, but he clarified that the issue is not actually about value, but it's about productivity. Mises said, the law of comparative cost is as independent of the classical theory of value as is the law of returns, which its reasoning resembles. In both cases, we can content ourselves with comparing only physical input and physical output. He clarifies the nature of the concept and says that not everything in classical economics was based on the labor theory of value, but adds an important distinction, to whom do we primarily attribute productivity differences?

12:02He says individuals associate with each other to take advantage of their productivity differences. And he says Ricardo was fully aware of the fact that his law of comparative cost, which he expounded mainly in order to deal with a special problem of international trade, is a particular instance of the more general case of the law of association that's in the line below. Now Rothbard, Murray Rothbard maintains that individuals specialize and exchange goods to take advantage of their productivity differences to their mutual benefit. So he maintains this individual focused approach. But this is not the case in the traditional and currently widely used, actually all in Samuelson-types models.

12:54We have two production possibility frontiers and they are actually all in variable proportions, technology put in a general equilibrium framework and expressed using Haberler's production possibility frontiers, so these are country variables, country production possibility frontiers and what Samuelson does, he still maintains Ricardo's country person metaphor by homogeneous inputs, capital and labor within an economy of each country, Single National Production Function and one optimization problem with all starting variables known and given. Now there were some model extensions and modifications making it more complex, but in the essence the core country person metaphor was preserved.

13:46Even when there is some firm heterogeneity within an economy, it is not necessary for the existence of prices. You could assume a way heterogeneity and the model structure the way it's mechanically built would still give you prices, market prices presumably. Heterogeneity is a secondary wrinkle in a general model, not a general feature of actual markets. So the emphasis is different. So why is not ignoring heterogeneity important? A number of speakers today and in previous days talked about that. In this instance of comparative advantage, why is it important? Well, first, it provides a logical basis for markets. For example, we would maybe simplify a little bit, but we could ask a question.

14:35Why do individuals continually specialize in exchange if everything is perfectly homogeneous and divisible everywhere as it is implied by the continuous functions? Second, if everything is the same everywhere, is there a knowledge problem? Any need for market prices as a source of information or a coordinating mechanism? And second, this comes from the actual comp of people who were trying to figure out whether you can mathematically aggregate heterogeneous production functions into an aggregate production function. and the conclusion was by Philippe and Fischer and Fischer did a lot of work in the 70s and 80s after the Cambridge Capital Theory controversy to see whether this actually can be done and he says, concludes, it is not theoretically sound to assume that.

15:37Now, what are the messages that we get from our models? Well, if we omit individual heterogeneity, the message that our model tells us is how do economists measure comparative advantage in a world where all the initial variables are given and knowable. And this is more predominant message that we get. The other message is if we don't omit individual heterogeneity, how do individuals determine their own comparative advantage relative to others in the world where most variables are that are not given and not knowable in the actual world. Implications for economic research. In the first case, when heterogeneity is omitted, we look for aggregate statistics with little attention on how markets give rise to these statistics.

16:27For example, try calculating capital-to-labour ratio in a country X without market prices. When individual heterogeneity is not omitted, we look for institutions that are best suited Discovering Individuals Comparative Advantage in a World of Uncertainty and Ignorance. Some conclusions from this, so the major shift in the theory of comparative advantage was from the Ricardian to the actual Olin-Samuelson aggregate models, so from fixed proportion technology to a variable proportion technology, however maintaining the country person metaphor has weakened the logical basis for the existence of markets in these models and extended the perceived limits of central economic planning beyond what may not be realistically feasible.