Friday, May 09, 2008
The debunking of comparative advantage
Conventional wisdom says that comparative advantage is a good thing. And that one must stick to it as it is the only enduring economic doctrine. What is comparative advantage ? Simply put it means that nations can benefit by mutual trade. And that a nation must stick on to a commodity which requires it minimum sacrifices relative to producing other commodities. Mind you that it is not related to absolute advantage. The principle of comparative advantage shows that even if a country has no absolute advantage in any product (ie. it is not the most efficient producer for any good), the disadvantaged country can still benefit from specializing in and exporting the product(s) for which it has the lowest opportunity cost of production. Essentially it means that the less advantaged country should only specialise in things in which it is only a little worse off than the bountiful country. This arrangement will maximise output and through trade both countries will be richer.
Now while this is all rational, it is perhaps self-destructive in the long run. In the pursuit of comparative advantage, a country might only produce which has the minimum opportunity cost. Suppose for a given country the most competitive products are primary products (agricultural/nature's bounty). Now acting rationally the country should continue to produce the same. The other sectors may be startegic and might propel the counties on the path of riches in the long run. So sticking to primary sectors is easier - but then industrialisation will never occur. A country may be stuck in exporing raw products without processing them which lead to substantial value-add and moving up the chain. HOwever, moving into other sectors is inevitably attendent with some pain. Moving to other sectors requires moving out of the comfort zone of what is easy. But it has to be done as other sectors might be more strategic - heavy industry, armaments and all sorts of sectors which give a country much more 'power' than agriculture. Not moving beyond the 'rational choice' of competitive advantage may lead a country of efficient farmers and nothing else. So - Comparative advantage is a good theory when one is referring to a static, peaceful and a just world. It aint gonna happen and hence countries need to move beyond comparative advantage.
Now while this is all rational, it is perhaps self-destructive in the long run. In the pursuit of comparative advantage, a country might only produce which has the minimum opportunity cost. Suppose for a given country the most competitive products are primary products (agricultural/nature's bounty). Now acting rationally the country should continue to produce the same. The other sectors may be startegic and might propel the counties on the path of riches in the long run. So sticking to primary sectors is easier - but then industrialisation will never occur. A country may be stuck in exporing raw products without processing them which lead to substantial value-add and moving up the chain. HOwever, moving into other sectors is inevitably attendent with some pain. Moving to other sectors requires moving out of the comfort zone of what is easy. But it has to be done as other sectors might be more strategic - heavy industry, armaments and all sorts of sectors which give a country much more 'power' than agriculture. Not moving beyond the 'rational choice' of competitive advantage may lead a country of efficient farmers and nothing else. So - Comparative advantage is a good theory when one is referring to a static, peaceful and a just world. It aint gonna happen and hence countries need to move beyond comparative advantage.
Why is a country rich
A country is rich when it's labour productivity is higher. What is 'labour productivity' ? Simply put labour productivity of a country is its output divided by the number of people involved in producing it. So a rough approximation is GDP divided by population. Any country which produces more 'stuff' (output) using the minumum number of people will be rich. Simply, the surplus will account for the 'richness' of the country.
Lets take an example and the most intuitive one i have come accross is one by Atanu Dey (deeshaa.org). While you can go and read the full text at his site, i will lay out the essential points. Suppose a 100 person economy produces 100 units of stuff. The average income of such a population will be 1. Now say 2 people from this population do some research and find out ways/invent machines which enables the population to make 300 units using only 90 people. The average income will jump to 3 with 8 more people freed up for further research. Now these 10 people working find out better ways of making 1000 units of stuff using 75 people...The average income will jump to 10 - a ten-fold rise over the first case where the average income was 1.
The miracle lies in the fact that machines can increase the productive capacity of humans manifold. This is an immutable truth and there is no escaping this. One can argue that the same amount of stuff can be produced by substituting labour for capital. While that will increase production, it will not increase productivity. So while more stuff is being produced, it is produced by a proportionate increase in the number of mouths to feed and thus average income remains static - i.e. the country does not grow richer. Richness is determined by productivity of a country.
Now the classic question arises : Should a labour-excessive country focus on policies that promote employment or productivity ? Maximising employment is promoting more of status-quo. In fact the country might become poorer in the future if more number of people are producing the same amount of stuff (more mouths to feed with the same output). A country therefore has to focus on production - and here not absolute production by employing proportinately more labour but more capital. Why ? As machines and technology are the ONLY way in which production can be boosted manifold increasing incomes for all as we saw in the example. Technology has only a positive 'arrow of time'.
Also to support this constant improvement in technology, there has to be more and more education and R&D efforts. In our example we saw that the average income could not improve without technological innovation. Innovation and improvements do not drop from the sky but they have to be painstakingly built grounds-up. It requires systematic and widespread education. And it also requires an ecosystem. The hardware of this ecosystem can be the universities, academies, centers-of-excellence etc. But more importantly innovation feeds on freedom. It also requires free thinking - and challenging authority. It requires incentives for innovation. It also requires a society tolerant of disruptions as any technological adaptation will involve change. Knowledge cannot thrive in an environment which is completely closed to new ways.
So without going into ideologies, a society can be richer (higher labour productivity) if it has the following characteristics :
1. Able to master techniques of production (including intangibles like services) employing technology
2. Able to transfer these techniques in some systematic manner in subsequent generations (widespread education) and also have an ecosystem of improvement. This ecosystem should both have the 'hardware' and 'software'
3. Able to best utilise talents of entire workforce -including women - and allocate people according to merit. (the non-employment of women seriously hampers prosperity as the number of mouths to feed goes up without full productive engagement)
4. Have a socio-cultural-political organisation geared to maximum production :-
- provide property rights to encourage investment and saving
- reduce transaction costs of doing business by having relatively honest public institutions
- have a continuity in economic policies i.e. political consensues on economic issues
Any society which is able to do the above will be on it's path of richness.
India performs poorly on almost all counts in the above analysis. Without going into details of every one of them, the most fundamental problem is that Indian polity and policy makers have not yet grasped the fundamental point : If we want to be rich, it is not employment that needs to be maximised but production (and hence productivity). Also india traditionally scores low on the 'software' required for innovation : a free thinking society, attitudes to women, being suspicious of wealth and woefully corrupt public institutions.
Lets take an example and the most intuitive one i have come accross is one by Atanu Dey (deeshaa.org). While you can go and read the full text at his site, i will lay out the essential points. Suppose a 100 person economy produces 100 units of stuff. The average income of such a population will be 1. Now say 2 people from this population do some research and find out ways/invent machines which enables the population to make 300 units using only 90 people. The average income will jump to 3 with 8 more people freed up for further research. Now these 10 people working find out better ways of making 1000 units of stuff using 75 people...The average income will jump to 10 - a ten-fold rise over the first case where the average income was 1.
The miracle lies in the fact that machines can increase the productive capacity of humans manifold. This is an immutable truth and there is no escaping this. One can argue that the same amount of stuff can be produced by substituting labour for capital. While that will increase production, it will not increase productivity. So while more stuff is being produced, it is produced by a proportionate increase in the number of mouths to feed and thus average income remains static - i.e. the country does not grow richer. Richness is determined by productivity of a country.
Now the classic question arises : Should a labour-excessive country focus on policies that promote employment or productivity ? Maximising employment is promoting more of status-quo. In fact the country might become poorer in the future if more number of people are producing the same amount of stuff (more mouths to feed with the same output). A country therefore has to focus on production - and here not absolute production by employing proportinately more labour but more capital. Why ? As machines and technology are the ONLY way in which production can be boosted manifold increasing incomes for all as we saw in the example. Technology has only a positive 'arrow of time'.
Also to support this constant improvement in technology, there has to be more and more education and R&D efforts. In our example we saw that the average income could not improve without technological innovation. Innovation and improvements do not drop from the sky but they have to be painstakingly built grounds-up. It requires systematic and widespread education. And it also requires an ecosystem. The hardware of this ecosystem can be the universities, academies, centers-of-excellence etc. But more importantly innovation feeds on freedom. It also requires free thinking - and challenging authority. It requires incentives for innovation. It also requires a society tolerant of disruptions as any technological adaptation will involve change. Knowledge cannot thrive in an environment which is completely closed to new ways.
So without going into ideologies, a society can be richer (higher labour productivity) if it has the following characteristics :
1. Able to master techniques of production (including intangibles like services) employing technology
2. Able to transfer these techniques in some systematic manner in subsequent generations (widespread education) and also have an ecosystem of improvement. This ecosystem should both have the 'hardware' and 'software'
3. Able to best utilise talents of entire workforce -including women - and allocate people according to merit. (the non-employment of women seriously hampers prosperity as the number of mouths to feed goes up without full productive engagement)
4. Have a socio-cultural-political organisation geared to maximum production :-
- provide property rights to encourage investment and saving
- reduce transaction costs of doing business by having relatively honest public institutions
- have a continuity in economic policies i.e. political consensues on economic issues
Any society which is able to do the above will be on it's path of richness.
India performs poorly on almost all counts in the above analysis. Without going into details of every one of them, the most fundamental problem is that Indian polity and policy makers have not yet grasped the fundamental point : If we want to be rich, it is not employment that needs to be maximised but production (and hence productivity). Also india traditionally scores low on the 'software' required for innovation : a free thinking society, attitudes to women, being suspicious of wealth and woefully corrupt public institutions.
