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Comparative advantage and factor endowments

4 January, 2016 - 16:53

A traditional statement of why comparative advantage arises is that economies have different endowments of the factors of production – land, capital and labour endowments differ. A land endowment that facilitates the harvesting of grain (Saskatchewan) or the growing of fruit (California) may be innate to an economy. We say that wheat production is land intensive, that aluminum production is power intensive, that research and development is skill intensive, that auto manufacture is capital intensive. Consequently, if a country is well endowed with some particular factors of production, it is to be expected that it will specialize in producing goods that use those inputs.

A relatively abundant supply or endowment of one factor of production tends to make the cost of using that factor relatively cheap: it is relatively less expensive to produce clothing in Hong Kong and wheat in Canada than the other way around. This explains why Canada’s Prairies produce wheat, why Quebec produces aluminum, why Asia produces apparel. But endowments can evolve. How can we explain why Switzerland specializes in watches, precision instruments, and medical equipment, while Vietnam specializes in rice and tourism? Evidently, Switzerland made a decision to educate its population and invest in the capital required to produce these goods. It was not naturally endowed with these skills, in the same way that Greece is endowed with sun or Saskatchewan is endowed with fertile flat land.

While we have demonstrated the principle of comparative advantage using a two-good example (since we are constrained by the geometry of two dimensions), the conclusions carry over to the case of many goods. Finally it is to be noted that the benefits to specialization that we proposed in Chapter 1 carry over to our everyday lives in the presence of comparative advantage: If one person in the household is more efficient at doing all household chores than another, there are still gains to specialization provided the efficiency differences are not all identical. This is the principle of comparative advantage at work in a microcosm.

Application Box: The one hundred mile diet

In 2005 two young British Columbians embarked on what has famously become known as the “one hundred mile diet” – a challenge to eat and drink only products grown within this distance of their home. They succeeded in doing this for a whole year, wrote a book on their experience and went on to produce a TV series. They were convinced that such a project is good for humanity, partly because they wrapped up ideas on organic farming and environmentally friendly practices in the same message.

Reflect now on the implications of this superficially attractive program: If North Americans were to espouse this diet; it would effectively result in the closing down of the mid-west of the Continent. From Saskatchewan to Kansas, we are endowed with grain-producing land that is the envy of the planet. But since most of this terrain is not within 100 miles of any big cities, these deluded advocates are proposing that we close up the production of grains and cereals exactly in those locations where such production is extraordinarily efficient. Should we sacrifice grains and cereals completely in this hemisphere, or just cultivate them on a hillside close to home, even if the resulting cultivation were to be more labour and fuel intensive? Should we produce olives in greenhouses in Edmonton rather than importing them from the Mediterranean, or simply stop eating them? Should we sacrifice wine and beer in North Battleford because insufficient grapes and hops are grown locally?

Would production in temperate climates really save more energy than the current practice of shipping vegetables and fruits from a distance – particularly when there are returns to scale associated with their distribution?

The one hundred mile diet is based on precepts that are contrary to the norms of the gains from trade. In its extreme the philosophy proposes that food exports be halted – and that the world’s great natural endowments of land, water, and sun be allowed to lie fallow. Where would that leave a hungry world?

What we have shown in the foregoing examples is that there exists a potential for gain, in the presence of comparative advantage, not that gains are actually realized. Such gains depend upon markets, not economic planners, and countries usually trade with each other using different currencies which themselves have a market. The rate at which one currency trades for another is the exchange rate. Citizens of Canada buy U.S. goods if these goods sell more cheaply in Canada than Canadian-produced goods, not because some economist has told them about the principle of comparative advantage! In recent years the Canadian dollar has traded more or less at parity with the US dollar: one Canadian dollar could buy one US dollar. But in the late 1990s a Canadian dollar could only purchase seventy US cents – it was more costly for Canadians to buy American products with their Canadian dollars. When it is more costly for Canadians to purchase foreign products we buy less of them. Hence the actual trade flow between economies depends upon both the efficiency with which goods are produced in the different economies and also the exchange rate between the economies.