CSCMP's Supply Chain Quarterly
January 17, 2020
Monetary Matters
Monetary Matters

Ricardo's "comparative advantage" still holds true today

The 19th-century British economist David Ricardo recognized that even when a nation is more efficient than another at producing all goods, it benefits by focusing on the one for which it is internally most efficient, and trading for the others.

Globalization, connectivity, trade liberalization, and technological innovation have all had a deep and lasting effect on international trade patterns and supply chain dynamics over the last 20 years. Although the way we conduct business in general and world trade in particular has changed a great deal, the fundamental principle that determines the direction of trade—that is, which countries produce what, and who imports from whom—has not changed. The major driver of world trade integration today continues to be the 19th-century British economist David Ricardo's often cited but little understood idea of "comparative advantage."

Ricardo (1772-1823) is best known for his classic work On the Principles of Political Economy and Taxation (1817), in which he adapted, reworked, and extended the works of other economist-philosophers such as Adam Smith, author of the seminal 1776 book The Wealth of Nations, and Ricardo's mentor, James Mill.

Article Figures
[Figure 1] Ricardo's
[Figure 1] Ricardo's "comparative advantage" Enlarge this image
[Figure 2] Purchasing managers' indexes for manufacturing
[Figure 2] Purchasing managers' indexes for manufacturing Enlarge this image

While David Ricardo's main contributions related to the "labor theory of value" (an economic theory, first proposed by Smith, that the value of a product depends upon the labor required to produce it) he also extended Smith's and other 18th-century free-traders' advocacy of free trade, anti-protectionism, and the importance of free interplay in the international division of labor.

Smith and other free traders had emphasized "absolute advantage," which said that nations should specialize in whatever they are best or most efficient at producing. Ricardo, however, demonstrated that "comparative advantage" also influences free trade. This principle holds that a country will profit by producing the product or commodity for which it enjoys a lower **italic{relative internal} opportunity cost, and then trading it for the ones other countries can produce at a lower relative internal opportunity cost.

Ricardo demonstrated that even when a nation is more efficient than another at producing all goods, it should focus on the one for which it is internally most efficient, and trade for the others. He brilliantly showed this with his famous example of English and Portuguese cloth and wine production.

In his example (Figure 1), Portugal could produce both wine and cloth with fewer resources (labor) than England could, but Portugal required **italic{relatively} more resources to produce cloth than wine. Ricardo used simple, deductive logic to show that since wine was harder to produce in England than cloth, both countries would increase both the volume and profits from trade if Portugal focused on wine production while England focused on the production of cloth, and they imported each other's product.

In Ricardo's example, it is assumed that cloth and wine are exchanged in standardized quantities at a homogenous international price. According to the law of comparative advantage, gains will be maximized if England exports cloth, which involves 100 labor hours, while importing Portuguese wine, which requires 80 work hours in Portugal (compared to 120 in England). Even though Portugal can produce cloth with less labor than England does, it has a greater comparative advantage in production costs for wine than for cloth. Portugal should therefore export wine and import cloth from England, thereby reducing its labor hours by 10. In other words, through free trade Portugal and England can both reduce their labor hours and redirect those resources to their best relative use.

Thus, the direction of trade is not determined by the absolute advantage in the production process that one country has compared to another, but rather by the internal, relative advantage necessary to produce alternative products. The key implication of the law of comparative advantage is that if free trade is allowed, then all nations can and will be integrated through the international division of labor. No nation is so poor or inefficient that it cannot gain from free trade.

The perils of overspecialization
There have been many modern, theoretical extensions of Ricardo's work on free trade, as well as qualifications related to transaction costs. However, as is easily seen from the above example, free trade generates a high degree of specialization that has the added benefits of economies of scale via the division of labor, as described by Adam Smith:

"As it is the power of exchanging that gives occasion to the division of labor, so the extent of this division must always be limited by the extent of that power, or, in other words, by the extent of the market."

Therefore, as the size of the market expands, so do the extent of labor specialization and the overall benefit to society.

The level of trade globalization and integration has increased at a rapid pace in the last three decades. The entry of China into the World Trade Organization (WTO) and the economic paradigm shifts of India and many other developing countries toward free-market economies have increased global trade volumes and supply chain dynamics. Clearly—as predicted by Ricardo—the world has moved closer to a highly specialized universe of comparative advantage.

A look at world trade patterns today supports that observation. Certain areas of China, for example, are producing the vast majority of the world's low-end, traded consumer goods; Thailand is a key source of electronic component production; India hosts a cluster of call centers and outsourced information technology services. Many of these centers benefit from economies of scale and agglomeration, and are a key source of world profits for multinational corporations.

The combination of specialized, globalized production and, to a lesser extent, the adoption of "lean" inventory practices (such as just-in-time and build-to-order) has helped many companies achieve significant financial success and has provided many countries with development opportunities. However, such specialization has its downside. In Ricardo's example, a storm that would wipe out the clothing industry in England would leave both countries without new clothing, while a drop in the price of wine due to changing tastes or prohibition in England would devastate the Portuguese economy.

As the events of the past several years have shown lean, inventory-constrained global supply chains have become more vulnerable to highly disruptive supply-side shocks, such as natural disasters, political unrest, government instability, or exchange-rate volatility, in addition to the impacts of the usual demand-side shocks. One example is that of the extreme flooding in Thailand in October 2011, which devastated a key global center of hard disk-drive production. According to some estimates, Thailand produces more than 70 percent of the world's hard drives.

As Ricardo's theory suggests, the impact of a negative event in one source country can have wide-ranging impacts on trade flows across the world. This is especially true today since all advanced economies, as well as most developing ones, are highly integrated with each other via trade and financial markets. This connection can be seen through the highly correlated Purchasing Managers' Indexes (PMI) for manufacturing in the United States, the euro zone, the United Kingdom, China, and Brazil (Figure 2). While emerging markets have recently led the global expansion, they have not been able to decouple from the more advanced economies. This illustrates the fact that economic or political events in one country or region can have significant consequences around the world.

The key point is that companies that keep inventories lean and depend on a limited number of specialized centers of production remain highly vulnerable to supply chain disruptions. They can be negatively and significantly affected by small cracks in the supply chain that iterate throughout the international trade system.

Given that specialization of labor and production will continue to drive global trade integration, as noted by David Ricardo two centuries ago, supply chain managers must recognize that their trade networks will remain vulnerable, exposed to events in distant places where little control can be exerted. And since they cannot evade these global economic forces, supply chain managers should focus on what they can do: building key redundancies and backup plans, and avoiding an over-reliance on what may appear efficient but is in fact very fragile.

Chris G. Christopher, Jr., is executive director of the U.S. Macro and Global Economics practice at the research and analysis firm IHS Markit. Gregory Daco is head of U.S. macroeconomics for Oxford Economics USA.

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