Comparative Advantage For Whom?

Obtaining the greater level of goods and services consumed by residents in the country is the economic motive for engaging in free trade and the justification for laws in America that promote international trade. Countries increase their economic prosperity, according to this story, by exporting the goods that they are relatively more efficient at producing and importing the goods that other countries are relatively more efficient at producing, so that residents in both countries can consume more goods and services.

David Ricardo, in his book On the Principles of Political Economy and Taxation (1817) used two countries, England and Portugal, as his examples. Before him, in 1776, Adam Smith described the benefits in terms of the wealth of nations. Comparative advantage is about the welfare of the residents of a sovereign nation.

Ricardo used the example of England and Portugal to show that even if the firms and workers in England were better than the firms and workers in Portugal at producing both cloth and wine, Portugal could still have a comparative advantage in producing one good, wine, and exporting the wine to England. The English workers would then consume the vast quantities of wine, and Portugal would obtain an advantage because the English would too drunk to produce any cloth. (just kidding).

The secret sauce of free trade for the residents in both countries happens because the opportunity cost of producing wine in England is greater, in England, than the opportunity cost, in England, of producing the cloth. The logic of free trade is based on the concept of opportunity cost of production of wine and cloth in England, not a comparison of opportunity costs of production between England and Portugal, which Adam Smith called "absolute" advantage.

The workers in each country must do what they are best at doing, in their own country. The firms and workers in England face a dilemma and must make a choice about the most productive use of their scarce resources. They love to drink wine, but they like to wear clothes, too. The opportunity cost of producing wine in England is higher than the opportunity cost of producing cloth, in England. In other words, given their scarce resources, they are better at producing cloth than wine, and it would be to their comparative advantage, in England, to export cloth and import wine.

The workers in England can obtain a comparative advantage in consumption through free trade, by exporting cloth and drinking more wine. The firms, and their shareholders, will, by-the-way, obtain greater profits as a result of the free trade if they export cloth and import wine.

The argument against free trade, in this article is about profits, not about consumption. The benefits of comparative advantage in the new global markets do not inure to the welfare of the American residents who live in the sovereign country of the United States, but are limited to the very small set of players in the global value chains, whose financial welfare is not integrated with the welfare of the other residents.

Comparative advantage and the benefits of free trade only work when there is one common set of financial interests (one social welfare function) of a sovereign nation whose residents share a common economic destiny. The gross value of national income can go up as a result of free trade, but the distribution of benefits from free trade in America does not benefit the great majority of residents who are not plugged into the MNC global value chains.

Profits, it may be stipulated, for MNCs may go up, as a result of the free trade in America, and the increased profits are counted in the aggregate measure of national income obtained in America, but the profits of the MNCs are never consumed by the residents of America because the economy of America is bifurcated as a result of outsourcing.

Free trade does not work, to paraphrase John Edwards, when there are two American economies (two disconnected social welfare functions) inhabiting the same geographical space.

Comparative Advantage For the MNCs In The Global Value Chains

How did the workers and firms in England initially obtain their advantage in producing both wine and cloth over the workers in Portugal? According to Eli Heckscher and Bertil Ohlin (hereinafter H-O), the benefits of free trade occur because workers in England were endowed by God different factor endowments than the workers in Portugal at the beginning of the cosmic poker game.

The workers and firms in England obtained a comparative advantage in producing cloth because God gave them more sheep to begin with. England has an abundance of wool, and if they used the wool very intensively to produce cloth, they may be able to drink more wine. At the start of every historical economic poker game, God gives the workers and firms of every country a factor endowment of poker chips.

H-O shows that open trade allows countries to play poker with the chips so that every country wins. One small caveat here is worth mentioning. According to Locke, when the workers in England agreed to use money to value the poker chips, they also agreed to leave the state of nature and enter the global market, an irrevocable decision.

H-O theory does not work without this small caveat about the use of money to value the initial factor endowments of poker chips in the country. The starting values of sheep in England, measured in sea shells would not be the same thing as the value of grapes in Portugal, measured in rocks. But, from H-O theory, if the starting values of both are measured in a common unit of money, then the theory can eventually show how England and Portugal benefit from free trade.

The global market that the workers in England entered, around 1995, was one comprised of global value chains, whose main economic actors were entities called Multi National Corporations, (MNCs).

Michael Porter (1985) introduced the concept of "value chains," and has subsequently refined the concept (1990, 1998). The value chain, according to Porter, is a series of value-generating activities, and a firm's maximum profits, according to Porter, depends on minimizing the cost of each link in the chain.

Smart senior executives in the MNCs view their entire value chain around the globe, and optimize profits by lowering production costs by outsourcing activities to the cheapest place in their global value chain to business.

Just like countries that are given an initial endowment of poker chips, MNCs, according to H-O, have an initial endowment of factors, which Porter describes as corporate "core competencies." In the analogy presented by H-O, firms are exactly the same type as entity as a sovereign country, and each entity maximizes shareholder (citizen) value, by intensive use of their factor endowments.

In a fascinating piece of global value chain research, "Who Makes Profits and What Do They Do With Them? Who Profits from Innovation in Global Value Chains? A Study of the iPod and notebook PCs,"

Jason Dedrick, Kenneth L. Kraemer, and Greg Linden (DKL) describe how two MNCs obtain profits in the global value chains. (2008).

They noted that initially, around 1995, the MNCs were only outsourcing part of the global value chain to low-cost countries. In the past 4 years, something dramatically different has occurred in the free trade management practices of the MNC.

"Although initially only non-core, commodity products were outsourced," they noted, "supplier capabilities expanded alongside other changes in the outsourcing firm and suppliers began to provide proprietary technologies, such as components supplied to Apple for its iPod. This raises under-researched questions regarding who controls technology value chains."

This new development in value chain management does not quite fit the pleasant story that Porter describes about value chains, and does not quite fit the H-O story about comparative advantage in free trade. "This would seem to be part of a new strategy quite different from the Porter outsourcing model," they wrote, "in which a firm out sources commodity components, but carefully protects core technologies and capabilities by keeping them within the firm."

In other words, the MNCs have traded away America's core competency in innovation, which could be considered the same thing as trading away the nation's God-given initial factor endowment of individual initiative and individual freedoms.

"In part, wrote DKL, "the basic strategy of "core competencies" was redefined to be quite flexible and refer, ex post facto, to those components that remained in the firm while other components were, by definition, not "core" even if they involved proprietary technology upon which a product was based (again, the iPod example is most widely known)."

The innovation potential of America's economy may not have been "core" to the MNCs who were in control of trading it away, but was core to the economic growth potential of the United States.