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The Hidden Costs of Comparative Advantage

The principle of comparative advantage works well in an ideal world where trade incurs no human or environmental costs. But in the real world someone has to ultimately bear every cost, whether it is part of the accounting or not. By Kumar Venkat

The principle of comparative advantage, on which the entire premise of global trade stands, has been called the "deepest and most beautiful result in all of economics." Originally stated by David Ricardo in 1817, it shows that a country has a comparative advantage if it can produce a good at a lower opportunity cost, relative to other goods it produces, compared to its trading partners. All nations can benefit if they specialize in goods where they have a comparative advantage, regardless of absolute costs of production.

The logic of this win-win proposition is irresistible, making it difficult for any nation to justify barriers to trade. The principle works well in an ideal world where trade incurs no human or environmental costs. In the real world where someone has to ultimately bear every cost, whether it is part of the accounting or not, it is not surprising that global trade draws passionate grass-roots opposition.

Princeton economist Paul Krugman has argued that the gains from trade, by way of workers earning more by moving into industries where a country has a comparative advantage, “simply fail to register” with many who are against trade. But how many workers can easily move into new industries and start earning more, especially in developing countries where very few have the education and skills to make such transitions?

Even in a wealthy nation like the U.S., there is a great deal of pain and anguish when jobs vanish in manufacturing, software and customer support as a result of trade. Between 1979 and 1999, among US manufacturing workers who lost their jobs and then were re-employed, a fourth of the workers took pay cuts of 25 percent or more.

Gurcharan Das, an Indian venture capitalist and writer, proposed a few years ago that India should concentrate on producing software, aluminum, cement, pharmaceuticals, and a few agricultural commodities, and import the rest. Software, which is seen as an advantageous area for India, employs no more than a few hundred thousand workers. Although software jobs are growing in India, it is not as if an unemployed farm worker can move to a big city and take a programming job. Nor, if the software industry is in a downturn, can a computer programmer easily turn into a factory worker producing aluminum or cement.

Unless there is some redistribution of the benefits of trade within each country -- for example, through unemployment benefits, wage insurance, education and retraining -- the winners would take most of the spoils and losers would be left with little. But the very mechanism of redistribution, designed to compensate for the social costs of trade, could change the mix of products in which a country has a comparative advantage. If such a mechanism were in place, a country might not choose to completely give up certain local industries. The benefits of employment and social stability -- and the costs of achieving these -- would then figure in calculations of comparative advantage.

In a similar vein, the true environmental costs of trade -- if accounted for uniformly -- would have a direct effect on what a nation produces and what it trades. Comparative advantage depends on the factors of production available to a nation, such as labor, capital and other resources. The factor endowments of a nation include not only natural resources, but also how those resources can be used and how waste must be disposed -- which are determined by environmental regulations. Thus regulations become part of the comparative advantage, or disadvantage, of a nation.

One of the effects of globalization is the easy mobility of capital in search of high returns. China has just overtaken the US as the largest recipient of foreign direct investment, attracting $53 billion in 2003 alone. One of the consequences of concentrating so much manufacturing capacity in China is the rapidly deteriorating quality of its environment. Of the 20 cities listed by the World Bank as having the worst air quality, 16 are in China. The New York Times recently reported that China’s rural areas, where two-thirds of the population lives, have become dumping grounds for toxic waste from refineries, smelters and other industries.

China attracts capital largely due to its low cost of labor. Very few multinational corporations would set up factories in China purely to avoid environmental regulations. But once factories have been set up there, local resources and regulations do play a role in the cost of production. Capital mobility can amplify and reinforce the “pollution haven” effect of international trade. Moreover, the World Trade Organization’s rules make it difficult for importing nations to apply tariffs to goods based on how they were produced. Thus, a country with weaker environmental standards would have an advantage in a wide range of products.

Conversely, if WTO’s rules were to allow for certain minimal environmental standards throughout the world -- keeping in mind that any trade-driven economic development must ultimately be sustainable -- international trading patterns would start reflecting some of the environmental costs of trade.

Global environmental quality, another externality, can also be unfairly degraded by some nations -- for example, through more carbon-dioxide emissions -- to gain a comparative advantage in producing certain goods. In addition, long-distance transport of goods is becoming a significant contributor of greenhouse gases. If greenhouse gas emissions were restricted under an international climate change agreement among all trading nations, it would not only change the type of goods traded, but would also shorten the average distance that goods travel. Local and regional trade would then become much more attractive than trade between nations that are geographically far apart.

The right formula for trade should favor minimal and prudent use of natural resources for maximal economic benefit to the greatest number of people. That formula can only be arrived at by internalizing the social and environmental costs of trade. Doing so would not destroy international trade, but would make it a far more equitable proposition than it is today.

Kumar Venkat is a technologist, entrepreneur and writer based in Portland, Ore.

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