Comparative advantage, as an economic concept, is intellectually understood, difficult to practice, and even harder to verify if it really works.
David Ricardo, in 1812, published the famous The Principles of Political Economy and Taxation. He coined the term comparative advantage — the concept not less important in shaping our world than Adam Smith’s basic theories on economy. Like Paul Samuelson said, it is also the concept least understood and most mis-used by politicians and probably the intellectual class alike.
The classic way to illustrate the concept is with an example. Say two countries, Altia & Barvola¹, both produce wheat and rice. Altia’s relative costs of producing them is 3:1, meaning it costs 3 times more to produce wheat than rice. If Barvola’s relative costs are 2:1, then Barvola has a comparative advantage producing wheat than Altia. It does not matter how absolutely the costs are. For example, Altia may have the costs of $30 and $10, per unit of wheat and rice, and Barvola $50 and $25. Here Altia has absolute advantages producing both wheat and rice, but not comparatively.
Ricardo’s theory states that, if conditions are right, it is better for both countries to specialize what they are comparatively better at and trade with each others. They might end up producing more wheat and rice. The societies, combined, will be better off.
What would happen really?
Barvola’s wheat and rice industries see the cost advantages and go off-shore. That offshore wave drives up Altia’s labor costs and, consequentially, the prices for both wheat and rice. Since Altia is really not good at producing wheat, it cannot keep up with the demand. Wheat price goes up faster than rice. Barvola wheat farmers knew they can do better and start to produce wheat. Soon, they wipe out Altia’s wheat industry. Both countries end up doing exactly what Ricardo predicted, with heart-aches, political instabilities, and social unrests.
Countries with absolute advantages always win first during the offshoring craze. Unless they maintain absolute lower costs, they will eventually lose to whichever comparatively more advantageous. Governments may erect barriers, but only to delay the inevitability or to advance short-term political interests.
Software engineers in India and China today have absolute advantages over the US, but not comparatively — their ratios of costs to GDP per capita is much higher. We have witnessed the 1st phase of the economy driven process — mad offshoring to capture the absolute cost advantages. The 2nd phase is happening — wages in both countries are rising faster than their GDP and the counter-parts in US. The 3rd phase, that they lose everything to another lower cost country or even back to US who has a comparative advantage today, will ensue unless one of the three things happens.
- Maintain absolute cost advantages.
By accepting lower pay, but equal work. This is hard to swallow. No one wants to be the “low cost leader,” since that gives up the hope for a better future. - Establish comparative advantages.
Make sure their relative costs to the rest of the country become less. They can hope and wait for the whole country to become wealthier. - Achieve even higher productivity.
This is really the other side of the same coin. As long as Indian and Chinese engineers can produce more, comparatively to the rest of their countries, they keep the advantage.
The only actionable and always safe choice is the 3rd one. Software industries in India and China must outperform their US country parts more than their relative costs in the country. If a software engineer in US earns 3 times than the average citizen and China 10 times. A Chinese software engineer must produce more than 10 times more than the average Chinese citizen, even when this engineer is earning less than his/her US counter-parts.
So, work harder and smarter. Out-run the wheel of Ricardo or get crushed.