FEATURED ARTICLE | NOVEMBER 6, 2006
Treasure Island: The Power of Trade. Part I. The Seemingly Simple Story of Comparative Advantage
So if I can knit and you can't, and if you can grow corn and I can't, it obviously makes sense for me to swap one of my sweaters for some of your corn. You and I might argue about the "price"—how many ears of corn one of my gorgeous sweaters is worth—but once the deal is done, you're warmer and I'm on my way to being less hungry.
Trade seems simple.
Almost two hundred years ago, David Ricardo discovered something not so simple about trade that came to be called comparative advantage. Here is a story that will let us explore the mysteries of trade together.
Once upon a time, Pete and Pamela Palmer of New York, NY were sailing alone on their South Seas honeymoon. Alarmed at a suddenly darkening sky, the Palmers tried to steer their small craft homeward, but it was too late. The Palmers found themselves in the middle of a terrible tropical storm. They were blown many miles from the marina at the resort where they were staying. The sailboat capsized and the couple barely made it to a island they somehow spied amid the sheets of rain and the surging waves.
The Palmers explored the island. Most of the island was surrounded by steep cliffs. Only the beach where they were washed ashore allowed easy access to the ocean. At the island's center was a spring of pure water. They found no sign of human habitation.
The Palmers slept near the beach so they could have all day to spear fish with a sharpened stick. They found broken coconut shells to carry fresh water from the spring at the center of the island. They spent their days fishing and bringing water from the spring, waiting to be rescued. But no help came.
The situation wasn't very promising. Pete was a graphic designer for a high-powered ad agency in New York City. Pam was in charge of information technology at the same firm. Neither was very skilled at island living.
Getting to the center of the island where the fresh water was located took a full day for the round trip. Neither Pete nor Pam was able to carry more than two coconut shells of water back to the shelter they made from palm fronds. And whether Pete or Pam did the fishing, either one in a full day of fishing could only catch two of the elusive fish that darted here and there in the shallow water.
The meager catch often left them hungry. If both of the Palmers fished, they could double their catch, but when they tried that, the lack of water led to dehydration and dizziness and their fish catch faltered. All they could do was to try and survive until they were rescued.
One night, a storm came up. The rain fell in torrents. A flash of lightning illuminated the beach and the ocean. Was that a person struggling in the water? There were two people! Another couple had been shipwrecked.
The Palmers helped the two young people out of the water. Fred and Felicia Fisher, from San Diego, California, also on their honeymoon, collapsed at the Palmers' feet, exhausted from their ordeal.
The next morning, the storm was over and the Palmers showed the Fishers the water hole, the improvised coconut shell canteens and the sharpened stick they used for fishing.
Before the week was out, it was clear that the Fishers were more prepared for island life than the Palmers. The Fishers were taller and bigger. The Palmers noticed that whether Fred or Felicia carried the coconut shells of fresh water from the middle of the island, they could carry three at a time, rather than the two that either Palmer could carry without spilling any. And they seemed a lot better at fishing, too.
Something else was clear, alas, to the Palmers. The Fishers didn't want to have anything to do with them. Any attempts at friendship or cooperation were quickly rejected. So the Palmers labored on, waiting for rescue and doing the best they could.
Weeks passed, then months. One night, the Fishers were grilling fish stuffed with herbs the Fishers had grown in the herb garden they were able to start because they had that extra coconut shell of water.
A breeze carried the delightful scent over to the Palmers. Pete did not enjoy it.
"One lousy fish," he said. "I think we're both losing weight," Pete answered. "Do I look gaunt?"
"No." Pam lied. But he did look thinner. She knew she was losing weight, too. Her clothes were much looser than when they had arrived, a giveaway.
"We have to get more food," Pete said. "More protein. I've been thinking about it for a few days now. It seems to me we have three options and none of them are very attractive."
Pete outlined the three options to his wife:
They both agreed that plunder would never work. The Fishers were bigger and stronger. Charity was out of the question. The Fishers didn't seem very charitable. Investment wasn't feasible. By the time they figured out a way to make a net or a better spear, they'd be dead from hunger. What could they do?
"Funny, you mentioned 'plunder.' " Pam said. "It's such an old-fashioned word. I had an economics professor who actually talked a lot about plunder. He said until the birth of capitalism, plunder was the main way you got ahead. You knocked your neighbor over the head and took his stuff. Here's the interesting thing about plunder. Plunder looks like it merely rearranges the economic pie."
"That's right," Pete said, happy to forget their troubles for a moment and think about the impact of plunder. "Theft means more for me and less for my neighbor. The total amount doesn't change."
"That seems right but my teacher pointed out that theft actually makes the size of the pie, properly measured, smaller."
"What's 'properly measured' mean?" Pete asked.
"If your neighbor might bang you on the head, you build a fence, you lock your doors, you buy a gun. All of those things are part of the economic pie, but they're a kind of economic activity you don't get any real pleasure from. They're things you have to do in order to keep your hold on the part of the pie you actually enjoy. So the true pie, the part that makes you happy or gives you satisfaction, is actually smaller. Plus, if you think your neighbor might bop you on the head, you don't bother to try and make the pie bigger. It's like that fishing net you mentioned. Even if we could build one before we starved to death, the Fishers would just steal it from us. So why bother in the first place? Theft makes the pie smaller and keeps it that way."
"Great. So now you know why I'm depressed. We need a miracle. Someone has to find us soon and given how long we've been gone, the odds of that aren't very good."
"Wait a minute," Pam said, lost in thought.
"Hang on." Pam stayed quiet for a moment. "There might be a fourth way."
"A fourth way? What do you mean?"
"Theft, begging, weaving a fishing net. That's three. But there's a fourth way. I learned it in my economics class."
"Oh, great," Pete said. "Let me guess. I've got it! Assume we have more fish!" Pete shook his head. He'd had an economics class in college. A bunch of theory and silly assumptions that had little to do with the real world. Economists were so unrealistic.
"You're close," Pam said. She took a stick and began making marks in the sand. She stared at the marks, then smudged them out and started over, making a new set.
Pete stared, too. The marks looked like fish and some circles. What did they mean? Something to Pam, evidently. Finally, she nodded. "It just might work," she said to herself.
"What kind of economics class, was it, Egyptian Economics? Those look like hieroglyphics."
For a history of comparative advantage, read Morgan Rose's essay A Brief History of Comparative Advantage"
"No, it was a principles of economics class. When you mentioned plunder, it reminded me of the coolest thing I learned in that class."
"What, assuming away all the unpleasant parts of reality?"
"Nope. Comparative advantage. David Ricardo's great contribution to economic theory."
"I've heard of that, Pam. But isn't that about trade?"
"It is. We're going to trade with the Fishers and it's going to save our lives."
She made some more marks in the sand and showed Pete what she had in mind. There were too many fractions and ratios for his taste, but he got the idea. She might be right, he thought. Maybe.
The next morning, Pam and Pete took the half-day journey to the water hole, filled up two coconut shells of water each and carried them back home, reaching the beach where they fished and slept at sunset, too late for either of them to go fishing. Pete couldn't help worrying that they were committing suicide by skipping fishing. Especially when they needed more protein and not less. But Pete trusted his wife.
They stored two of shells of water near where they slept and carried two over to where the Fishers were hanging out on their stretch of beach, enjoying the sunset.
"Hello," Pam said. "Would you guys be interested in some extra water?"
"Sure," Felicia Fisher said. She thought about how nice it would be to have a little extra. She could grow a few more herbs. She could take a bath without having to trek to the water hole and getting back late.
"So what's the catch?" asked her husband.
"I'd like to swap. Two shells of water for four fish."
"Four fish!" Fred Fisher was furious. He stood up. "Four fish! We catch six fish a day. If we gave you four, then—"
"You catch six fish a day? That's wonderful. That means—"
"If we made that deal," Fred Fisher interrupted, "we'd end up with two fish a day. I'm still hungry after eating three fish a day. So beat it."
After the Palmers were out of earshot, Pam had an inspiration.
"Let's just leave the Fishers this water as a gift."
"Are you crazy?"
"No, I don't think so." And once again Pam explained what she had in mind. While the Fishers were enjoying the sunset, the Palmers left the water at the entrance of the Fisher's hut. The next day, they did the same thing. And the next day as well, though by the third time, it was dark. They had to walk slower than usual—they were weak with hunger.
But on the third day, as they left the water for the Fishers, they were met by Felicia Fisher.
"Here," she said, extending her arms. She handed Pam four fish, wrapped in cool leaves to keep them fresh. "Enjoy. You were wiser than we were."
The Fishers continued to make the deal every day, accepting two waters for four fish. It turned out to be a good deal for both families. The possibility of trade changed how the Fishers and Palmers spent their days.
Once the trade was in place, both of the Fishers went fishing and caught 12 fish. After giving four to the Palmers in exchange for two waters, they were left with 8 fish, two more than they had enjoyed when they were self-sufficient. They had one less water, but they could survive on two waters a day. Their herbs died. But eight plain fish each day were better than six tastier ones.
The Palmers both went for water every day. After giving two waters to the Fishers, they were able to have four fish, two more than they had enjoyed when they were self-sufficient.
The textbook story of this transformation is that the Fishers have a comparative advantage in fishing. Though they are better than the Palmers at both water collecting and fishing, the Fishers have a comparative advantage at fishing. They are relatively better at fishing than they are at collecting water, compared to the Palmers. Notice that there are two senses of comparative in the previous sentence—we are comparing fishing to water collecting and the Fishers to the Palmers. Comparative advantage has no meaning in a one-good world or in a one-family economy.
But the tricky nature of the sense of "comparative advantage" leads to confusion when people say things like "the lesson of comparative advantage is to do what you do best" or "the lesson of comparative advantage is to do what you do 'relatively well.' " What do these statements mean exactly? How do they generalize to international trade in a world of many nations and many goods and services?
An easier way to understand the lesson of comparative advantage is to see that there are two ways the Palmers to get fish, the direct way and the roundabout way. The direct way is go fishing. The roundabout way is to collect water and trade it for fish. Which is better? It depends of which way is cheaper. If the Palmers fish, they must sacrifice four waters to get four fish. If the Palmers swap with the Fishers, it only costs them two waters in trade to acquire fish. The roundabout way is cheaper for the Palmers.
For the Fishers, the logic is the opposite. Even though they are better than the Palmers at gathering water, it is cheaper for the Fishers to gather water by catching fish and swapping it for water. And it is cheaper for the Fishers to get fish by catching fish themselves, the direct way. There is no way for the Fishers to get water and find a trade with the Palmers that can make both of them better off.
A visitor arriving on the island to rescue the two families would see one family that was good at fishing and another at collecting water. The picture would look like the one I told at the beginning of this essay—if you're good at growing corn and I'm good at knitting, we should swap corn for a sweater. So the Fishers swap some of their fish for some of the Palmers water. But clearly the visitor is missing the real picture of what was going on. What the visitor sees masks what is really going on.
Even a visitor who discovers the history of the island might be misled about the power of specialization. We usually think of the gains from specialization as coming from getting better at something from doing the same thing over and over again. Yet no one on the island had gotten better at what they do.
So where did those extra fish come from? Even in the simplest of worlds, this world of Treasure Island where two families swap two goods among themselves, things are not so simple. And what are the lessons of comparative advantage in the real world, the world we live in where there are millions of us trading millions of goods and services across international borders, a world where jobs are destroyed and created rather than just rearranged as they are on Treasure Island, a world where the terms of trade are set by markets rather than a negotiation by two parties in desperate straits? Is the simple Ricardian lesson of comparative advantage anything more than a clever textbook example that yields tricky exam questions?
I'll try and answer these questions in the next part of this essay.