The Components of Advantage

This is a continuation of the Unfair Comparative Advantage series.

David Ricardo discovered that under a very wide range of circumstances, countries actually benefit from trading with each other.

Even if one country is the best at everything, it can still benefit from trade. Even if one country is the worst at everything, it can still benefit from trade. This is comparative advantage, and I think it was a monumental discovery.

In this article, we will show that it is not enough. It's possible to argue that not all trades are equally beneficial, even if they are positive.

In the last article, I showed how if I were a cleaner and you were a literary genius, it would still benefit both of us if you paid me to clean your room, and then I showed you why, as a cleaner, even though I'm benefiting from the arrangement, my benefits are capped, and I can do much better.

A person's comparative advantage is only a small part of their total advantage, and a person can stack multiple advantages to win in the market.

It is this logic that we want to now apply to Nations.

There are four main things to consider, and we will do that now.

1. Returns Regime

In the quest to become wealthy, Nations must increase the production quantity or quality of the things they produce and earn a "return" on that production.

Let's say the country is producing X amount of a specific good or service, and then they increase that by ΔX. And let's also assume that they were earning an amount Y, and they expect that earning to increase by ΔY.

So they expect ΔX ≈ ΔY

In other words, an increase in production should lead to a commensurate increase in profit. But this doesn't always happen. In fact, a small increase in production can lead to a massive increase in profit, or it could lead to no increase in revenue, or it could actually lead to a reduction in profit. This is the returns regime.

There are some goods, like, say, cash crops, where the world's current production is very near the saturation point, so additional production can tank the price. There's only so much chocolate you can eat or drink in a day, and people have become absurdly good at growing cocoa, so if some country were to increase the world's supply of cocoa by 3%, the price of cocoa worldwide would drop significantly, negatively affecting both the country that increased supply and the other suppliers that didn't even do anything.^[1]

Not all goods are like this. Compare with semiconductors, where production has been ramping up year over year while the industry has remained enormously profitable.

One advantage a country can have, and consequently, how it can get rich, is to find itself in a sector where there are positive and increasing returns to production.^[2]

2. Income Elasticity

Similarly related is the income elasticity of a particular sector. What this describes is whether rising global incomes translate to rising demand for what you are selling. When people get richer, they tend to consume bigger houses and fancier cars and more healthcare and more compute and more energy, but not all these expenses scale with income at the same rate. For example, rich people spend significantly more on travel and tourism than poor people do, but they spend barely more than poor people on sugar. This is known as Engel's Law.^[3]

A rising tide lifts all boats: when your nation finds itself in a sector with high income elasticity, as the world gets richer, your country gets a strong chance to get richer too. Since the world is generally consistently getting richer, entering sectors with high income elasticity grants a massive advantage to nations by providing a demand base that's constantly expanding.

On the other hand, in sectors with low income elasticity, suppliers can quickly saturate the market, and it may not grow by much, which means that suppliers find themselves cutting production to maintain profits, like, for example, OPEC's quotas. This is a terrible situation to be in as a country because you have something that makes you money and you can't make more of it to make even more money, and because the market size itself is capped, your prospects are permanently limited.

3. Capability Optionality

Yet another advantage here is what you are able to make as a result of what you can already make. For example, if you already make palm oil trees at scale, it's probably easier to start making coconuts, but it's not so easy to make memory cards. But if you are making IC chips at scale, it's probably easier to make memory cards and harder to make coconut trees.

Here I'll use an analogy first described by the economists Ricardo Hausmann and Bailey Klinger: Think of all the possible products and services as trees that exist in a huge rainforest and you are a monkey swinging between trees. If you are already on any tree, you can easily get to the trees nearby. So the tree you are on right now decides how easy it will be to get to any future tree.^{[4, 5]}

Countries making simple electronics components find it easier to make complicated electronics components. Countries making simple heavy machinery find it easier to make complicated heavy machinery. Countries extracting minerals find it easier to extract co-located minerals.

Some capabilities have wide optionality because they allow you to make a vast range of goods and services. For example, by being able to make electronic components, you can make everything from phones to cameras to laptops to satellite components to car components to aircraft components, etc.

But if you can grow some hyper-specialised crop like, say, vanilla, it would be hard to easily transition into anything else.

Being positioned in specific industries with high capability optionality grants Nations immense advantage over others.^[4]

4. Value Retention

Every country incurs some cost in order to produce some good or service. They must then set a price at which they are willing to sell.

But at the global scale, many countries are price takers. A lot of commodities and minerals have global prices set by the interaction of multiple players, and they cannot unilaterally decide to hike the price (or no one will buy).

So one way countries benefit is when the cost that they incur is so much lower than everyone else's, leading to higher margins.

The key concept here is Ricardian rent.^[6] Let's use this analogy to understand how it works.

Suppose you and I have a tomato farm and we supply a large market, and it costs you 200 naira per kg in fertiliser to get any tomatoes growing on your farm. Now suppose I was blessed by God and don't actually have to spend anything; the thing grows like grass in my yard.

If we both sell our tomatoes in the market for 1,000 naira, I automatically have more profit than you. Worse for you, you can't even raise the price of your tomatoes to match how much I'm making in margins because all that would do is route your previous customers to me.

Another mechanism that allows countries to retain more value is differentiation. Suppose that instead of trying to grow generic tomatoes and compete with me, you decided to move upmarket, sell a premium tomato breed that requires more care and soil mix; then you could in fact charge higher without losing customers, because if your customers came to me, they wouldn't actually get what you are selling.^[7]

So countries that become rich have either some sort of structurally lower cost than others, which gives them more profits when they sell to the world market, or unique differentiation such that their customers don't want to switch even if they can find a cheaper option. Countries that don't have any of these tend to pass most of their productivity gains to consumers (other countries) instead of retaining them in the country as profits and higher wages.^[8]

5. In Conclusion

Countries become rich when they acquire economic advantages over other countries. This is what elevates their returns on investment and allows them to grow. Countries that are able to accumulate persistent advantages grow persistently. In this piece, I've gone through 4 main ones, and perhaps in your own time you can evaluate it against various countries to see how they hold up.

We will be using these components as our units of analysis. For any country trying to become wealthy, it should ask itself the following:

1. If we produce more of what we currently produce, will we actually make more money?
2. If people become more wealthy globally, will they buy much more of what we are making?
3. If we become good at making what we make, what else can we also make?
4. How much of the value of what we make can we actually retain as profits inside the country?