Unfair Comparative Advantage

Cocoa and Clothes

Today, in economic terms, the gap between South Korea and Côte d'Ivoire is over an order of magnitude. Due to the differences between their Nominal GDP per capita, South Korea is considered a rich, developed nation, and Côte d'Ivoire is considered a lower-middle-income nation.^[1]

But back in the 1960s, things were a bit different. BOTH South Korea and Côte d'Ivoire were booming in this period. In fact, Côte d'Ivoire was actually ahead. Its GDP per capita was higher than Korea's well into the late 1960s.^{[2, 3, 4]}

The reason why this happened was simple: comparative advantage. For Côte d'Ivoire, planting cocoa and coffee involves using only a small portion of their total available labour,^[5] and they have enough uncultivated land to produce commercial quantities of the crops. Being a tropical country, they can produce a ton of high-demand tropical cash crops for very little cost.^[6]

Korea, on the other hand, has very little land, isn't a tropical country, and doesn't have a lot of institutions for cash crops. It, however, has a ton of cheap labour that can't be put to work in large plantations. So it produces cheap garments and wigs.^[7]

The result was that both countries experienced an economic boom. Both had above 7% growth for most of the 1960s and 1970s.^[8]

However, this parity didn't last long. Korea today is vastly richer than Côte d'Ivoire. By the mid 1960s, South Korea's growth had surpassed Côte d'Ivoire's,^[8] and furthermore, commodity price crashes, combined with Volcker-era rate hikes, wiped out Côte d'Ivoire's boom for multiple decades,^{[9, 10]} and crucially, they never managed to catch up to South Korea.^[4]

Many factors have been proposed for why comparative advantage didn't save Côte d'Ivoire: corruption, the one-party state from 1960 to 1990, a coup in 1999, civil wars from 2002 to 2007 and 2010 to 2011, failure to reform, etc.^{[11, 12]}

While those are correct explanations, Côte d'Ivoire was doomed from the start. Even if they had a good government and no succession crises, they simply could not have done what Korea did. This is because their "Comparative Advantage" was not advantageous enough. Here's why.

Advantage is dynamic

Suppose it takes you 1 hour to write an article that makes you $100, and it takes you 3 hours to clean your room.

Now suppose that it takes me 5 hours to clean people's rooms for $100 but 10 hours to write an article that makes me $100.

What this means is that you're better than me at both writing valuable articles AND cleaning your room. Comparative Advantage is that even though this is true, you should still let me clean your room.^[13]

Because suppose you have 10 hours in a day and you spend 3 hours of it on cleaning your room, you'll make $700. (For the sake of brevity, we'll assume you have no other human needs.) But if you spend all 10 hours, you'll make $1000.

Meanwhile, in the same 10 hours, I can write only 1 article, making $100. However, if I clean rooms for 10 hours, I'll make $200. You pay me $100 to clean your room, and you're left with $900, and I have $200 because I spent my time cleaning rooms instead of writing an article, with which I would have made $100. You make more, I make more, everyone's happy.

That's the story of Ricardian Comparative Advantage, and it's a great sell. But consider what's actually happening in my story... I'm a cleaner! Even though I make more money than I would have if I tried to write an article, I'm still a cleaner, and the amount of money I can make is fundamentally capped. If I charge more than $300, then you'll clean your room by yourself; I'll make zero money unless I go back to writing, and you still get to make $700!

Indeed, even if I could clean your room in 1 hour and I charged $100, if there is someone else who takes 5x more time, if they decide to undercut me by just $10, my entire speed advantage is entirely eroded. So what actually happens is I get in a race to the bottom, and because I'm already close to the bottom and what I'm doing is easy to replicate, I almost always end up near that bottom.^{[14, 15]}

So while it's awesome for me to make the most money I could possibly make right now by just cleaning rooms, if I actually doubled down and cleaned rooms, I'm likely to never become as rich as you. Indeed, maybe I am actually better off going to write articles, losing 50% of my income today, so that maybe one day I can make what you make.

This relationship holds at the country level. The fundamental mechanism is basic supply and demand interacting with market structure. The fact is that you, the article writer, could also, theoretically, be undercut by someone who charges half as much as you do. But because there aren't that many great writers, the chances of that happening to you are low. Because I clean and many people can clean, it's more likely to happen to me. It's not always that individual situations can apply at the scale of nations, but as Prebisch and Singer each argued in 1950, it does apply.^[14]

In other words, just because Comparative Advantage exists doesn't mean it's fair. Indeed, the advantage that any country has in any industry is multi-faceted and depends on many different properties. In 2007, the Norwegian economist Erik Reinert explored some of these properties and showed how they are unevenly distributed, which means that some countries can be structurally disadvantaged long term, even if their short term comparative advantage holds.^[16]

Advantage is a Vector

Think about the following problem:

Company X produces 100 widgets at a profit margin of 30%. If they can buy a new shiny machine that produces 1000 widgets, they can make a bigger profit margin of 40% due to higher automation and capital intensity.

But the Market Company X operates in is only supporting the 30% margin on those widgets because there aren't enough of them. If Company X floods the market with ten times the amount of widgets, they'll be everywhere, and customers won't have to buy them at the same price to clear the market.

So Company X may not actually make that 40% margin because their actual price is set by the market according to the laws of supply and demand. In fact, in some cases they may actually make a smaller margin than they otherwise would have.

This is a basic returns problem. The question is, are there diminishing or increasing returns to scale? Does demand satiate at a price that maintains existing margins, lower margins but higher total revenue, or worse?

This is one of the problems that countries have. Some countries have increasing returns to scale. They can increase output significantly while maintaining or increasing profit margins. Think cars or precision equipment.^[17] Some others have no such luxury. Think Cocoa or Oil, where a production glut of even a few percentage points can crash the price.^{[18, 19]}

From this, you can plausibly see how some countries can seemingly endlessly grow their economy while some others stagnate and run faster just to stay in the same place.

Take Côte d'Ivoire, for example, which by 2022 was using almost a third of its entire cultivated land area to grow cocoa. Clearly, they can't 10x their economy off of growing more Cocoa. They would run out of land!^{[6, 20]}

But that's not the only problem; really, there are four main questions to ask when trying to understand the advantage a nation actually has.

1. Are there diminishing or increasing returns to what they are doing?
2. Does the demand for what they are producing increase rapidly as the world gets richer?
3. Based on the fact that they can produce this thing, what else can they produce? ^[21]
4. How much of the value that they are producing stays inside the country?

In the next part, we'll dive deeper into these four questions. For now, we can walk away with a concise summary, which is that comparative advantage captures the advantage that a country has under a specific set of economic arrangements, and while it is immensely useful, countries must also think about their advantages over time and how easily the arrangements they find themselves in can change.