Fundamental Economic Concept Lost in Translation

The principle of comparative advantage is one of the fundamental insights of economics. In everyday language, this principle teaches us that we can produce more goods in total if each of us specializes in the production of a product he or she is most productive in compared to other people. This productivity is expressed relative to the quantity of all those goods that each individual could have produced but are now foregone because he or she specialized only in one product. The beauty of this concept is that in our world of omnipresent interpersonal differences someone always has a comparative advantage in something. Consequently, division of labour is a natural consequence of interpersonal differences and the law of comparative advantage.

The thesis of the article is that the concept of comparative advantage has lost a fundamental aspect of its meaning in the works of economists who rely on stylized models of “aggregate” economies.  These models present the concept as a national or regional phenomenon rather than individual.

However, according to the logic of human action, only individuals can experience costs and benefits and consequently act upon those costs and benefits. All the production and consumption decisions are performed by individual human beings based on their knowledge of their own production possibilities and preferences.

As Friedrich Hayek noted, time- and place-specific knowledge owned by any individual in the society is not directly available to other human beings, including the economic analyst. Nevertheless, some of this individual knowledge is reflected in market prices through specialization and exchange. While some economists have maintained these principles attached tightly to the concept of comparative advantage, some have marginalized or even completely ignored them through the process of translation into a language that employs aggregate variables.

The individual-specific view of comparative advantage is generally accepted in the “mainstream” microeconomic literature. It is said that individuals may differ in terms of the quality of inputs they own or skills of combining those inputs into final outputs. Consequently, there is a potential for increased productivity leading to mutual benefits if some individuals specialize in some activities while others specialize in some other activities and then exchange the surplus production with each other. This is the well-known law of comparative advantage or, as Mises calls it – the law of association. This law simply states that in the world inhabited by people who differ from each other in a near-infinite number of ways, possibilities for mutual gains from association with other individuals are omnipresent.

However, the traditional macroeconomic literature is built upon the Ricardian climatic and the Heckscher-Ohlin factor-endowment aggregate models where comparative advantage is national and it is based on the difference in technologies or relative quantities of aggregate inputs between countries. For mathematical convenience, it is generally assumed that inputs are homogeneous within a country or a region and that they are assembled into outputs in an identical way throughout the entire country or region. These assumptions are seen as useful abstractions, and not as serious logical flaws.

Even when heterogeneity within an economy is introduced (at the firm level), it exists only as a special wrinkle in the generic Heckscher-Ohlin or the Ricardian model. These modifications are generally intended to explain two-way trade between countries. This is the case when the same product is both imported and exported from the same country. This situation cannot be explained using the traditional models and thus some economists called upon firm heterogeneity within countries as an explanation. However, heterogeneity within an economy is not seen here as a fundamental general requirement for the existence of a market. These models would still produce market prices within each “national” economy through its mathematical mechanics, even if heterogeneity is assumed away.

There is a logical conflict in this reasoning. Market prices are exchange ratios observed in an interpersonal exchange of goods and services. For an exchange to occur, there need to be at least two individuals in an economy. If there was only one individual in a country, he or she could not constitute a market. All the exchanges that this individual would make would be intra-personal exchanges. He might choose to devote more time to the production of clothing and thus give up some of the food he might have produced instead. However, in this situation there is no exchange ratio to be observed – there are no market prices to be compared with the market prices in some other (hypothetically isolated) country.

In the mathematical language, the intra-personal exchange ratios (i.e., the individual trade-offs when deciding between two actions) are the shadow prices or the slope of the individual Production Possibilities Frontier, not market prices. Some economists using the aggregate models of comparative advantage often ignore this important distinction between an individual and a country and treat them as equivalent economic concepts.

In order to introduce a possibility of a market, we need another individual in this country. But, if this individual was identical in all respects[ref]It should be noted that, unlike Block et al. (2007) critique of Mises and Rothbard, this article looks at homogeneity in the pure mathematical sense implied by the aggregate models of “national” comparative advantage. Inputs available to any individual within a country are identical in all possible respects. Given the properties of the production function, the basic unit of inputs is infinitesimally small. It is also assumed that specialization does not affect the individual level of skill in either line of production.[/ref] to the already present individual, there would be no logical reason why any of them would specialize in the production of one good and exchange some of that product with the other individual. They both own equal quantities of homogeneous inputs and are equally skilful in combining these inputs into any output they may desire (and their desires are identical). In this situation there are no gains either in productivity or in the alignment of individual means and ends resulting from specialization and exchange. There is no particular reason for a market to emerge in an economy inhabited by identical clones who own identical inputs that are assembled into outputs in a precisely identical way.

Therefore, input[ref]Since human action ultimately enters all production processes, the actor’s physical body with all its physical and mental capabilities is an input as well.[/ref] heterogeneity is not an additional wrinkle in a general market model – it is a necessary condition for the existence of any market. More precisely, input heterogeneity is an unavoidable attribute of any market. Even if all individuals were identical in all respects before specialization, if this specialization will not change them in any way and make them more productive in the selected line of production, there is no particular reason to specialize.[ref]Preference in production of one good over another as a reason for specialization is also excluded since it is assumed that all individuals have identical preferences.  The only remaining reason for specialization and exchange would be that all individuals prefer exchange for its own sake. But, this would be a trivial explanation because exchange would be its own end.[/ref] Consequently, there are no market prices to be compared between two hypothetically isolated economies.

In this case, if there were two hypothetically isolated “economies” composed of individuals identical within an economy but different across economies, the only thing we could observe is two groups of self-sufficient autistic clones. This is why individual heterogeneity is important. The same laws govern interpersonal exchange, regardless of whether the exchange occurs within a fence we call a country border or across the fence.

Conclusion

This article is a reflection on the nature of misunderstandings among economists, looking at the law of comparative advantage as an example. There are different sub-languages within economics, and the structure of the language we use can be more or less conducive to fully encompassing the meaning of the concepts we wish to explain. Sometimes, the alignment between different languages is quite thin or even nonexistent so that some messages get lost in translation. However, it is important to constantly clarify the subtle differences in the understanding of economic concepts in order to facilitate better communication, and ultimately, discover the messages that are too important to be lost.

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