January 8, 2017

Comparative advantage: why capitalisme is not inherently bad

Someone asked me, some time ago, why I do not see capitalism in its core as something bad but as something good (see here). This person argued, in brief, that capitalism is the cause of much misery in the world, such as poverty, corruption, and the subversion of democracy. Moreover, this person said, capitalism is inherently bad because it is always a matter of exploitation. If two parties trade with each other and one of the parties makes a profit, that profit has to come from somewhere. This then must mean that the other party is exploited, in other words, must make a loss. 

Indeed there are problems

Before trying to explain why I think capitalism at its core is something good, I will clearly say that many of the problems capitalism's critics mentions are real and dangerous problems, indeed. Badly regulated capitalism had strongly contributed to the above mentioned problems. However, I agree with Robert Reich who says that the solution of these problems is not to replace capitalism (I know no credible alternative) but to save it from its own excesses.

A central misunderstanding

A central misunderstanding which is often expressed is that the market and government are entirely separate entities and that government should not interfere with the free market in order to not distort it. Reich explains that government plays a crucial role in making the market function well. The market is an instrument which needs to be set up and regulated so that society as a whole benefits the most from it.

Setting up and regulating markets involves topics like property, market power, contracts, monopolies, bankruptcies, and enforcement (read more). The way in which the government (and in a democratic society ultimately its people) sets up and regulates its own market, determines how good or bad the effects of the market will be. How well we define and limit the market determines how desirable the consequences of market activities will be.

Comparative advantage

Now, I will try to explain why I see trade and capitalism in a well regulated market not as something bad but as something good. For that, I will use the concept of comparative advantage which was discovered about two centuries ago by David Ricardo. This concept explains why it is not true that when two parties trade one of them always has to be exploited. The central idea of comparative advantage is that when two parties (whether they are individuals, companies, or countries) trade with each other, normally both of them benefit.

The next example (source) illustrates how this is possible. Suppose Liam and Emma both catch fish and gather fruit. Liam needs 3 hours to catch one fish and 4 hours to gather one portion of fruit. Emma needs 2 hours for one fish and 1 hour for one portion of fruit. Emma does both things faster than Liam. Intuitively you would think that Emma has nothing to gain from trading with slow Liam. But this is not so. Both Emma and Liam benefit from trading.

Emma is better at both catching fish and gathering fruit. But the difference Liam is greatest in gathering fruit. For this, Liam needs 4 hours and Emma only 1 hour. Emma has a comparative advantage in gathering fruit. If she gathers two portions of fruit and trade the second portion for Liam's second fish both she and Liam benefit. Emma now only needs to work 2 hours for 1 fish and 1 portion of fruit. Without trading she would need 3 hours. Liam now only has to work 6 hours while he would have to work 7 hours without trading.

By trading both parties can now start to specialize in what they do which makes it likely that they will become better/faster at what they do best. Liam may learn to catch fish in, say, 2 hours and Emma may learn to gather fruit in, say, 3 quarters of an hour. Because of this, the benefits from trade will increase. Also, a second type of benefit will start to happen which is that Liam and Emma will become interdependent which is likely to have a pacifying effect. When you are cooperating and mutually benefit you will be less likely to fight.

I acknowledge that there are ifs and buts with respect to comparative advantage. It does not always happen and there are certain factors which may negate its effects (read more). But the idea that trade is bad by definition is not right. In essence it is something good, something which can both increase prosperity and civilization providing we set it up and regulate it wisely. 

2 comments:

  1. The most important argument in favour of capitalism is that the only well-known alternative is Marxism which turns out so badly that capitalism's crimes are small in comparison (see: The Gulag Archipelago, Mao's Cultural Revolution, the Cambodian genocide).

    Capitalism can also point to Canada, Denmark, Singapore, Japan, Sweden, France, Germany, the Netherlands and more as examples of pretty good outcomes.

    In fact the difference in outcomes is so stark that we should be concerned that many academics promote a fashionable Marxist / anti-capitalist ideology seemingly blind to outcomes they are promoting.

    ReplyDelete
    Replies
    1. I agree. And from what I understood from economists, Marxism, in practice, is not only ineffective from a moral standpoint but also from an economic standpoint because it lacks an adequate mechanism for establishing prices.

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