A Note on Comparative Advantage and Money

Bin Zhou


Although all current college economic geography textbooks incorporate the notion of comparative advantage as a mechanism of spatial exchange, none of them discusses comparative advantage in conjunction with money. This gives the illusion that trade always follows comparative advantage and implies that trade always achieves long run equilibrium. This note examines comparative advantage in monetary economies. It shows that in monetary economies, short run monetary conditions may cause short run trade disequilibrium against comparative advantage. Only in the long run, where long run monetary equilibrium is established, can trade follow a long run equilibrium pattern dictated by comparative advantage.

1. Introduction

If you open a college economic geography textbook published during the 1960s and 1970s, more likely than not, you will find no mention of the notion of comparative advantage. Examples are Economic Geography by Durand (1961), A Geography of Manufacturing by Millder (1962), the Geography of Economic Activity by Thoman (1962), World Economic Geography by White, Griffin and McKnight (1964), A Geography of World Economy by Hans Boesch (1974), and Location in Space by Lloyd and Dicken (1977), just to name a few. Of course, there are exceptions. For example, Geography of Economic Activity was updated in 1974 by Thomas with an additional co-author Corbin, and contains discussion of comparative advantage. Today, all college economic geography textbooks include the notion of comparative advantage as part of the mechanisms accounting for patterns of spatial exchange. These include Principles and Applications of Economic Geography by Hanink (1997), the Global Economy in Transition by Berry et al (1997), Economic Geography by Wheeler et al (1998), the World Economy by Stutz and de Souza (1998), the Geography of the World Economy by Knox and Agnew (1998); and the Geography of Economic Development by Fik (2000). Since the notion of comparative advantage is mostly used as a framework in analyzing exchange and specialization at the international scale, such a change reflects not only that geographers have reached out for new conceptual tools in geographic analysis, but also the increasing importance of international coverage in college economic geography courses.

One common shortcoming of current economic geography textbooks in incorporating comparative advantage, is the omission of the discussion of comparative advantage in conjunction with money. All the textbooks mentioned above carry their discussion of comparative advantage in economies but the role of money appears either to be ignored or is implicitly assumed at its long term equilibrium (no money illusion). This barter exchange approach not only generates an illusion that trade always proceeds according to comparative advantage, but also neglects the role of money in shaping spatial exchange patterns at least in the short run.

The purpose of this note is to discuss comparative advantage in monetary economies and to bring money into trade determination. This approach allows an understanding of how money affects trade as well as a distinction between the short-run trade pattern and the long-run trade pattern.

Section 2 discusses two ways of expressing the cost of a good and gives a brief account of the notion of comparative advantage as it is advanced by Ricardo, and subsequently by Heckscher and Ohlin. This is followed by Section 3 which discusses how the real exchange rate is formed in a general equilibrium process. Section 4 incorporates money in the exchange. Section 5 summarizes and concludes the note.

2. Comparative advantage

The essence of comparative advantage is to express the cost of a good in terms of the amount of other goods. For example, if you can use one hour to make either a pizza lunch or 2 omelet breakfasts, we can express the cost of a pizza lunch in terms of the number of omelet breakfasts. If a pizza lunch in country A costs two omelet breakfasts but only 1.5 omelet breakfasts in country B, it is obvious that pizza lunch is cheaper in B than in A. Some traders may be willing to buy pizza lunch from B and sell them in A for a profit, given that the shipping cost is less than half a omelet breakfast.

During the early 19th century, Adam Smith used the amount of hours used in producing a good as a measure of the cost of a good (Krugman and Obstfeld 1997). Suppose workers in country A use 2 hours to make a pizza lunch and workers in country B use 1.5 hours. According to Smith, a pizza lunch is more expensive in country A than B since it contains a half more hour labor. This is called the absolute advantage approach. Table 1 gives the number of hours required to make one unit of cheese and wine in countries A and B. In Smith's view, country A should export both goods to country B since both goods are cheaper in A than in B. Today many people would reach the same conclusion since it seems quite intuitive. However, in the eyes of mainstream economists opposing the Labor Theory of Value, Smith uses an invalid approach in measuring the cost of a good. The argument is easily made as follows. Nobody would deny that it is impossible to make a judgment in regard to which location has cheaper pizza lunch without knowing the two currencies' exchange rate if a pizza lunch costs 2 Australian dollars in Sidney Australia and 1.5 U.S. dollars in St. Louis, USA. That 2 is numerically larger than 1.5. does not necessarily mean that 2 Australian dollars are worth more than 1.5 U.S. dollars. The units, the Australian dollar and the U.S. dollar make all the difference. For the same reason, one cannot conclude that country A's 2 hours are worth more than country B's 1.5 hours because the units, country A's hours and country B's hours, make all the difference. Without knowing the exchange rate between labor hours in the two countries, we simply cannot say which country has the cheaper pizza lunch though we can say that pizza makers in country B are more efficient than those in country A. In fact, according to the law of one price, 2 Australian dollars and 1.5 U.S. dollars, and 2 labor hours in country A and 1.5 labor hours in country B, all have the same value since they are all worth 1 pizza lunch.

      Table 1  Number of hours required to produce a unit of goods

                                 Cheese  (1 pound)        Wine (1 gallon)

             Country A        2                                     1

             Country B        5                                     4

It is left to Ricardo to argue that it is comparative advantage that determines the trade pattern. Since the 2 hours used in making 1 pound of cheese in country A can also be used to make 2 gallons of wine, the comparative cost of a pound of cheese is 2 gallons of wine in country A. Converting all costs into relative or comparative costs in the same manner results in Table 2.

Table 2 Comparative cost of a unit of good in terms of the amount of the other good

                                     Cheese (1 pound)               Wine (1 gallon)

             Country A        2 gallon wine                     0.5 pound cheese

             Country B        1.25 gallon wine                0.8 pound cheese

Numbers in Table 2 illustrate that producing one pound of cheese in country A would cost it 2 gallons of wine while making a gallon of wine would cost it 0.5 of a pound of cheese. Similarly, country B would have to sacrifice 1.25 gallons of wine to produce a pound of cheese, or forgo 0.8 of a pound of cheese to make a gallon of wine. The opportunity to trade for extra gain is apparent: country A can sell a gallon of wine to country B for extra cheese. Similarly, country B can sell cheese to country A for extra wine. We can then say that a unit of wine is cheaper in country A than in country B measured in cheese, and that cheese is cheaper in country B than in country A measured in wine.

As a classical economist, Ricardo adhered to the Labor Theory of Value. As a result, he used labor hours contained in one unit of a good as a measure of cost, and calculated comparative cost. The resultant ratio is relative labor productivity. Since the late 19th century, the Labor Theory of Value has been abandoned by mainstream economists. Ricardo's comparative advantage theory, based on relative labor productivity, was in danger of losing its theoretical base. In the early 20th century, Haberler (Salvtore 1990) proposed the notion of opportunity cost. Since then comparative cost is defined by opportunity cost instead of relative labor productivity. The question is why places have different opportunity cost? Heckscher and his student Ohlin answered this question with their Factor-Proportions theory.

Factor-Proportions theory proposes two crucial elements in determining a location's opportunity cost in a certain industry. The first element is a country's resource abundance, as measured by the ratio between the amount of different resources of a country, or by the ratio of resource prices. The second element is an industry's resource use intensity, measured by the ratio of the amount resources required for an industry.

Suppose country A has abundant labor resource but scarce capital while country B is capital rich but labor scarce. In addition, suppose that the wine industry is labor intensive while the cheese industry is capital intensive. Given both countries' resource endowment and industries' resource use intensity, it would be easy to see that if country A devotes all of its resources into making wine, it would produce plenty. However, if it devotes its entire resources to cheese, it would not produce much. For country A, the opportunity cost of wine in terms of cheese is low. Similarly, for country B, the opportunity cost of cheese in terms of wine is low. With country A having a low opportunity cost in wine and country B in cheese, exchange may take place as Table 2 suggests. In general, countries with an abundant resource have a lower opportunity cost in the industries that use that resource intensively, and thus should specialize in producing and exporting those goods.

3. Gains from trade and the real exchange rate

The comparative advantage principle measures the cost of making a good in terms of other goods. It also measures the revenue made from selling a good in terms of the amount of another good (we can call it comparative revenue). As previously discussed, Table 2 shows that if country A brings a gallon of wine to country B, it can sell for 0.8 pounds of cheese. Compared with the wine's cost in country A of 0.5 pounds of cheese, the revenue of 0.8 pounds of cheese represents a profit of 0.3 pounds of cheese. Similarly, country B would earn a profit of 0.75 gallons of wine if it sells a pound of cheese to country A. These represent the potential gains from trade.

In reality, the actual (real ) exchange rate between wine from A and cheese from B cannot be as described as above because, if it is, one of the trading parties would not be able to gain from trade, and thus would not have the incentive to engage in trade. For example, if the actual exchange rate between wine from A and cheese from B is set at one gallon of wine exchanging for 0.8 pounds of cheese, all profit, 0.3 pounds of cheese, would go to country A. This is because in country B, 0.8 pounds of cheese is worth 1 gallon of wine before trade. When B exchanges 0.8 pounds of its cheese for a gallon of wine from A, it does not gain any extra wine from the trade. The same can be said about the other extreme where country B sells 1 pound of cheese to country A for 2 gallons of wine. This exchange rate exists in A even without trade with B. Therefore, only B gains a profit of 0.75 gallons of wine for each pound of cheese sold. For trade to occur, both countries have to gain. This requires that the actual exchange rate between A's wine and B's cheese fall somewhere between 0.5 to 0.8 pounds of cheese for a gallon of wine, or between 1.25 to 2 gallons of wine for a pound of cheese. For example, if the actual exchange rate is 1 gallon of wine for 0.7 pounds of cheese (that is, 1 pound of cheese for 1.43 gallons of wine), country A gains extra 0.2 pounds of cheese for each gallon of its wine sold, and country B gains extra 0.18 gallons of wine for each pound of cheese sold.

Since many possible real exchange rates may exist between 0.5 to 0.8 pounds of cheese for 1 gallon of wine, which particular rate should be used? The real exchange rate that finally prevails in exchange between A and B must be a market clearing rate. That is, under this rate, supply of A's wine exactly matches B's demand for it, and at the same time, demand for B's cheese from A is precisely equal to the supply from B.

Walras (Harris 1980) conceptualized an auction process through which the market clearing real exchange rate or the equilibrium real exchange rate is arrived at. At the beginning of the market, an auctioneer calls out an arbitrary exchange rate. For the given exchange rate, traders decide and report the amount of their trade they would like to trade, though no actual goods change hands. If the total reported demand for and reported supply of a good is not matched, the auctioneer will call out another exchange rate which causes adjustment in the amount of intended demand for and intended supply of the good amount traded. This process continues until an exchange rate is called out at which the total intended demand for, and intended supply of the good, are equal. This real exchange rate is the equilibrium real exchange rate. Only at this point do the goods change hands.

Let's use our example of exchange between A's wine and B's cheese to illustrate such a process. Suppose at the beginning of the market, an auctioneer calls out an exchange rate at 1 gallon of wine trading for 0.78 pounds of cheese (or 1 pound of cheese trading for 1.28 gallons of wine). Since this rate is very close to 0.8 pounds cheese for a gallon of wine at B, most of the gain goes to traders in country A. For instance, for each gallon of wine A's traders sell, they gain extra 0.28 pounds of cheese as profit. That is 56% more than they can receive from a trade in the home country. On the other hand, traders from B only receive a gain of extra 0.03 gallons of wine for each pound of cheese they sell. That is only 2.4% more than what they would get from selling cheese domestically. As a result, traders from A will offer to sell as much wine as possible while traders from B will not offer much cheese for sale. Since selling wine also means buying cheese, and selling cheese means also buying wine, there will be a lot of supply of wine and demand for cheese from A's traders but there will not be as much supply of cheese and demand for wine from B's traders. Obviously, we do not have a market clearing exchange rate. Seeing that there is an over-supply of wine and shortage of cheese, the auctioneer will adjust the exchange rate in the direction that encourages demand for wine and supply of cheese (or equally discourages supply of wine and demand for cheese). If the new rate is set at 1 gallon of wine for 0.7 pounds of cheese (or 1 pound of cheese for 1.43 gallons of wine), A's traders will obtain extra 0.2 pounds of cheese for each gallon of wine sold (40% more than they sell wine domestically) and B's traders will receive an extra 0.18 gallons of wine for each pound of cheese sold (14.4% more than in the domestic market). Consequently, A's traders will supply less wine while B's traders will supply more cheese. In other words, demand for cheese decreases while demand for wine increases. The supply versus demand gap shrinks in both products. This process will continue until a market clearing exchange rate is obtained.

In a market with multiple goods where possible exchanges take place between any pair of different goods, the auctioneer will call out an exchange rate for each of these exchange pairs, traders will report their supply of a good and demand for all others for the given set of rates. Total supply and demand for each of the goods in the market will be tallied. If a supply and demand gap exists in some goods, the auctioneer will adjust the exchange rate set so as to narrow the gaps. This process will continue until a set of exchange rates are obtained which clear all markets. This is what is called the general equilibrium.

In this section, we have discussed the production of cheese and wine as if countries use fixed input techniques. In other words there is no input substitution. In more elaborate analyses where input substitution is allowed and the law of diminished return takes place, the opportunity cost varies at different levels of production. However, including this complication will not change our general conclusion with regard to the real exchange rate reached in this section.

4. Money, trade, and the balance of payment

Trade based on comparative advantage and the Walrasian general equilibrium market clearing process discussed so far takes place in a barter economy, where money plays no role. These notions and processes illustrate the essential operation of the real economy (goods) underlying a monetary exchange economy. That is, the real movement of an exchange economy is the process via which various goods change hands at the terms set under market clearing conditions. It is important to understand how the interaction between the exchange auctioneer and the traders sets the terms of trade in a general equilibrium process.

In a monetary exchange economy, money plays the role of the auctioneer. Goods are labeled in monetary prices. Based on monetary prices, traders can easily calculate relative prices within a country and compare them with those of other countries, and thus determine comparative advantage of different countries. As an example, assume that for the two countries in Table 1, the hourly labor wage rate is $6 for country A and $2 for country B (for simplicity, we ignore the fact that different countries may have their own currency and thus there is the issue of currency exchange rate. We deal with this issue a little later). As a result, the prices of a unit of goods are as follows.

Table 3 Price of goods measured in dollars

                                     Cheese (1 pound)               Wine (1 gallon)

             Country A        12                                                6

             Country B        10                                                8

Given the prices of goods, we can easily see that in country A $12 can be used to purchase 1 pound of cheese or 2 gallons of wine, or $6 is used to purchase 1 gallon of wine or 0.5 of a pound of cheese. In country B, $10 can be used to purchase 1 pound of cheese or 1.25 gallons of wine; or $8 is used to purchase 1 gallon of wine or 0.8 pounds of cheese. Apparently, the opportunity costs are the same as in Table 2. More significantly, the result will still be the same even if the price levels in two countries are drastically different. Suppose country B is experiencing inflation and the wage rate is $10 per hour. The prices in two countries will be as follows.

Table 4 Price of goods with country B experiencing inflation ($)

                                     Cheese (1 pound)               Wine (1 gallon)

                 Country A        12                                       6

                 Country B        50                                     40

The comparative advantage pattern is still the same as in Table 2. Given the price pattern in Table 4, it is obvious that trade pattern will not follow comparative advantage. Actually, consumers in country B will be more likely to purchase both goods from country A, a specialization pattern suggested by Smith based on Table 1. Although the pattern is the same here as Smith's prediction, its logic is different. Smith's conclusion is based on comparing, incorrectly, terms that are not really comparable. In Table 4, all terms are in the same unit, the dollar, therefore they are comparable. As an extreme example, suppose country A is experiencing inflation and the wage rate is $20 per hour. The prices of goods in the two countries will be as follows.

Table 5 Price of goods with country A experiencing inflation ($)

                                     Cheese (1 pound)               Wine (1 gallon)

                  Country A        40                                   20

                 Country B        10                                     8

Now, although country A has absolute advantage measured in labor hours as shown in Table 1, the price pattern suggests a trade pattern where country B sells both goods to country A, opposite to Smith's prediction. This once more proves that Smith's prediction is based on incorrect logic.

Of the trade patterns revealed in Tables 3, 4 and 5, only Table 3 is consistent with what comparative advantage would indicate. In Tables 4 and 5, although underlying comparative advantage is as Table 2 indicates, the actual trade pattern deviates from that which comparative advantage indicates. The trade illustrated in Tables 4 and 5 involves extreme cases of one way trade.  In monetary economies, such extreme one way trade means monetary flow to cover the shortfall. Less extreme cases of trade imbalance involve two way trade, but the amounts of export earning and import spending are not equal and also need to be balanced by money payments. Trade imbalance in monetary economies is a phenomenon not seen in a barter economy where, since exchanges are conducted in real terms (i.e. purchase a good by paying with another good) in a barter economy and the notion of trade imbalance does not exist. As a result, trade imbalance is a unique issue in monetary economies' trade.

In monetary economies without capital movement (i.e.. cross border investment), trade imbalance can only last as long as a country's monetary reserves allow. In the long-run money flows between countries will cause price adjustment and the trade imbalance will disappear. Therefore, the trade pattern that causes trade imbalance can be considered as a short-run scenario. The long-run trade pattern is reached when the long-run price level is achieved by money supply adjustment between countries. Therefore, an important distinction between exchange in a monetary economy and a barter economy is that in a monetary economy, there are short-run as well as long-run trade patterns corresponding to the short-run and long-run money supply conditions.

The adjustment process from a short-run trade pattern to a long-run trade pattern will largely go as follows. A trade deficit country will be running a balance of payment deficit, which involves a monetary out-flow and resultant price level reduction (or the price increase in the country that is running a trade surplus). Price reduction in a deficit country will make its product more competitive and eventually exportable to the other country. The opposite happens to the other country where increase in price level, as a result of increase in money supply, causes its good to be less competitive. Such a price level convergence continues until a point is reached where one country exports some good and imports another. We can imagine an initial one way trade as in Table 4 (or Table 5) to be followed by a two way trade as in Table 3 after monetary adjustment takes place.  In a trade pattern displayed in Table 3, a certain price level in each country, and thus a real exchange rate between two countries, will be reached at a point where the amount of imports is exactly offset by the amount of exports. Trade is in balance and the goods market is cleared. Apparently in a monetary exchange, balance of payment condition, money flow, and price level adjustment change the real exchange rate between exports and imports and establish eventually the equilibrium real exchange rate. This is how money plays the role of an auctioneer in exchange. Here the real movement (real exchange rate) is achieved due to nominal (money and price) movement. A comparative advantage trade pattern occurs when trade balances. Comparative advantage indicates the trade pattern under the long run and balanced trade conditions.

When countries use different currencies, real exchange rate is determined by EPa/Pb where E is the exchange rate (the price of currency a expressed in currency b), and Pa and Pb are price levels in A and B respectively (Krugman and Obstfeld 1997). The deficit country will lose money supply and/or experience depreciation, and the surplus country increase money supply and/or currency appreciation. The price adjustment and currency depreciation (appreciation) together cause the price levels of two countries to converge. For example, suppose country B is in a trade deficit. As a result, E increases as a result of depreciating currency in B. The loss of reserve money from B also causes Pb to decrease. Both movements lead to a larger real exchange rate, which means a unit of goods in A can exchange for more units of goods from B. We say the terms of trade deteriorate for B. Although the producers in B suffer from the deterioration of the terms of trade on each unit of goods sold, country A may increase the amount of units imported from B. Under certain conditions, called the Marshall-Lerner condition (Salvatore 1990), increase in earnings due to a larger amount of units of goods exported may more than offset the reduced earnings due to lower prices. The trade imbalance in B may improve. When the trade imbalance eventually disappears, the resultant real exchange rate is the equilibrium real exchange rate.

5 Conclusions

We can summarize the main notions in exchange economies with money as follows. First, in monetary exchange, countries' money supply condition, price levels, and exchange rates play an important role in shaping the trade pattern. As a result, secondly, trades do not always follow comparative advantage. Countries that are experiencing inflation or have an over-valued currency may have a trade pattern opposite to what comparative advantage would indicate. Trade pattern that appears consistent with what absolute advantage predicts is actually the result of drastically differing price levels. Thirdly, balance of payment imbalance is a unique phenomenon associated with monetary exchange economies. For economies without cross-border capital flows, the existence of balance of payment imbalance is indicative of trade patterns deviating from comparative advantage real exchange rate under general equilibrium. In the long-run when trade balances and money flow reduces to zero, the real exchange rate settles at the level determined by the general equilibrium conditions. Therefore, comparative advantage indicates the long-run pattern of trade. Since no country is able to maintain a balanced trade at every moment, it is important to recognize that no country trades exactly according to what its comparative advantage and the equilibrium terms of trade would suggest. A meaningful discussion of comparative advantage should necessarily include the role of money.


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