Comparative Advantage in the Modern Era: The Impact of Free Trade on Developing Economies

Long ago, nations traded based on the concept of absolute advantage: which producer was more efficient?  It made little sense to import goods you could make yourself.  Thus, until the 1800s, most international trade was limited to exotic goods and luxury goods.  British economist David Ricardo, however, revolutionized international trade in the early 1800s by creating the concept of comparative advantage.  The question is not whether you can make more units of X, but whether you give up less units of Y to make more units of X.

The law of comparative advantage states that a producer should produce goods for which it has a lower opportunity cost than a rival, thus meaning having a comparative advantage.  For example, the United States can produce more lumber than Canada, and therefore has an absolute advantage in lumber production.  However, it has much higher opportunity costs.  If the United States wants to produce another thousand tons of lumber, it must give up a hundred smartphones.  However, if Canada wants to produce another thousand tons of lumber, it sacrifices much less valuable alternatives.

Although highly developed nations like the United States and Britain have absolute advantages in the production of most goods, they must give up other valuable goods to do so.  Therefore, they will trade with poor countries - even for things they can produce themselves - to save more of their productive energy for their most valuable goods.  This is why developed nations will import goods from impoverished countries, even if the goods are of somewhat lower quality than domestic rivals.  

Comparative Advantage and Free Trade

Prior to Ricardo’s concept of comparative advantage, international trade was largely controlled by monopolies that were granted charters by European powers.  Famous examples include the British East India Company and the Dutch East India Company, which effectively ruled colonies and even possessed their own armed forces.  These monopolies kept prices of imports high through limited supply, with monopoly power protected by government charter.  Chartered companies lost power during the 1800s and a new concept arose: free trade.  Free trade is simply international trade without artificial restrictions like tariffs, quotas, or other government-imposed limits.

Under free trade, all production decisions are governed by the law of comparative advantage, with producers only making those goods for which they have a comparative advantage.  This is considered best for consumers, as this will maximize total output through gains from specialization and trade.  When two producers do not have the same opportunity cost in producing goods, there will always be one with a comparative advantage in one good and one with a comparative advantage in the other good.  

If each nation focuses on producing only the good for which it has a comparative advantage, the two nations will together produce more total goods than before, when each nation produced both items.  A mutually advantageous term of trade will be found, based on the opportunity cost of each producer, and consumers in both nations will benefit from international trade.  The greater amount of goods enjoyed by consumers after specialization and trade is known as gains from trade.  Free trade allows all consumers to experience gains from trade.

Developing Economies, Comparative Advantage, and Free Trade

Developing economies have an advantage in production due to their lower costs of production.  While the quality of many complex goods may be relatively low, this is often outweighed by far lower costs of wages and inputs.  For many goods, such as foodstuffs, the quality difference between products from a developing economy and products from a wealthy economy may be relatively small.  This allows the lower wages in the developing economy to be the primary determinant of comparative advantage.

For example, a farmer in a wealthy nation may produce agriculture that is 20% better (i.e., healthier and more palatable) than agriculture from a developing nation.  However, to accomplish this, the farmer in the wealthy nation requires 120% more money in terms of wages and inputs, such as pesticides and fertilizers, than his rival in the developing nation.  Thus, the wealthy nation is motivated to import agriculture and save its own money and resources to make other products, like automobiles and computers.

Free trade has benefited developing economies that can produce labor-intensive goods and services.  Wealthy nations could preserve their own labor for making more technologically-advanced goods or transition to service economies by importing simple goods and resources from developing economies.  Many credit this specialization and division of labor, thanks to the law of comparative advantage, with increasing real GDP per capita for the entire world.  Over 43 years, from 1960 to 2023, this value has almost quadrupled.

History of Free Trade Agreements

In England, the free trade movement began in the 1820s, shortly after economist David Ricardo created his famous concept of comparative advantage.  However, there was much resistance to the idea of trade without protectionist policies to advantage local producers.  Although international trade steadily expanded for the next century, most nations continued to use tariffs and quotas to limit imports and protect domestic producers.  In the United States, tariffs were an important source of federal government revenue prior to 1916, when a constitutional amendment finally allowed a federal income tax.  

Tariffs came to be viewed negatively during the Great Depression, when the United States’ unsuccessful Smoot-Hawley Tariff Act created a wave of reciprocal tariff increases across the globe.  International trade drastically decreased, reducing export revenue and worsening the Depression.  After World War II, which had expanded in part due to a desire to avoid tariffs and acquire foreign resources, many nations wanted to promote free trade.  The era of free trade is often considered to have officially begun in 1947 with the passage of the General Agreements on Tariffs and Trade (GATT).  

In 1995, the World Trade Organization (WTO) absorbed GATT and promoted reduced tariffs worldwide.  Famously, the 1990s also saw the rise of two large free trade blocs: the European Union (EU), which went so far as to create a common currency, and the North American Free Trade Agreement, or NAFTA.  NAFTA was credited with opening up a developing economy, Mexico, to increased trade with the United States and Canada, two wealthy economies.  

Unintended Consequences of Free Trade Policies

While free trade benefits consumers in wealthy economies by giving them access to lower-cost imported goods, it does harm domestic producers who cannot compete with lower costs of production.  This has led to frequent political demands to re-institute some degree of protectionism to protect domestic firms (and jobs).  In a broader sense, some opponents of free trade in wealthy economies worry about over-reliance on imports and losing production capacity or capital base that may be needed in the event of a crisis.  While free trade may benefit consumers when things are happy and peaceful, what happens when a war or natural disaster cuts off international trade?

Developing economies do not uniformly benefit from free trade either, and some argue that workers in these countries are exploited by outsourcing.  Wealthy multinational corporations build factories in poor countries that often lack worker safety or environmental protection standards, allowing those companies to benefit from being able to use child labor and unchecked pollution emissions.  To attract foreign investment, some poor countries may intentionally avoid creating labor standards or environmental standards, with only the top echelon of society benefiting financially from new factories.

Research has pointed to mixed results from globalization for citizens in developing economies.  In positive news, there appears to be consensus that free trade has reduced poverty worldwide, with nobody losing goods and resources.  However, the gains from specialization and trade are often unequally distributed, with most gains going to the wealthiest in developing economies.  This can create sociopolitical tension and unrest as the rich get richer while the poor see little improvement.  This creates an argument about whether any economic gain, however minute, is ethical if it is unequal.