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Thursday, June 21, 2012

Economists Find Evidence for Famous Hypothesis of Comparative Advantage

Evidence for comparative advantage:

Economists find evidence for famous hypothesis of ‘comparative advantage’, MIT News: David Ricardo’s concept of “comparative advantage” is one of the most famous and venerable ideas in economics. Dating to 1817, Ricardo’s proposal is that countries will specialize in making the goods they can produce most efficiently — their areas of comparative advantage — and trade for goods they make less well, rather than making all kinds of products for themselves.

As a thought example, Ricardo proposed, consider cloth and wine production in England and Portugal. If English manufacturers are relatively better at making cloth than wine, and Portugal can produce wine more cheaply than England can, the two countries will specialize: England will concentrate on making cloth, Portugal will focus on making wine, and they will trade for the products they do not produce domestically.

Neat as this explanation may seem, it is by definition hard to prove. If England does not make wine, and Portugal does not make cloth, it is very hard to say how efficiently they could produce those goods. The same applies to any country not manufacturing any given product. So does Ricardo’s idea resemble reality?

A recent paper by MIT economists Arnaud Costinot and Dave Donaldson uses a novel approach to suggest that Ricardo’s hypothesis is buttressed by real-world evidence. ...
Why nations specialize

To arrive at this conclusion, Costinot and Donaldson identified a data source that let them quantify nations’ potential productivity: The Food and Agriculture Organization (FAO), an arm of the United Nations, analyzes farming conditions globally, estimating potential agricultural productivity based on factors such as soil type, climate and water availability.

Costinot and Donaldson looked at the numbers from an FAO model of yields of 17 crops on 1.6 million plots of land in 55 countries to examine whether countries specialize in the way Ricardo believed. That is, if a country’s terrain allows it to grow wheat more productively than grapes, comparative advantage suggests that specialization will occur. So Costinot and Donaldson compared the predicted output of crops in each of the 55 countries (based on the FAO data and on prevailing prices) with the actual output of those crops.

The numbers show that Ricardo was right — to an extent, anyway. Costinot and Donaldson analyzed the results so that if the real world worked just as Ricardo supposed, the correlation between productivity and output would be 1.000. Instead, the logarithmic correlation they found was 0.212, with a margin for error of 0.057.

“We found a positive and statistically significant correlation,” Costinot says.

The paper, “Ricardo’s Theory of Comparative Advantage: Old Idea, New Evidence,” was published in the May issue of the American Economic Review. ...

Caveats and future directions

That said, Antras suggests a couple of caveats to the paper. One is that agricultural productivity is not purely a function of environmental factors; technical know-how and the availability of equipment also influence which crops are grown where. Secondly, Antras notes, the less-than-total correlation indicates that additional factors affect international trade as well. “The results suggest the theory is validated, but it is also quite clear that there are many other things that drive trade patterns,” Antras says.

For their part, Costinot and Donaldson acknowledge these qualifications...And the MIT economists add a third caveat: The data consist of productivity estimates made by agronomists; if those estimates are a bit off, it would affect the bottom-line findings as well.

Still, Donaldson says, “I was surprised at how, even with all the complexity in the real world, there was still this positive correlation between the theory and reality.

    Posted by on Thursday, June 21, 2012 at 08:28 AM in Economics, International Trade | Permalink  Comments (58)


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