Once upon a time, the leading car-maker of a developing country exported its first passenger cars to the US. Unfortunately, the product was a total failure. Most US consumers thought the little car looked lousy and were reluctant to spend serious money on a car that came from a place where only shoddy products were made. The car was such a failure that it had to be officially withdrawn from the US market.
This disaster led to a major debate in the country. Many argued that the industry should be shut down. Here was an industry, they said, whose best company could not penetrate even the lowest of the low end of the US market. And that was after the country’s government had given it 25 years of high tariff protection and banned foreign direct investment for 20 years.
The critics argued that the country should forget about industries like automobile, ship building and steel, which its government had been promoting – these industries were too capital-intensive for a country with very little capital and a lot of labour. The country should instead, they argued, concentrate on industries that intensively use its abundant labour force. After all, silk was the biggest export item of the country at the time.
They pointed out that the received economic theory supports their argument. The theory of comparative advantage, the most widely accepted trade theory, tells us that given its resource endowment, the country should specialise in labour-intensive products in which it has comparative advantage, rather than capital-intensive products in which it does not have comparative advantage.
The reader will be shockd to learn that the year was 1958, the country was Japan and the company was Toyota, and the car was called Toyopet. Japan’s automobile industry had been protected with high tariffs since its inception in 1933. Since it kicked out General Motors and Ford in 1939, in the run up to the Pacific War, the Japanese government had not allow any foreign company to produce automobiles in Japan. We may add that Toyota was doing so badly that in 1949 the Japanese government had to inject public money through the Bank of Japan, the Central Bank, to bail it out.
Today, Japanese cars are considered as ‘natural’ as Scottish salmon or French wine, but only two generations ago most people including many Japanese, thought that the Japanese car industry simply should not exist. Indeed, at the time, the Japanese car industry was, to put it bluntly, a joke. In 1955, all the Japanese car companies combined (there were around a dozen of them) produced 70,000 cars (with Toyota, the biggest company producing 35,000 cars) compared to 3.5 million cars that was produced by General Motors alone and 7 million cars by the US automobile industry as a whole.
Starting from this stark reality and going against one of the most widely accepted theories in economics (that is, the theory of comparative advantage), Japan persisted with the promotion of the automobile industry. By the late 1970s, it conquered the smaller car market, prompting the US and the European countries to impose quotas on Japanese car imports – euphemistically called ‘voluntary export restraints’. Even so, when the Japanese companies announced in the late 1980s that they are going to enter the luxury car market with new brands (Toyota’s Lexus, Nissan’s Infiniti, and Honda’s Accura), most people sniggered, muttering, “Japanese luxury car, that is an oxymoron, isn’t it?”. By 2008, however, Toyota became the biggest car-making company in the world beating General Motors, and the Japanese luxury car brands are neck-and-neck with BMW and Mercedes-Benz.
Do a little thought experiment to see how monumental the progress of the Japanese automobile industry has been. Suppose that you went back to 1958 and told people that there is this totally unknown third-rate car company called Toyota in Japan but that the company will in 50 years beat General Motors, you would be lucky if people thought you were writing a science fiction. More likely, they would have put you in a mental hospital.
The car industry is not alone. Japan developed its other key industries – such as steel, shipbuilding, electronics, and so on – by using similar mixtures of tariff protection, ban on foreign direct investment, subsidised loans from government-regulated banks, subsidies for R&D, special treatment for domestic firms in government procurement programmes (especially important for the development of the main frame computer industry), and many other internvetionist measures.
Moreover, Japan is not alone in this. It is well known that countries like Korea and Taiwan and more recently China, have used similar policies to industrialise and develop their economies. Less well known is the fact that virtually all other rich countries – the UK (in the 18th and the early 19th century), the US (throughout the 19th century and the early 20th century), Germany and Sweden (in the late 19th and the early 20th century), and others – also promoted their economic developments in similar ways.
Thus, given that virtually all countries have developed their economies by defying their comparative advantages and ‘artificially’ developed industries in which they do not have comparative advantage, we need to seriously re-examine the theory of comparative advange as the guideline for a country’s trade, industrial, and even development policies.
The concept of comparative advantage was first developed by the 19th century British economist David Ricardo. It is actually a very counter-intuitive idea. Before Ricardo, everyone believed that a country should trade with another only when it can produce something more cheaper than the other. This is known as the idea of absolute advantage. However, using the concept of comparative advantage, Ricardo argued that even a country with no absolute international cost advantage in any industry (that is, even if it cannot produce anything more cheaper than other countries can), the country will still be better off if it specialised in industries in which it is least bad at and traded with other nations. Conversely, even if a country can produce everything more cheaply than other countries can, it will still pay for that country to specialise in industries in which it is particularly good at and engage in international trade, rather than trying to produce everything itself.
The theory of comparative advantage is often misunderstood. I have heard professional economists saying things like “such-and-such poor country does not have comparative advantage in anything”. This is a logical impossibility. All countries, however inefficient they may be compared to other countries, have comparative advantage in something. To put it more starkly, even if you are rubbish at everything, there must be something at which you are the least rubbish at, and that is where your comparative advantage lies and that is therefore what you should specialise in.
From this concept, a whole body of theoretical edifice has been constructed to argue that free trade will naturally make countries specialise in industries in which they have comparative advantage, thereby making them better off. From there, it is but a small step to argue that following comparative advantage is the best development strategy.
The theory of comparative advantage is absolutely correct – in so far as the assumptions that underlie the theory are met. However, there are many assumptions that underlie the theory that do not hold in reality. The theory assumes that there is perfect competition, when the real world economy is dominated by monopolies and oligopolies. It assumes that there is no slack in the economy, when in the real world you have under-utilised resources and unemployed workers. And the theory does not work without the assumption that capital and labour can easily be re-deployed across sectors if changes in trade flows demand so. However, in reality machines and worker skills are very specific to the industry they are deployed in and cannot be used elsewhere.
There is nothing unusual about the fact that the theory of comparative advantage make all these assumptions that do not hold in reality. All theories, not just this theory, are constructed on the bases of certain assumptions and therefore do not hold if those assumptions are not met. What is special about the theory of comparative advantage, however, is that it has been used as a guide to economic development despite making assumptions that assume away the very core issues of economic development – that is, the nature of technology and the development of technological capabilities.
The currently dominant version of the theory of comparative advantage, known as the Heckscher-Ohlin-Samuelson model (after Eli Heckscher, Bertil Ohlin, and Paul Samuelson, who constructed the theory in the mid-20th century), assumes that there is only one best technology for producing a particular product and more importantly, that all countries have the same ability to use that technology. The only difference between countries in this model is the relative amounts of capital and labour they have – richer countries have more capital than labour and poorer countries have more labour than capital. So, in the Heckscher-Ohlin-Samuelson model (henceforth the HOS model), if Sri Lanka should not be producing things like BMWs, it is not because it cannot do it, but because doing that has too high an opportunity cost, as producing BMWs will use too much of its scarce factor of production, capital.
Thus seen, the main problem with the theory of comparative advantage is that it is not a theory that is useful in understanding the process of economic development. It is largely true that in the short run, a country will benefit the most by specialising in products in which it has comparative advantage in (I say ‘largely’ because the theory has assumptions that are often not met in reality even for this to be true). However, in the longer run, a country’s development success depends on how it finds a way to defy its comparative advantage and get into industries with dynamic demand growth, faster technological progress, and greater impacts on other sectors of the economy.
In doing so, the theory of comparative advantage can act as the ‘compass’ that tells a country’s policy-makers where their country stands and how much of the static gains from trade they are going to forego if they protected industries in which their country does not have comparative advantage. However, in the same way in which a compass cannot tell us where to go and, even less, how to get there, the theory of comparative advantage cannot tell the policy-makers which path of development path of their country should take and how to navigate the country through that path.
For far too long, developing countries, including Sri Lanka, have been told that sticking to their comparative advantages by following free-trade, free-market policies is the best development strategy. It is time that developing countries realise that the theory of comparative advantage is not a theory about economic development. It is only like a compass, helping us figure out where we are, but is of little use unless they have a clear destination, a good detailed map, and a knowledge of how to navigate the terrain that is full of physical obstacles, dangerous animals, and unpredictable weather conditions.