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In my latest column for AIER I was prompted by a student’s question about comparative advantage to better explain how the simple, classroom account of it maps onto reality [2]. I also offer some general thoughts about theorizing. Two slices:
One reason a country might both import and export a particular kind of good (or service) is that producers often diversify their sources of supplies. Producers do so rationally. Diversification of sources of supplies better ensures that producers will not be without adequate access to inputs if one particular source dries up.
American as well as foreign automakers might, for example, purchase American-made tires from Goodyear and also foreign-made tires from Michelin. The demand for a diversity of supply sources results in producers in different locations each having comparative advantages. Even if, say, Goodyear cannot produce tires at a cost quite as low as can Michelin, the fact that Goodyear is a different company operating in a different geographical and political location gives to Goodyear tires a market value that more than compensates for Goodyear’s higher costs of producing tires. Goodyear’s comparative advantage, in this example, is made possible by its factories being located in different places than are Michelin’s factories.
There is at work here another comparative advantage worth noting. Private companies have a comparative advantage over governments at achieving ‘optimal’ diversification of supply sources. Private-company executives not only have intimate knowledge of the industries in which they operate (knowledge not possessed by government officials), private-company executives also have singularly powerful incentives to assess correctly the costs and benefits of diversifying supply sources. They are motivated to diversify up to the point, but not beyond, where the costs of further diversification of supply sources outweighs the benefits.
Private-company executives might, and sometimes do, err in assessing the costs and benefits of diversifying their sources of supplies. But their chances of erring are much lower than are the chances that government officials will err if decisions about supply-source diversification are seized from the private sector by the state.
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A more-general lesson here is that more than mere textbook mastery is required to usefully squeeze improved understanding of reality from economic theories. Also required is wisdom. Theorizing about reality is necessary to gain understanding. But when we theorize we unavoidably simplify, a fact that’s true at all levels of analysis, from Econ 101 to Econ 999 and beyond. We use words that mask the real-world details of the things or actions that the words describe. We use graphs, equations, and statistics that inevitably do the same. Taking these words, graphs, mathematical symbols, and statistical classifications literally generates a heady-but-false sensation of grasping reality with a fullness that, in fact, is impossible.
Words and other tools of theorizing are indispensable for coherent thought, but they are not the actual phenomena to which they refer in reality. Those phenomena, especially in the social sciences, are nearly always inconceivably more complex and fluid than they are made to appear by our words and other theoretical tools.