The comparative advantage argument for free trade and its consequences

David Ricardo (1772–1823) put forward the idea that countries trade in order to gain from their comparative advantages. In his model, countries differed only in the productivity of their labour for producing different goods, and the country that was relatively efficient at producing something should export this good. So, for example, England should export cloth to Portugal and import wine. An important implication of this theory is that countries should trade even if they do not have an absolute advantage in the production of goods: it is not whether a country is better at producing something than another that decides whether or not it should export it, but whether it is relatively better in comparison with other goods. The argument relates to the concept of opportunity costs and is the same idea as that we met in Chapters 2 and 4 as one of the bases of pre-industrial growth. When population or the ‘extent of the market’ expands, specialization is possible. Trade allows the ‘extent of the market’ to cross international borders and for countries to specialize.

The concept of comparative advantage is often considered to be one of the most difficult to grasp in economics, and yet its understanding is crucial. In short, producing a good diverts labour from producing other goods, which are thus lost (the opportunity cost). Of course, in the absence of trade it is necessary to produce all goods, and this is unavoidable. However, with trade it is best for a country to focus on the goods it produces relatively well, because by so doing it can produce most. This extra output can then be traded for the goods it is relatively poor at producing and hence enhance the level of consumer welfare. This is the classic idea of ‘gains from trade’. A numerical example is given in the appendix.

Efficiency in the use of resources shapes the wealth of nations

Economic history is concerned with how well mankind, over time, has used resources to create wealth, food and shelter, bread and roses. Nature provides resources and man transforms these resources into goods and services to meet human needs. Some resources remain in fixed supply, such as land, but the fertility of land can and must be restored after harvest. Over thousands of years of agriculture, mankind learned how animal dung, rotation of crops and the introduction of nitrogen-fixing crops could increase the yearly harvest. Natural resources such as coal, oil and iron ore are, however, non-renewable. Other resources are made by mankind. Capital, for example factory buildings and machinery and tools, is therefore renewable. Labour, finally, is a resource whose supply relies on how well mankind uses the other resources at hand. But labour has been in increasing supply since the transition from hunter-gatherer technology to agriculture about ten thousand years ago. The skills of labour, so-called human capital, were primarily based on learning by doing, and it is only since the nineteenth century that formal education has played an important role.

Efficiency is determined by the technology of production and by the institutions that give access to the use of resources. A convenient way of measuring efficiency is total factor productivity. The more output you get from a given amount of resources the higher the level of total factor productivity in an economy. You can measure the growth of total factor productivity by the growth in output which is not caused by an increase in inputs in production. Total factor productivity growth is caused by better use of resources due to new technological knowledge and better organization of production.

Institutions can be understood as the rules of the game for economic life. Institutions or principles such as the Rights of Man matter because if labour is not free to move it is unlikely that labour will find its most productive employment.

Light in the Dark Ages

The Dark Ages in Europe, the centuries after the decline of the Roman Empire, were not as dark as we used to think, although they did not possess the political, cultural and economic grandeur of the Roman Empire. Nor did Europe match Muslim civilization in terms of wealth and technical ingenuity. Products and technologies for the manufacture of sugar, paper, cotton and fine fabrics, chemicals for dying and glassmaking, would be imported during subsequent centuries. However, modern historians are now rewriting the history of the sixth to ninth centuries, and the prevailing pessimistic view is giving way to a more nuanced view of what happened after the decline of the Roman Empire. Settlements were abandoned and cities lost population and skills; roads deteriorated because of lack of proper maintenance; political maps were redrawn and social order was difficult to maintain; money was scarce and uniform coinage was lacking; income fell for ordinary people as well as the rich. Income declined because traditional trade links had been disrupted and because the social disorder and declining population could not support the infrastructure of public institutions and roads, markets and fairs, or the division of labour and specialization of the previous centuries. Income per head did not attain the peak level reached in the Roman period until the twelfth or thirteenth century in the most advanced parts of Europe.

In one respect this age remains dark: we do not have much written documentation, so we have to rely on archaeological evidence which is difficult to interpret. Historians use numismatic evidence, deposits of pottery and metal utensils; they analyse the nature and extension of settlements and of course the few written documents that are available. By locating coins you can, with a critical eye, trace trade links, for example. The extension of a market network can be revealed by the diffusion of specific types of pottery, jewellery and coins.

Institutions and efficiency

Institutions are the rules of the game. Some are upheld by law, others by mutual and spontaneous consent and quite a few by the (brute) force of privileged elites. Some institutions are informal, such as trust and commitment, while others – say, the limited liability corporation – needed coordinated action by lawmakers to get established as they did by the end of the nineteenth century.

Modern economic historians tend to explain institutions by pointing at their efficiency-enhancing effects. That works well for a large number of institutions and this is how we shall explain the emergence and persistent use of money as well as the evolution of banks in Chapter 7. Welfare State institutions are explained by the way they resolve potential market failures in private insurance and capital markets (Chapter 10). Private property rights can be seen as solving the inefficiencies of communal property rights; this is known as the tragedy of the commons. The tragedy of the commons is a metaphor for the waste of resources that may occur if there are no restrictions on the use of resources. If all have access to a resource – a forest, say – it will be over-exploited unless there are centrally planned restrictions on its use. The over-exploitation stems from the fact that each individual user generates a cost to others, what is technically known as an externality. If an individual logs timber for her own use, she will reduce the future availability of timber not only for herself but for others as well. But the cost to others does not affect or restrain the individual user because that cost does not enter as a private cost. The social costs of individual action are larger than the private costs. Deforestation is a serious problem in large parts of Africa at present because households need wood for cooking their meals.

Economy and politics at the close of the nineteenth century

In the last third of the nineteenth century, a number of Western European economies started to catch up with Britain (see Chapter 6), and participated in a phase of modern economic growth. It was an era of the minimal state. Government expenditure, central as well as local, as a share of GDP was around 10 per cent and most public expenditure was consumed by the military, law and order and civil administration. Public education, state-funded health and assistance to the poor and elderly amounted to less than half of government expenditure. The role of the state was to set the rules of the game, i.e. to enact laws and regulation for industry and trade, which might include legislation about maximum hours of work and safety standards for industrial workers. Poor relief actually stagnated in the nineteenth century and did not surpass 1 per cent of GDP until democracy gave the poor more say. In some nations, unemployment insurance was introduced with the help of the state, but trade unions were instrumental in setting them up. State subsidies were resisted in other nations on liberal grounds. A liberal consensus emerged, although attitudes to free trade differed when the losers from trade liberalization triggered off a protectionist backlash in the 1880s. However, the role of government was limited.

Money supply was left to the banking system and ultimately to central banks when they were granted a monopoly on note issuance. Macroeconomic management by using deliberate changes in taxation and expenditure to influence the business cycle had not been heard of. The first use of the word macroeconomics stems from the early 1940s. An economic orthodoxy which viewed the economy as a self-regulating entity dominated the minds of the ruling elite. It was thought that shocks to the economy could be absorbed through changes in prices and wages and would therefore have no real effects even in the short to medium term.

Why is there inequality?

Inequality refers to unequal access to welfare as manifested in consumption, health, life expectancy and schooling. It is usually allied to inequality of income. However, income is not an end but a means of acquiring a good life, which has a number of attributes apart from consumption. Needless to say, income is an imperfect guide to welfare distribution because some aspects of welfare are only vaguely linked to income. For example, income inequality on a world scale went on increasing until recent decades while inequality in terms of literacy has fallen sharply since 1950. The dramatic fall in child mortality during the last two centuries is also only remotely linked to income, and inequality in terms of life expectancy across nations has fallen. In the advanced welfare states of Europe, a growing number of services such as health, childcare, schooling and access to cultural sites such as theatres is provided at subsidized rates that again weaken the link between income and actual consumption. Despite these reservations, income inequality is an important, although insufficient, guide to welfare distribution.

The major sources of income are work, acquired or inherited wealth and, from the twentieth century onward, transfers such as pensions. Excluding property income, the income inequality we observe is closely related to skills acquired through formal education and on-the-job training. However, throughout history we have seen that discrimination can distort the relationship between skill and reward. Property income is not necessarily related to one's own efforts in the past but simply to the sheer luck of being born well endowed.

On a world scale we note that the poor in poor nations are usually much poorer than the poor in rich nations, while the rich in poor nations are almost as rich as the rich in rich nations, although less numerous.

Historical trends in population growth

Economics is sometimes called the dismal science because many of its pioneers expressed pessimism about the possibility of sustained economic growth in a world of limited resources. We meet this view today in the worries about shortages of raw materials, such as oil, eventually putting an end to economic growth. Late-nineteenth-century economists worried about coal shortages, but the concern today is rather that coal generates too much CO2, which might in the long run harm growth. The first economist to develop a coherent theory of limited resources as a binding constraint for sustained long-term economic growth was Thomas Malthus (1766–1834), whose An Essay on the Principle of Population was first published in 1798. The date of publication is not without interest, since it falls within the first decades of the Industrial Revolution in Britain, which combined unprecedented population growth with increasing (or at least constant) income per head. Malthus argued that given limited land the supply of food would eventually constrain income and population growth. We will soon return to a detailed exposition of the Malthusian view, but we will first review the evidence on long-term population growth in Europe. Reasonably precise population estimates are available only from the sixteenth century onward; before that, populations are estimated from projections based on scarce data and conjectures of the carrying capacity of a given area using the prevailing technology.

Cultures based on hunter-gatherer technology, which preceded the breakthrough of agriculture and sedentary civilization in the Middle East some 12,000 years ago, are very demanding in terms of land, and this limited world population to an estimated 8–12 million. A hunter-gatherer culture satisfies its food requirements from nature without actually controlling it: consequently an equilibrium between the stock of animals and the stock of men will evolve. If mankind over-exploits the animal stock the reproduction of both will be disturbed.