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LVRG ScrapbookWednesday, October 24, 2007:

Alternative Economic Review  No. 1: Locational/comparative/absolute advantage

The global economic crisis
from a non-neoclassical viewpoint

Inaugural Edition — October 2007


Locational/comparative/absolute advantage

Within one country, as labor and capital are mobile, the returns to laborers and investors (allowing for such things as risk, unpleasantness, and necessary skill) tend to be independent of location; if, for example, returns to labor in one location were to become higher, additional labor would be attracted until competition brought returns back to the normal level. Hence, if the optimal application of labor and capital to land gives a greater product (net of the costs of labor and capital) in one location than in another (in the same country), the difference can be claimed by the land owner as rent.* It follows that the rent of land is the excess of its productivity (net of the costs of labor and capital) over that of an equal area of the most productive land that can be had for no rent (in the same country), with the optimal application of labor and capital in each case.* This is Ricardo's law.

[More precisely, it is Ricardo's law as refined by Max Hirsch in Democracy vs. Socialism (Melbourne, 1901), pt.II, Ch.VIII. The original formulation, accepted by Hirsch himself as late as 1896, assumed the same application of labor and capital in each location. Hirsch's refinement is to be preferred not only because the “same application” formula is ambiguous (“same” doesn't tell us how much or what kind), but also because the optimal application, which is the application that the highest rational bidder will wish to use, varies with location.]

Note, however, the assumption that labor and capital are mobile within one country. The italicized qualification becomes crucial when we consider the merits or otherwise of what is called free trade. But first we must define two more terms.

Comparative advantage is the advantage to one country of allocating its factors of production (land, labor, and capital) in one way as opposed to another. Can this country get richer by producing its own widgets, or by exporting excess whatsits and using the proceeds to buy whatever widgets it needs?

Absolute advantage is the advantage to one industry or firm of operating in one country as opposed to another. Is it more profitable to produce widgets in this country or that country?

The argument for “free trade” is Ricardo's principle of comparative advantage, which states that under perfect competition (“free trade”), perfect mobility of labor and capital within each country, and perfect immobility of labor and capital between countries, each country will allocate its factors of production so as to maximize its comparative advantage. In short, free trade is mutually beneficial.

The assumption of immobility of factors between countries is referred to as Ricardo's caveat by one of this month's contributors. When “free trade” includes free movement of capital between countries in violation of the caveat, it no longer maximizes the comparative advantages of countries, but instead maximizes the absolute advantages of multinational corporations. That “free trade” agreements indeed allow free movement of capital between countries is an indication of who calls the shots. This is not to say that global mobility of capital is bad. When a manufacturer moves production to a third-world country in order to “exploit” cheap labor, it adds to the demand for labor in that country and thereby raises wages there. But it has the opposite effect in the country from which production is moved, so that, from the viewpoints of the two countries, the benefit is not mutual.


In consequence of the quest for absolute advantage, the U.S. economy produces less and less, and finances its consumption by selling or mortgaging assets. In “Ricardo's Caveat”, posted at The Agonist, Ian Welsh considers how it might end. None of the options is painless.

If the economic rent of finite resources, especially land, is not tapped for public revenue, speculation on such resources prices them beyond the reach of potential productive users, while revenue must instead be raised through taxes on productive activities. Such taxes discourage employment not only directly, but also by feeding into prices, hence increasing inflationary pressure, which provokes higher interest rates, which squeeze employers and consumers and render productive investments “uneconomic”, causing still more unemployment. Thus, in the teeth of unsatisfied wants that cannot be satisfied except by work, governments have created an artificial shortage of work! This in turn allows employers to get away with casualization, ageism, and glass ceilings, and makes offshoring a problem for domestic workers who otherwise wouldn't care. The Baglady, in “Early Retirement May Not be Optional for Twentysomethings”, recognizes none of this, treating casualization, ageism, and glass ceilings as independent causes, and suggesting that an increasing population is competing for a limited pool of jobs while technology drains the pool. But by acknowledging that job-seekers are also competing for a limited pool of “resources” — presumably including land — she briefly glimpses the truth and narrowly avoids being tossed aside as a neoclassicist!

What is the present status of the USA in international trade? According to a certain housewife with a politically incorrect pseudonym, it's like being subject to economic sanctions and it's a sure formula for recession — as she explains in “Economic Sanctions for Us Instead of Them?” posted at her blog with a politically incorrect title.

Official figures on GDP growth are purportedly adjusted for inflation. If the measure of inflation is too low, the resulting growth figure will be too high. That may explain why, according to official figures, your editor's prognostications of a U.S. recession have been premature, and why popular perceptions that the U.S. economy is already in recession have not been officially vindicated (although the latter situation may change with the release of preliminary figures for Q3, 2007). Official inflation figures also artificially screened out the recent housing bubble and prevented it from influencing monetary policy. While the bubble was inflating, both asset inflation and true goods-and-services inflation would have recommended monetary tightening. But now that the U.S. housing market has collapsed and recession seems inevitable, any attempt to restrain goods-and-services inflation by raising interest rates will further depress the housing market, hence availability of credit, hence the money supply, perhaps leading to deflation and depression. What will Bernanke do? Stirling Newberry at The Agonist untangles the threads in an article that is best read with Wikipedia and Google open in separate tabs. It's called “The Sound of Barn Doors Locking”.

If the USA is indeed headed for recession, what are the implications for the rest of the world? T. Pettinger considers the arguments in “Effect of US recession on Japan and China” at Economics Blog.

Of course events in China would not only be affected by any U.S. recession, but might also help to cause it. Adam Kritzer at CurrencyTrading.net explores several possibilities, including “How China Could Crash the US Dollar on a Whim” (but probably wouldn't).

In any field of economic policy, sudden-death thresholds are liable to create perverse incentives. If the law requires your employer to give you greater security of tenure after a certain period of service, don't be surprised if you're fired just before that period is up. If people who qualify for even a partial age pension are entitled to health and transport concessions, the semi-retired will carefully limit their part-time earnings so that they just qualify for the pension. Now there is a faint hope that the Iraq war — which cleared the way for Iraqi oil to be sold for U.S. dollars again, after Saddam had been selling it for euros — might be terminated by another such threshold. It seems that the U.S. Army is extremely reluctant to allow any soldier to serve in Iraq for longer than 729 days. In case you missed the story, Holly Ord sums it up in “No, They Won't Pay For School” at Woman Tribune.

“Software programming, oddly, teaches us that treating transactions as one-offs which aren't can cost us a great deal more money than approaching them as part of a series of transactions. This is the same lesson we need to understand about relationships — that making them into single transactions reduces long term value or increases our costs.” With these words, Charles H. Green at Trust Matters offers his article “Software Programming and the Economics of Trust vs. Transactions”, in which he attacks what he calls the transactionalization of finance — that is, the pursuit of one-off fees at the expense of long-term interest supported by long-term revenue — which he blames for various ills including unsound investment financed by unsound lending.

Next edition

Articles for the next edition of Alternative Economic Review (published November 28, 2007) may be submitted via the carnival submission form. Information on future editions can be found on the index page for this carnival. For further submission guidelines, see the carnival homepage.


* The sentences marked thus are written from an employer's viewpoint. To make them valid for employees as well, “product” and “productivity” would need to be generalized to (say) “advantage”, including employment opportunities. (Note added Nov.13, 2009.)

[First published at gavonomics.blogspot.com. Edited Oct.26, 2007. Relocated Nov.13, 2009.]

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