The hopeful myth about foreign trade is that each country has its own unique resources and skill sets so that international trade functions as a kind of division of labor that benefits all. Your climate is conducive to growing cotton; our technology and population density are conducive to textile mills. You sell us cotton; we’ll sell you fabrics. We’ll all be better off.

An extension of this idea is found in Samuelson and Nordhaus as “the elegant theory of comparative advantage.”

It is only common sense that countries will produce and export goods for which they are uniquely qualified. But there is a deeper principle underlying all trade—in a family, within a nation, and among nations—that goes beyond common sense. The principle of comparative advantage holds that a country can benefit from trade even if it is absolutely more efficient (or absolutely less efficient) than other countries in the production of every good. Indeed, trade according to comparative advantage provides mutual benefits to all countries.

It is initially a little unclear what claims are being made on behalf of this “deeper principle underlying all trade.” The principle, which is elsewhere labeled a “law,” was first formulated by David Ricardo in the 19th century. He derived it by analyzing a hypothetical situation involving two products and two countries: wine and cloth in Portugal and England. Portugal is more efficient at producing wine than cloth and England is more efficient at producing cloth than wine. In absolute terms Portugal may be more efficient than England in producing both wine and cloth, but the fact that each country is more efficient relatively in producing a different product from the other means that both countries can benefit from trading if they each specialize in the product where they are relatively more efficient. Ricardo’s analysis of makes a host of assumptions and is presented in purely verbal logical terms, but others following him were able to express the principle with simple math which lent itself to a neat graphical representation.

Samuelson and Nordhaus use an example based on food and clothing in America and Europe, and they analyze the efficiency of production in terms of “opportunity costs” rather than simply basing it on an “amount of labor.” This enables them to incorporate the concept of the “production potential frontier” for each country into their graphical presentation. They also expand it to explain how the world market gravitates towards an equilibrium price for the products. Their presentation, however, seems basically to be an endorsement of Ricardo’s original argument.

The principle of comparative advantage holds that each country will benefit if it specializes in the production and export of those goods that it can produce at relatively low cost. Conversely, each country will benefit if it imports those goods which it produces at relatively high cost.

This simple principle provides the unshakable basis for international trade.

Whether the existence of comparative advantage gives rise to foreign trade in the first place or whether it is discovered after trade has begun for other reasons is perhaps debatable. The real point of the analysis seems to be an argument in favor of free trade and even an argument that “outsourcing” is just another instance of comparative advantage working to everyone’s mutual benefit.

Needless to say the concept of comparative advantage has had its critics. Some have pointed out that trade relations between England and Portugal in the 18th century were a great deal more complicated than Ricardo’s hypothetical account and others have made arguments undercutting Ricardo’s analysis because it is based simply on a labor theory of value with “labor” somehow being completely homogenous. More importantly it has been argued that all of the assumptions about perfect competition or flexible prices and wages make the theory irrelevant to real-world trade. It can also be shown that often international trade involves monopolies and commodities where economies of scale can be exploited to achieve dominance in a world market. Protectionist policies and subsidies or other forms of government intervention can also give a developing economy a chance to build up its own industries to a point where they can compete on the world market.

Most economist will concede that there are circumstances in the real world which may justify “strategic” trade policies if not protectionist policies like tariffs and quotas. Nonetheless the textbook conclusion is that free trade is ultimately best for all: 

Notwithstanding its limitations, the theory of comparative advantage is one of the deepest truths in all of economics. Nations that disregard comparative advantage pay a heavy price in terms of their living standards and economic growth.

When Paul Krugman felt compelled to reassess the case for free trade in 1987, he began:

If there were an Economist’s Creed, it would surely contain the affirmations “I understand the Principle of Comparative Advantage” and “I advocate Free Trade.” For one hundred seventy years, the appreciation that international trade benefits a country whether it is “fair” or not has been one of the touchstones of professionalism in economics. Comparative advantage is not just an idea both simple and profound; it is an idea that conflicts directly with both stubborn popular prejudices and powerful interests. This combination makes the defense of free trade as close to a sacred tenet as any idea in economics.

One of the “stubborn popular prejudices” that conflicts with the idea of comparative advantage is the idea that our economy suffers when cheap labor in other countries lets foreign businesses sell products more cheaply in the U.S. than they can be sold by domestic producers. It also encourages U.S. manufacturers to relocate their plants abroad to improve their competitiveness and their profits, regardless of the impact that such a move has on unemployment at home. Our economics textbook tells us that wages are determined by productivity and that outsourcing can in the long run be seen to be just another way in which comparative advantage can benefit both countries.

Samuelson and Nordhaus consider the argument that free trade agreements like NAFTA will harm the U.S. economy by driving down domestic wages and thereby reducing our standard of living.

This argument sounds plausible, but it is all wrong because it ignores the principle of comparative advantage. The reason American workers have higher wages is that they are on average more productive. If America’s wage is 5 times that in Mexico, it is because the marginal product of American workers is on average 5 times that of Mexican workers. Trade flows according to comparative advantage, not wage rates or absolute advantage. …

The cheap-foreign-labor argument is flawed because it ignores the theory of comparative advantage. A country will benefit from trade even though its wages are far above those of its trading partners. High wages come from high efficiency, not from tariff protection.

They also view outsourcing as a form of trade in services rather than goods and agree with their colleague Alan Blinder’s “careful analysis”:

Rich countries such as the United States will have to reorganize the nature of work to exploit their big advantage in non-tradable services: they are close to where the money is. That will mean, in part, specializing more in the delivery of services where personal presence is either imperative or highly beneficial. Thus, the U.S. work force of the future will likely have more divorce lawyers and fewer attorneys who write routine contracts, more internists and fewer radiologists, more salespeople and fewer typists. The market system is very good at making adjustments like these, even massive ones. It has done so before and will do so again. But it takes time and can move in unpredictable ways.

That last caveat is similar to textbook’s caveat in its description of how the labor markets adjusts to the needs of comparative advantage:

Over the long run, labor markets will reallocate workers from declining to advancing industries, but the transition may be costly for many people.

It appears that it may take the labor market a generation or more to adjust to these changes, and obviously that is not an attractive solution politically or even morally. The other caveat one discovers eventually is that there is no guarantee about how the “benefits” of comparative advantage will be distributed. What is good for the bottom line of multinational corporations and their shareholders is not necessarily good for the rest of the population, especially when large numbers of workers are laid off and find their skills are no longer in demand anywhere near where they live.

These are the some of the considerations that lead economists as well as politicians to advocate “strategic trade policies” and lead Paul Krugman to conclude

free trade is not passé, but it is an idea that has irretrievably lost its innocence. Its status has shifted from optimum to reasonable rule of thumb. There is still a case for free trade as a good policy, and as a useful target in the practical world of politics, but it can never again be asserted as the policy that economic theory tells us is always right.

Nonetheless Krugman still considers the principle of comparative advantage useful and relevant to the the 21st century. The textbook International Economics: Theory & Policy that he wrote with Maurice Obstfeld and Marc J. Melitz begins its discussion of international trade theory with a discussion of comparative advantage and says

In sum, while few economists believe that the Ricardian model is a fully adequate description of the causes and consequences of world trade, its two principal implications— that productivity differences play an important role in international trade and that it is comparative rather than absolute advantage that matters—do seem to be supported by the evidence.