Tuesday, June 15, 2010

Comparative Advantage: A Behavioral Theorem

The comparative advantage of a nation is its ability to produce products or services more efficiently and cheaply than others. Nations such as China and India can power their way in global economic ranking only through sustainable comparative advantage. The comparative advantage of a nation, however, is broader than either the advantage of natural resources and factor supplies or the competitive advantage of industries in a nation.

Comparative advantage is a behavioral theorem rather than an economic model as is commonly understood. In fact, while economic parameters may quantify comparative advantage, they do not adequately adequate describe the sources or processes of comparative advantage of a nation. The comparative advantage is a function of certain basic behavior patterns exhibited by socio-economic constituents in a nation.

Each nation comprises individuals and entities. Though entities are the creations of individuals, over time entities and individuals develop their own behavior patterns. These determine the economic performance of a nation. Individuals and entities simultaneously function as producers and consumers, savers and investors, and ruled (governed) as rulers (governors). These behavior patterns in the aggregate define the national comparative advantage.

Individuals and entities in nations

At a broad level, individuals and entities of a nation need to function in harmony and synergy. The elaborate governance systems (for example, the corporate entities, the democratic polity, the administrative framework and the regulatory systems) are intended to align economic performance to society’s needs. However, individuals and entities are usually unable to make choices that are aligned to each others’ interests. Conflict rather than collaboration characterizes the functioning of individuals and entities thus affecting the comparative advantage of a nation.

There are a few cases in economic history that demonstrate how alignment of individual and entity behaviors leads to national comparative advantage. It occurred, decades ago, in America with swift economic construction, development of a large labor market and arguably one of the best university and research systems of the world. It occurred in Japan with emphasis on innovation and productivity, and almost seamless integration of social, national and corporate cultures for global economic domination. Select countries in Europe had at different points of time reflected periodic alignments and misalignments.

Nations which had individuals and entities passionate about efficiency and effectiveness clearly could generate national comparative advantage. However, over time, the very same nations began to lag as divergence between individuals and entities, and misalignment across behavior patterns within individuals and entities began to emerge. The loss of competitiveness of advanced nations, whether due to peaking of living conditions, unionism, lack of reinvestment or slowing down of knowledge formation, reflects this trend. The competitiveness of emerging countries, initially quantified through low labor costs and cheap facilities, need not as a corollary mean the natural emergence of sustainable comparative advantage.

China recognized the challenges of natural evolution of comparative advantage and began to shape the society’s behavior patterns through stringent rule. Mao’s Great Leap of the 1960s and Deng’s Great reforms of 1980s reflect unparalleled examples in behavioral management of nations. Factor supplies were regulated, utility costs administered, employee mindsets regimented and bank finances channeled to funnel competitive industrial growth. Massive investments in infrastructure fueled industrial consumption, opened up labor markets, encouraged labor migration, attracted foreign technologies and turned out cheap manufactured goods. Virtually all consumer electronic products are manufactured in millions and billions in China with perpetual lowering of scale-led manufacturing costs.

India, in contrast, relied on natural evolution to align individuals and entities for greater economic growth. Even though economic growth and export performance have been the avowed goals of post-independent India from 1947, India could not discover sources of sustainable comparative advantage for as many as five decades. The first signs of comparative advantage of India became evident in the globalization of India’s information technology and business process outsourcing industries between 1995 and 2005 during which decade China continued to take long strides as the manufacturing capital of the world. However, between 2005 and 2010 India also started to display new sources of comparative advantage on both manufacturing and services fronts.

Comparative advantage, beyond cost arbitrage

Quality related incidents (Heparin and toys, for example) and industrial regimentation aftereffects (Foxconn, for example) in China, mining backlashes in Asia, Australia and Africa, and operational safety hazards (from fireworks companies in India to oil drilling companies in advanced countries, for example) demonstrate that comparative advantage based on planetary exploitation, low labor costs, extended output targets, indiscriminate outsourcing and cheap manufacture may not constitute a sustainable phenomenon. Sooner or later cost levels and output levels would need to reflect realities of physical human life, and lead to equalization across economies and labor markets around the emerging countries eventually.

Sustainable comparative advantage, on the other hand, would stem from aligning the individuals and entities on shared responsibilities and goals, which are broader than monitory ones. The behavioral theorem is based on individuals and entities being producers and consumers, savers and investors, and ruled and rulers simultaneously. In an ideal national system production is balanced by consumption, imports are compensated by exports, savings are directed towards investments and wealth maximization is harmonized with social equalization. This process, however, gets impeded by the fact that all nations are not equally endowed.

Globalization commenced as an answer to this disparity but could not provide an equitable solution. Globalization has had three phases. In the first phase products, technologies and people were imported from advanced countries into less developed countries to meet local demand. In the second phase, technologies were imported to mass produce products for consumption in developed markets. The third phase which is now emerging involves a fusion of technologies and management approaches of advanced and emerging markets to optimize production and consumption globally. The world order should logically move to an equilibrium state as the third phase of globalization progresses.

Cost arbitrage would diminish in importance as improvements in living conditions and greater consumerism would lead to demands for higher salaries in emerging markets. Producers would need to not only channel a large part of their production to local markets but also build global brands around local designs. As earning potential in emerging markets improves savings would need to be invested in productive activities in local markets. Employees and managements as well as societies and governments need to be bound by shared ethics of productivity, efficiency and egalitarianism. This would require nations to raise capabilities in a wide spectrum of products and services rather than being focused on only a few industries or just leverage natural resources.

Intellectual edge versus physical rigor

The days of glossy products deriving attractive revenues and profits from low cost internals could be over sooner than later. Rather, high quality standards in design, manufacturing and service could differentiate products in future. The days of a pioneering brand and scores of follower clones could also be over sooner than later. Rather, novel ways of fulfilling the user requirement through innovative products and services could become necessary. There could be limits to stretching physical performance given the machine speeds and 24 hours all that being available in a day. There would, however, be no limits in stretching human intellect to generate novel products and services, and novel methods of design, manufacturing, delivery and service.

The industrial revolution started in laboratories with scientists and technologists creating new products. As demand burgeoned methods of factory-led mass manufacture shifted accent from design to manufacture. The limits of manufacturing efficiency as derived from cost arbitrage may well have been reached. There is still a residual possibility to innovate in manufacturing system design and equipment configuration as being discovered by global automobile firms with Indian engineering ingenuity. Even this phase will get over in the next five to ten years. Time is appropriate to get back to fundamental research in laboratories to develop novel products and services.

As India gets increasingly recognized as a global hub of manufacturing India has choices to make; whether to follow the established Chinese model of low-cost mass manufacture, albeit with more consistent quality, delivery and regulatory parameters, modify it with innovative manufacturing system designs or supplement it with novel research innovations. Sustainable comparative advantage emerges from all the three. Natural resources and synthetic outputs would need to be protected with novel research and manufacturing technologies. Waste needs to be eliminated and savings generated by adopting optimal business and conversion processes. Employees and citizens need to see value in generating comparative advantage. Comparative advantage becomes a behavioral and intellectual exercise.

Individuals and entities tend to have production, consumption, savings, investment, governance and governed behaviors that could be synergistic or antagonistic. The sustainability of comparative advantage of a nation arises from how well these behaviors are made harmonious.

Production and consumption behavior

Modern industrial theory is based on aggressive production and consumption behavior to boost growth. Resources being limited it is important that production and consumption are supported by meaningful behavioral patterns that support wise utilization of resources both from production and consumption points of view. China and India may have paltry automobile ownership rates of 14 and 8 respectively compared to 478 in USA but what should be the levels to which the vehicle density would need to grow? Should not road density per unit area grow first in India before vehicle density leapfrogs? And even when road density leapfrogs should not bus density jump ahead of car density? These are complex questions that need to be answered as much by public policy considerations as by individual and social behaviors.

Modern competition theory suggests that corporations intensify their efforts to segment the markets with diverse products of multiple functionalities to capture market share. Supported by saturation marketing this would prompt higher consumption, increased production and better economic growth. Such industrial theories lead to nagging worries on true competitiveness. Would not multiplication of products reduce innovation or at best perpetuate incremental innovation? Would not corporations be better placed by opening out new products with new features rather than by crowding out existing market segments with only incrementally relevant products? Would not consumers be better off by owning different types of products and services rather than many variants of the same product and service? These again are complex questions to be answered as much by regulators and strategists as by individual and social behaviors.

Modern economic theory has favored consumerism. It is believed that increased purchases and ownerships of houses, gadgets, equipment and stocks will lead to multiplier effects in the economy. Supply push and demand pull are considered synchronous. Consumerism is measured by the screens on which a movie is screened in the first days, the millions a gadget is sold on launch, the apartments that are booked on announcement and the times a capital market issue is oversubscribed. Consumerist economic thought generates its own questions. Would not overwhelming consumerism reduce product life cycle artificially and lock up capital in both production and consumption? Would not producers and consumers be better served by an orderly, rather than by a hyperactive, production and buying spree? Are considerations of quality well-served by saturated production and consumption? These are challenging issues that need to be answered as much by resource considerations as by individual and social behaviors.

Savings and investment behavior

Traditional Indian society moorings favored living within means. Savings were the pillar of social security for families and driving force of banking behavior. Typically, the Indian salaried class used to own a house at the end of the career out of the savings. The savings paradigm has undergone a fundamental transformation over the last three decades. Ambitious executives splurge their earnings on gadgets and are willing to make early purchase of loan-funded houses, only to live on wafer-thin savings. Credit cards are used by people to live beyond the means. Loans are treated as deferred savings. This distinctly American trend raises disturbing question for the Indian society. At a time when the American society has learnt at great cost the perils of living beyond means on credit the wisdom of Indian society following the disastrous trend is highly debatable. Have banks and financial institutions developed a vested interest in funding the society to profligacy? These questions need to be answered by economists and individuals as well as society in search of security and status.

Savings are meant to be channeled as prudent investments. Investments are to be made keeping in view lifestyle goals for retirement. Investments are to be made in assets to be held over a long time for capital appreciation. Modern trends have turned investment into expenditure and popularized buy-sell transactions as opportunistic short term alternatives to long term investments. With the proliferation of such investment trends America created asset bubbles in housing which shook the global economy to its core. Would not societies be safer by prudential allocation and management of investments? Should mathematical models be allowed to blur rational and logical investment behavior? Should complex instruments like derivatives and opportunistic methodologies such as short sales and day trades be banned? Again, these are critical questions for the stability of economies and societies to be answered by policy makers and market participants.

Ruler and ruled behavior

Rulers come in many forms; employers, companies, leaders, regulators, ministers, administrators, and so on. Correspondingly, ruled also come in more simple forms; employees, followers and citizens. The relationship between the ruled and rulers, or the governors and the governed, determines the equity, strength and stability of the society and polity. The drivers for rulers and the ruled are quite distinct. Rulers whether of corporations or nations are driven by control over resources and power. Ruled, on the other hand, are driven by needs for security and development. Different socio-economic systems and national governance systems sought to develop different methodologies to align the interests of the rulers and the ruled. The welfare states of Sweden and Switzerland represent one end of the spectrum while the controlled state of China represents another end. The purely capitalistic, but democratic, state of USA and the highly fragmented democratic polity of India represent other typical examples.

Totalitarian states provide quick fixes and democratic capitalistic states encourage but also punish excesses while fragmented democratic states are caught in chaotic turmoil of informed and uninformed debate. In the long run, informed democracies align the ruled and rulers better than highly controlled totalitarian states which force the ruled to subjugate free expression in exchange for economic rewards. The challenge for the ruled in democratic states is to gain absolute literacy and awareness and exercise the democratic power to keep the ruled focused on the imperatives of equitable economic growth. If any single factor is holding back India becoming a super economic power, it is neither industry nor infrastructure as commonly hypothesized but it is its inability to achieve complete literacy. The ruled in India which hitherto had a vested interest in keeping literacy at low levels has taken an epoch-making step with the Right to Education (RTE) bill. When the RTE and other education bills are implemented in letter and spirit India will beat all the emerging countries including China to a virtuous superpower status.


Comparative advantage is more of a human endeavor rather than an economic or industrial endeavor. Individuals and entities in a national system pursue aggressive pursuit of production and consumption patterns on one hand and savings and investment patterns on the other that encourage profligacy. Ruled are unaware of their rights and responsibilities on one hand and their capabilities and potentialities on the other hand. The rulers tend to have a vested interest in achieving a totalitarian control or a democratic fragmentation of these human behavior patterns. All these behaviors need to be harmonized for sustainable comparative advantage. Universal education is the key enabler for a tolerant society and democratic nation as India to discover its full potential through creative intellect rather than regimented labor.

Posted by Dr CB Rao on June 15, 2010

1 comment:

Narayanan said...

A thoughtful commentary on a subject that is arguably a turn-off for non-economists to borrow from Paul Krugman. RTE is long overdue and failure is not an option for India. Trade liberalization tends to be biased in the benefits it brings towards skilled workers therefore it makes eminent sense to build this from the bottom of the pyramid. However, this is also likely to shift workers to the formal labor market from traditional households suggesting potential policy ramifications for implementers of RTE in trying to balance short term pain vs long term gain (i.e., bread today vs cake tomorrow) in the background of poverty, corruption and the like. In addition, although the impact of recession in India has been thought to be minimal, globalization is here to stay. Long term changes to immigration policies in developed countries due to disparities in demographics is also likely to bring with it fair share of challenges and opportunities. Education and training as a sector is attracting investments; an encouraging sign indeed for the long term literacy health of India.