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The Olympics and Comparative Advantage

Mises Daily: Friday, August 24, 2012 by

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We have just finished our quadrennial search for who is the very best in the world in a dizzying array of sports. We discovered who was absolutely the best at a given time, under the same circumstances, even if it was by a fraction of an inch or a hundredth of a second. But, especially in those photo finishes that provided audiences so many thrills, it seemed that the differences in rewards (gold versus silver medal, bronze medal versus off the medal stand, making the team or the finals versus just missing them, etc.) were far greater than the often small differences in performance.

That can lead to serious misunderstanding when people reason by analogy from sports competitions to market competition (shorthand for whatever voluntary arrangements people make with one another).

In the Olympics, the rewards seem to only go to a very few "winners," which could be taken to imply that most of the participants — however talented, hardworking, and admirable in many ways — were losers (the most cynical version is that "second place means first loser"). In economics language, absent careful thinking, it appears that the "winnings" go to those with an absolute advantage at a task, however slight their superiority, and such winner-take-all gains leave others worse off.

Even though that is a narrow and misleading view of winning (ignoring the value of self-improvement and the accomplishment of making it that far, for instance), I believe similar thinking discolors many people's views of market competition.

From the idea that in competition, including market competition, rewards are unfairly disproportionate to performance, it is but a short step to a host of statist interventions in the name of fairness that do little to advance fairness but a great deal to undermine the benefits we all derive from the competition involved in voluntary arrangements.

The analogy from winners in sports to winners in market competition reflects, in part, a confusion between absolute advantage (who can do absolutely more of something with their given resources) and comparative advantage (who is relatively better at doing one thing relative to what else they could have done with the same resources) — a distinction, first recognized by David Ricardo, with such important implications that every principles-of-economics course tries to make it clear. And a central part of that discussion is to demonstrate that, even when one party is better than another at both of two tasks considered, gains don't go to the one with the absolute advantage at the expense of the other party. Instead, specialization and exchange benefits both parties, as long as arrangements are voluntary, as in free markets.

Economists have been through this story so often it seems obvious to us. But over 30 years of classroom experience has taught me that many students struggle to break out of a default setting of thinking in terms of absolute advantage ("to the winner goes the gold, but others lose" sports analogy), which is necessary to really understand comparative advantage. And many of those who do "get it" can still get confused by the jargon, sloppy thinking, faulty logic, and misrepresentation that typically misinform public-policy discussions.

As a result, to help students get and retain what they have learned against the assaults of what Henry Hazlitt called "the best buyable minds," it is very helpful to both personalize things (so students can understand things as explaining what they would do) and use simple stories that keep to the essentials. And if this is useful for those who are taking economics courses, it is even more so for the vast majority with no economics training whatsoever.

Let me illustrate with one of several examples I use in my principles class to demonstrate the logic and implications of comparative advantage.

I ask my students who has a sibling still living at home. Out of the hands that go up, I pick a "volunteer." Say it is a female student and her sibling is a brother. The circumstance is simple. I posit that my student can mow the lawn at home in half an hour, but her brother takes one hour to do the same job. Then I ask my student who is the lowest cost or most efficient lawn mower. Even though students are assigned to read about comparative versus absolute advantage before class, about two-thirds of the time, my student (or others who jump in, eager to impress by being right first) chooses the obvious (for those thinking in terms of absolute advantage) and wrong answer: she is.

I then take my student through the process of recognizing what is wrong with her logic. I point out that the right answer to my question is "it depends," because I have not, in fact, provided enough information to answer the question correctly beyond that.

The key is to recognize that the relevant costs of mowing the lawn are not one hour versus half an hour of time. The central question is who gives up less of other things they could do with the time (or resources generally) that it took to mow the lawn, not the time required for the task itself.

So I add the assumption that my student could earn $20 an hour working at something else (where the $20 reflects the value of output others anticipate receiving as a result of her efforts), but her brother could only earn $8 an hour elsewhere (also reflecting the value of output others anticipate receiving as a result of his efforts).

With that added information, I demonstrate that the absolute-advantage answer (she should mow the lawn) is wrong, and that both parties could gain from having the absolutely worse but comparatively better producer specialize and exchange.

In this example, the half hour of foregone output necessary for my student to mow the lawn is $10 of goods and services, as valued by others' willingness to pay. But the hour's worth of forgone output for her brother is only $8, also as valued by others' willingness to pay. The counterintuitive result is that even though her brother is absolutely worse at mowing the lawn (and at other things as well), he is comparatively better. In this case it is because while he is half as good at mowing the lawn, he is only 40 percent as good at what is being given up, so he actually gives up less to mow the lawn.

The implication is that it makes sense for her brother to mow the lawn despite his absolute disadvantage. This is where the conflict with absolute-advantage ("only the best win") logic comes to a peak.

How do we counter it? We demonstrate how both parties could be better off by having the person with each comparative advantage specializing in it, and exchanging with one another at mutually acceptable terms, regardless of absolute advantages. It is not win-lose but win-win.

One simple way is to start by assuming it is my student's responsibility to mow the lawn, and then show how it is in both of their interests to arrange a trade of services. In this case, my student would be willing to pay anything less than $10 to save her the $10 opportunity cost of mowing the lawn. Her brother would be willing to accept anything more than $8, because it would more than cover his opportunity cost. Say they propose to exchange services for $9. Both would say yes, and both end up better off. And because they would voluntarily agree, no third party need involve itself — their self-interests lead to the mutually beneficial result.

Why doesn't this reasoning, which can be conveyed to (eventually) nodding heads in a classroom, not have a larger or more lasting effect on people's reasoning? This brings us back to reasoning by analogy to the Olympic-medal stand, because the victory celebrated there is substantially different from the victory for others that results from market competition.

On the medal stand, the relevant "output" achieved and rewarded is victory, regardless of the speed, height, etc., with which it was achieved. But a more accurate analogy to the gains from competition in market arrangements is the improvement in results (higher heights, longer distances, faster times, etc.).

Competition leads to people being able to achieve certain tasks better as time passes, both through the direct effect of winners and through emulation by others of what works most successfully. The result is that both the participants and society get more productive at those tasks. More can be produced. It is a positive-sum game. And that fact is the often-missing link in people's understanding.

Society gains from increasing what is produced with our resources, because competition to offer more of what other people desire makes them improve (as when record times fall), as opposed to the zero-sum conception of winning at others' expense embodied in a gold medal. And that fact — that more of what others value is produced as a result of market competition, which can be overlooked in medal-stand thinking — is why all participants will gain and why they seek out those arrangements voluntarily without anyone having to force them. It is also why, when the heavy hand of government intervenes in those affairs (whether it is with price controls, entry restrictions, taxes, regulations, mandates, subsidies, licensing requirements, ad infinitum), it destroys improvements — wealth — that would have occurred without its coercive interference.

If we wish to avoid the misleading absolute-advantage, winner-loser view of competition that people can infer from sports when focusing only on medal stands, we need to focus elsewhere. We need to keep our analytical eye on the expansion of benefits for others as individuals get better at providing what they value — e.g., that a 3:48 mile allows someone to achieve a given result with 5 percent less time (resources, generally) than a four-minute mile.

The better we can demonstrate this point to others, the fewer people will be convinced by bad logic and false attacks on voluntary arrangements. Then the political payoff to such nonsense will fall and government will abuse people's wealth-creating dealings less. If any of us could achieve some of that, it wouldn't matter whether we won a gold medal, a silver medal, or even 10,000th place — society would benefit greatly. And as people discover ways to do so even better, our own real contribution to our fellow man is in no way tarnished. We win every time anyone finds ways to do this better, resulting in expanded voluntary arrangements. The reason is that, gold medal or not, that is the gold standard for social organization.

As is so often the case when the issue is freedom and its corollary, competition to attract the voluntary cooperation of others, perhaps the most lucid distinction between athletic competition and market competition comes from Ludwig von Mises, in his monumental book Human Action:

Catallactic competition must not be confused with prize fights and beauty contests. The purpose of such fights and contests is to discover who is the best boxer or the prettiest girl. The social function of catallactic competition is, to be sure, not to establish who is the smartest boy and to reward the winner by a title and medals. Its function is to safeguard the best satisfaction of the consumers attainable under the given state of the economic data.