Polarization effect, descriptive explanation
Here, I will try to explain why the Comparative Advantage
Theory not works, when the number of goods are lower than the number of
countries. Let’s see the simplest comparative advantage model as it was
presented by David
Ricardo (British economist from the beginning of XIXth century,
today are more sophisticated, but they are still based on David Ricardo
assumptions and premises).
Let’s assume that we have two countries: Antigua (A) and Barbuda (B), which produce and trade two
goods: avocado (A) and bananas (B). On Antigua prices are high:
banana costs 100 $ and an avocado 200 $ (not mentioning olive). On
Barbuda prices are lover:
an avocado costs 100 $ and a banana costs 10 $. Moreover, let’s assume
(as Ricardo did) that prices are money-neutral, so we can use relative
prices (i.e. not nominal - in dollars - but we will measure the price
of one good using the number pieces of another good, you can buy for it
- this is a very
dangerous assumption, scroll down for explanation). On Antigua
we can buy one avocado for two bananas (avocado is relatively cheap,
bananas are relatively costly). And on Barbuda we can buy one avocado
for ten bananas (avocado is relatively costly and bananas are
A merchant from Antigua who have one avocado can buy 2 bananas
here on Antigua but also can go to Barbuda, and sell the same avocado
for 10 bananas, then go back to Antigua, and sell bananas to buy 5
avocados, then go to Barbuda again...
Comparative advantage at work
The merchant goes richer and richer, and everything started
from one avocado. Moreover, citizens of Antigua will consume more
bananas and citizens of Barbuda will consume more avocado than without
a trade. Everybody is happy, and the most important observation:
is profitable, even if prices of both
are much higher on Antigua than on Barbuda. And that was Ricardo’s point.
| Warning: there
is a major mistake in this reasoning, see below.
Now let see, what will happen if we add a third country -
Montserrat (M) - but we do not add a third good that can be traded
(there is no mango). On Montserrat island prices are medium
(intermediate): an avocado costs 160 $ and a banana 40 $ (we can buy 1
avocado for 4 bananas).
And what our merchant with one avocado will do this time? Will he go to
Montserrat to buy 4 bananas and go back to Antigua to sell these
bananas for 2 avocados? Or will he go straight to Barbuda, where the
relative prices are better? The same is true for a merchant from
Barbuda. She will not try to sell bananas on Montserrat, if she can get
better prices on Antigua.
A country eliminated from
As you can see, when the number of traded goods is lower than
the number of countries, it is pretty possible that a country with
intermediate relative prices will be completely excluded from
international trade. I did not write that the country will be always
excluded, because there are at least two little exceptions here. See
When the demand in a rich country is very high and neither the poor and
the middle-income country alone can’t satisfy demand in the rich
country, then the middle-income country is not eliminated from trade by
polarization effect. So, the volume of export and import also matters.
|Second: Prices in the
trade aren’t stable and can be manipulated. If the trade itself gives
the country’s merchants great profits (net profit from buying at lower
prices in one country and selling at higher prices in another),
merchants sometimes could manipulate prices to increase the volume of
trade. Even if the “bare” trade balance of their country will be
negative, the net profit from trade (when we add the income of
merchants) could be positive.
What is the polarization effect?
Usually the number of traded goods is much more higher than
the number of countries. But when the global economy shrinks, every
country take some protectionist measures to make its comparative
advantage (relative prices) better. It is unavoidable, because every
country has some debts - money borrowed when the global economy was
growing - that have to be repaid (see also virtual
A side-effect of this polarization of
international trade is a very deep crisis in middle-income countries
very serious social conflicts. Not
only the polarization effect launches the
economic crises in middle income countries but also a very similar
polarization effect destroys the economic prosperity and safety of
middle-income citizens (internal demand for their work, services, and
manufacture, also shrinks). The best examples for democratic countries
are the Argentina collapse (2001) or crisis in France (1934). True democratic
country survives polarization crisis but in populistic
times a quasi-democratic system changes into true dictatorship (or
authoritarian, or totalitarian system) — good example is the
history of Germany, Austria, Poland, Spain,
Hungary and Latin America between two World Wars (1919-1939).
Rich countries take efforts to make the export of capital-intensive
goods (or the capital, which is an important element of their export)
relatively more profitable and try to make import of labour-intensive
goods less profitable. Poor countries take the opposite strategy:
promote the export of labour-intensive goods and try to protect its
economies against the import capital-intensive goods. Middle-income
countries have these times very serious problems, because their export
rapidly shrinks. Moreover, middle income country couldn’t take any of
those two strategies described above, because right-winged GPIs (groups of political interests),
which are interested in “capital-intensive” strategy have almost the
same political strength like left-winged GPIs, which are interested in
Here is the picture showing the normal distribution of goods (plus
capital) in the international trade. Vertical axis represents the net
income from export (revenue minus costs) of different goods. Horizontal
axis orders goods from capital-intensive (right) to labour-intensive
Distribution of goods in the
international trade in times
corrected - April 2006
Middle-income countries have a privileged position. The reason
traded goods usually have the normal distribution (statistic term) - i.e. the group of medium goods (with
more or less the same costs of labour and capital used to produce them)
is most numerous.
Distribution of goods in the
international trade in times
And here is another picture, this time showing the “polarization
effect”. Now traded goods forms two large “mountains”, and the number
of medium goods rapidly shrinks. Number
of traded goods do not decrease but they form two groups
(capital-intensive and labour-intensive) and the effect is more or less
the same as we had only two traded goods - so middle income countries
Picture corrected - April 2006
The most typical protectionistic measures taken, are:
- The increase of interest rates (for rich countries to
increase the income from capital)
- The devaluation of national currency (for poor countries
to increase the income from labor-intensive goods)
Again, middle-income countries have problem to chose the right
protectionist strategy, because supporters of right-winged strategy
(high interest rates, strong national currency, low taxes, reduction of
government spendings, especially social spendings) and supporters of
left-winged strategy (devaluation of national currency, expansive
fiscal economic policy, protection of social spendings) have almost
equal political strength. When crisis lasts for a few years, debt of
middle-income country increases because of export problems. Eventually
we can observe very serious crisis like Argentina collapse (of course
institutional weaknesses, and corruption inside government mattered
But there are many other protectionistic measures possible: trade
duties, more intensive exploitation of labour workers, etc. Moreover there are many variants of the
polarization effect. When the top of the mountain (normal distribution
of goods) is little shifted - i.e. is over capital-intensive goods or
labour intensive goods (not over medium goods) - then the polarization
crisis, and protectionistic measures taken may be different. And the
crisis may affect middle income countries at different times, depending
on their position on X (horizontal) axis. This explains (for example)
different variants of oppressive populistic systems that evolved in
Italy, Japan, Spain, Germany, Poland and other Central European or
Latin America countries between 1919 and 1939.
Major flaw of the
Comparative Advantage Theory
Please look carefully at the first (“Ricardo”) example. We
actually have really three goods
here: avocado, bananas and money. If you look closely, you will find
that Antigua really have the comparative advantage in money -
money are cheap and fruits (avocado and bananas) are costly. On the
other hand, on Barbuda money are costly and fruits are cheap. No one
merchant will be so stupid to transport avocados bought on Antigua for
200$ and try to sell these avocados for 100$ on Barbuda, if he could
simply buy avocados for 100$ on Barbuda, and sell for 200$ on Antigua.
As you can see, Barbuda will export both kind of fruits and Antigua
will export the third good - money.
So, the comparative advantage theory is actually no more than a David
Ricardo’s mistake. I feel little ashamed that I haven’t spot that
before (i.e. before 23 Aug 2003), and knowledge that for nearly 200
years no one of thousands economists found that, doesn’t help.
Ricardo’s model of
Comparative Advantage could still work in case of
internal exchange inside the monopoly (for example when some country
monopolizes the international trade).
Of course rich countries still can export goods to poor
countries, but the reasons for that are different (i.e. export is not
the effect of comparative advantage as classic model describes it):
- rich countries are exporting “bare” money, like precious
- rich countries are exporting capital
- rich countries are exporting goods that could not be
manufactured in other countries because of the lover technology level
(like advanced software)
- rich countries could export trade and financial services
(like insurance, transport, etc.)
- rich country could export “international currency
service” (like USA exporting dollars)
- If the prices are not much higher, goods could be exported
to the country where the prices are little lower, because without the
international trade local market in the second country could be
dominated by some local monopoly (and thus without the trade, prices
here would be higher, not lower).
Taking all these reservations into account I have to say that
the real mechanism of the polarization effect is little more
complicated than presented above. But the real mechanism is not very
different. The most important thing to remember is that in case of very
rich income countries, raising of interest rates could be a way to
protect their trade balance.
Comparative Advantage in money - consequences
Knowing that a very rich country
have a comparative advantage in money
- not in any “normal” good - wwe have to make three reservations about
economic models derived from the Comparative Advantage Theory:
- When analyzing trade exchange in a model with two goods we can’t use relative
prices and have to use absolute prices.
- Model with relative prices and two goods will be applicable only for analysis of natural
trade exchange (i.e. before the invention of money).
- Or one of two analyzed goods (when we consider relative
prices) have to be money.
These precautions apply to all economic models explaining the
trade. For example to the Edgeworth
box - when analyzing a trade exchange between two countries that
two different goods, we have to use three-dimensional Edgeworth box
(one dimension for each of two goods and one for money). Moreover, even
the three-dimensional Edgeworth box will not give us unambiguous answer
when there are more than two countries!
Rich country usually exports money in one of three forms:
- As the pure money
- rich country has a negative trade balancce
(its supplies of precious metals or currency reserves will shrink)
- As the capital
- country lends some money to governments or firms from abroad, gaining
some extra income from interest rates.
- As the international currency
service (like US Dollars today, British Pound in XIXth
century, Florence or Venetia coins in Renaissance), gaining this way
some extra income.
We can formulate a quick-and-dirty law:
- When a income from exporting capital and international
currency service is higher than an outflow of pure money, a
very rich country will promote (even using
military ways) a free trade.
- When a income from exporting capital and international
currency service is lower than an outflow of pure money, a very
rich country will take some protectionist measures (duties, subsidies,
increase of interest rates, etc.).
Increase of interest rates have two effects:
- Increases the income from exporting capital
- Increases the costs of capital-intensive goods production.
So, it works against all countries which are specialized in exporting
capital-intensive goods and importing capital - i.e. some middle-income
countries (like Argentina
Devaluation of national
currencies launched by poor countries will have a similar, but not
exactly symmetric effect (like polarization picture above may suggest).
Of course, these effects appear only when a very rich country
is so important supplier of capital, so can enforce (dictate) the
prices of capital - i.e. interest rates. Moreover, we have to
remember that some times interest rates are increased because of some
actions taken by countries borrowing capital (like nationalization of
property of foreign investors), or simply because of falls on world
stock markets (when overproduction crisis comes). These times effects
mentioned above are simply side-effects and increase of interest rates
is not intended to be a tool of a protectionist trade policy.
As you can see, free trade is not always profitable for every
player in international market. This is mostly because of diffusion
powers (reason for protectionism in rich countries) and because of
political factors (trade policy that is best for the country is not
always the best choice for ruling GPI - i.e. ruling group of political
interests). But generally we can assume that free trade is rationale in
times of prosperity, and protectionism may be rationale policy in times
of global economic crisis.
Polarization effect, quick summary:
Variant in liberal periods:
- When the overproduction crisis comes (i.e. after the series
of falls on world stock markets, usually starting from emerging
markets), rich countries increase interest rates to protect their
income from abroad investments.
- When the price of capital increases, poor countries
devaluate their currencies to increase income from exporting
labour-intensive goods, and this way compensate higher costs of credit.
- Therefore middle-income countries (which imports capital
and specialize in exporting labour-intensive goods to rich countries
and capital-intensive goods to poor countries) face serious problems
with their trade balance. It is the reason for fierce political
conflicts between left-winged GPIs and right-winged GPI, especially in
This is true when world economy is in a free trade phase.
Polarization crisis for a protectionist economy will be little
different. Mechanism of crisis is
not exactly symmetric, because economy of capital is little different
than economy of labour. Although some protectionist strategies may look
similar: ex. nationalization of foreign capital investments in
countries exporting labour-intensive goods and deportation of
immigrants in countries exporting of capital. Capital usually has a
privileged position because it have to be accumulated again and again
(I will explain this in The World History Rewritten section).
a final note: probably I should completely rewritten that page
when I found the major mistake in the comparative advantage theory, and
make text under the horizontal line an integral part of this
explanation, but science develops thorough mistakes and only half-true
answers, so I decided to present you one of mines. Both elements
mentioned here (problem of trade when the number of goods is smaller
than the number of countries and comparative advantage at money) are
important when we try to understand periodical trade problems of
middle-income countries (ex. Argentina collapse 2001).
Warsaw, 17 July 2003
text under the horizontal line: 18 November 2003
last revision: March-April