Comparative vs Competitive Advantage Why is it that some regions can produce a product more cheaply than others? What should a region produce?

Competitiveness How can we define “competitiveness” of a region or location with respect to a particular product What do we mean by competitiveness?

Definitions – two concepts Comparative advantage Competitiveness

Comparative Advantage The issue: What is the location best advantaged to produce and sell a particular product?

Comparative Advantage The issue: What is the location best advantaged to produce and sell a particular product? Where should biofuel feedstocks be produced? Should the US attempt to compete with India in auto production? Should the Federal government try to save Detroit but not Georgia’s auto plants?

Comparative Advantage The issue: What is the location best advantaged to produce and sell? Constraints on the decision: spatial distribution of  Natural conditions and resources  Technology available for producing manufactured goods;  Human resources are differentially distributed  Social preferences Focus is on resource use

Intuition If you have a fixed resource that can be used to produce value, how should you use it?

What resources might be fixed? Ag land Mineral deposits Educated workforce? Transportation infrastructure? Information technology? We call these “nontradables” also “limited resources” and because they are located in particular region, sometimes called “domestic” resources

Opportunity cost and resource use Use the resource such that it produces the highest value possible If you chose some other use, the “opportunity cost” of that lower value use would be  Opp cost = highest value – value of your choice Example: What is the highest and best use of PA’s farm land?

Comparative advantage Suppose you have two regions with fixed resources as follows. What is the comparative advantage of each region? Region 1: Located far away from urban population, rich ag land. Region 2: Urbanized coastal location with deep-water ports, substantial labor force. High population density.

Definition: Comparative Advantage Adam Smith says…… "What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. The general industry of the country, being always in proportion to the capital which employs it, will not therby be diminished... but only left to find out the way in which it can be employed with the greatest advantage." (Adam Smith, The Wealth of Nations, Book IV:2, Modern Library edition)

Boiling it down…… Locations can produce nearly anything, but what would best serve their interests? What would pay greatest return on fixed resources? Comparative advantage says two things  Produce what you are relatively best at producing  Specialize and let others produce your lesser advantaged products If a country is relatively better at making wine than wool, it makes sense to put more resources into wine, and to export some of the wine to pay for imports of wool. Because it is relative advantage that matters, it is meaningless to say a country has a comparative advantage in nothing.

Comparative advantage - implications Region 1: Located far away from urban population, rich ag land. Region 2: Urbanized coastal location with deep-water ports, substantial labor force. High population density. Specialize – region 1 produces land intensive ag products, region 2 produces labor and raw material (e.g. ore) intensive manufactured goods. Why does this make sense?

What determines Comparative Advantage? If technology diffuses instantaneously across geographic space, If there are no fixed or unique resources, why would one region have a particular advantage over another?

Fixed resources as a basis for advantage? The traditional perspective is Each region specializes and exports products that are relatively more intensive in their use of fixed resources with which that region is endowed. Intuition?

Your product Think about your product, what regions have a comparative advantage in producing it? Why?

How can we measure comparative advantage? Comparison of  productivity  costs of production <<price  profitability? The idea was to find intrinsic relative advantage, but how can we do that without looking at prices, institutions, etc?

Old school approach to comparative advantage Does Senegal have a comparative advantage in rice production? Should the World Bank grant a loan for development of rice production to Senegal? How could we analyze quantitatively Senegal’s comparative advantage? New concept: domestic resource cost (DRC) DRC compares price of importing rice to cost of producing it in the country. Cost includes opportunity cost of using scarce resources.

DRC intuition Suppose a product like rice is produced using  Fixed “domestic” resources  Tradable inputs Suppose the product could be imported. DRC compares the opportunity cost of using fixed domestic resources to product it vs. net value created from tradables.

DRC calculation Domestic fixed (nontradable) resources Y d quantity used to produce a product, e.g. rice P d opportunity cost of using Y d Product to be produced (e.g. rice) Y o quantity producible with Y d P o border price of Y o Tradable goods used Y T quantity used P T price DRC = P d Y d / [P o Y o - P T Y T ] = value of limited resources used/value-added created = 1/rate of return to limited resources

Using the DRC to evaluate comparative advantage DRC = P d Y d / P o Y o - P T Y T So, product Y has a comparative advantage if DRC = P d Y d / [P o Y o - P T Y T ] = 1/rate of return < 1 In practice, you compute DRCs for a set of possible uses of the domestic resources, the best use is that which provides the lowest DRC  highest rate of return to use of domestic fixed resources.

Opportunity cost of using the fixed resource? DRC = P d Y d / P o Y o - P t Y t How could we measure P d Y d ?? Next highest value of alternative use of the resource. Rice or what? Peanuts? Cassava?

DRC use Type of social valuation of cost vs. benefit of producing vs. importing Senegal rice - Thai broken imports are cheap, Senegal has ag land with potential, should it produce rice or something else?

Critique of comparative advantage Today, many of the resources that were once thought of as nontradable are in fact tradable. Technology that once provided advantage to one country or region, is now easily tradable. What might be the basis of comparative advantage?  If useful, we must recognize comparative advantage changes over time, today that change is rapid.

Competitiveness, a better measure? Michael Porter’s book Plain old economic sense If the economic environment is taken as given, what can a location most profitably produce  how can it create greatest value from its resources? Definition: A location is relatively competitive in a product if it can profitably produce and market it. Competitiveness is a much broader concept than comparative advantage.

Competitiveness Focus is on profitability Considers  Fixed resources  But also, Strategic capability of achieving and maintaining profits. Depends on use of technology, tradable and nontradable inputs!

Implications Locate production where it is most profitable. Critique: We want an indicator of persistent relative advantage, can we use price related measures when prices are institutionally, socially, and politically affected?

Interest in competitiveness html Nearly every region and country is looking for its competitive advantage. Google “competitiveness” “your favorite region or nation” Example

Appendix – Details on DRC For the brave at heart…..

Back to our notation in profits…. We define profits as return to fixed inputs, Suppose we define the opportunity cost of using the fixed, local (domestic) resources as involving multiple domestic resources………

Back to our notation in profits…. Domestic resource cost compares value created to opportunity cost of use of resources We argue location i has competitive advantage in good 1 if

How to measure….. We measure profits based on “border prices” for variable cost and revenue we define the opportunity cost of using these fixed, local, or domestic resources Z as r, the highest value next use……

Bottomline For any case where we have a fixed or limited resource, we can examine competitiveness. Labor force….what is its comparative advantage  Fixed resource is its current educational attainment, knowledge, skills.  What is its best use? Region…….shale deposits under ag land what is best use of surface ?