Friday, 19 December 2014

The russian economic crisis and comparative advantage

As the Russian economy heads towards tough times Putin seems to be pulling up the drawbridge. If Russia is going to prosper then, so the logic goes, it needs to rely less on foreigners and more on itself. This is a familiar nationalist argument that long pre-dates Putin. But it is one that economists have long tried to counter with the logic of comparative advantage.
        Simply put comparative advantage says that a country should produce what it is relatively good at. To give an example suppose that both a barrel of oil and a tablet computer sell for $100 on international markets. If it costs Russia $40 to produce a barrel of oil and $100 to produce a tablet then Russia should produce oil because this is where it has a comparative advantage. Crucially this logic holds even if Russians only want tablets. For instance, with $400 of cash they can produce 10 barrels of oil and trade these on the market for 10 tablets. Or, they can produce 4 tablets themselves. Clearly 10 tablets is better than 4. And pulling up the drawbridge is a bad idea.
        Analysts have also been quick, however, to criticise Russia for becoming too reliant on oil. And this does seem to make for an inconsistent argument. Comparative advantage says that a country should specialize, but then we criticize Russia for becoming over specialized! So, is there a flaw in the logic of comparative advantage?
        Comparative advantage says what a country should produce, not how well it will do producing it. The recent dramatic fall in the price of oil is clearly bad news for any country that specialized in oil. But the logic of comparative advantage still holds firm. To illustrate, let us return to the example above and say the oil price is $60 per barrel. With $400 Russia still produces 10 barrels of oil, which sells for $600 and buys 6 tablets. The purchasing power of Russians has dropped from 10 to 6 tablets but this is still better than the 4 tablets they can make on their own. There is no flaw in the logic of comparative advantage.
         So, where does the call for diversification come from? As far as I know there is no strong economic argument for diversification. The popular argument essentially seems to be specializing is 'too risky' because a country becomes vulnerable to shock. Many, for instance, worry that the UK is over-reliant on the financial services sector. But, risk is something that could be insured against, as evidenced by Norway's wealth fund. 
         I'm not convinced, therefore, that Russia's 'over-reliance' on oil deserves the criticism it gets. Specialising in oil is fine if that is where Russia has comparative advantage. For comparative advantage to really benefit Russians, though, the Russian economy needs a big scale market liberalization and associated reduction in corruption. There is not much sign of that happening any time soon! 

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