Theory of Comparative Advantage - Essay Example

?Running head: Theory of Comparative Advantage Theory of Comparative Advantage Insert Insert Insert 27 March Theory of Comparative Advantage Introduction Before Ricardo developed the theory of comparative advantage, the economics world had utilised the theory of absolute advantage. The theory of absolute advantage argued that, citizens of every nation had the ability to improve their economic welfare by specialising in the production of goods in which they possessed an absolute advantage and exporting them to other countries (Ghai and Gupta 2001). In turn, the countries would have an opportunity to import goods from the country that had an absolute advantage in those goods (Hall and Lieberman 2007). However, in 1817, David Ricardo disputed the postulation of absolute advantage and instead developed and enhanced the claim of comparative advantage (Hall and Lieberman 2007). According to the author, a country obtains comparative advantage if it possesses the ability to produce a particular good and be able to produce the good at lower opportunity than some other country (Carbaugh 2010). Initially, absolute advantage talked and fore so, resources as key to obtaining absolute advantage in production of goods, comparative advantage on the other hand regards opportunity cost as key in production of goods. For instance, Ricardo postulates that , a likely potential trading partner may be perceived to be absolutely inferior in the production of every single good, where more resources per unit of each good may be required than any other country and still have a comparative advantage in some good (Hall and Lieberman 2007; Maneschi 1998). The comparative advantage comes about because the country is inferior at producing some goods than others (Misra and Yadav 2009). At the same time, a nation that possessed absolute advantage in producing everything as it was perceived could still benefit from trade since it would have a comparative advantage only in some but not all the goods. What is comparative theory? Globalisation in the world has postulated that, trade unlike before can be conducted between countries. As a result, trade between countries has become important and necessary for the growth of international economy (Ezeani 2011). In order to understand how countries may end up coming to be trade partners, one theory developed by Ricardo has become important in explaining such relationships. Comparative advantage, which explains how trade relationships between countries may be established, has come out as a key theory in explaining how countries benefit from each other by having goods that they do not produce due to cost matters. Adam Smith emphasised the need of each nation to look for absolute advantage as far as production and consumption of goods is concerned. What when this postulation is analysed in practical sense, then it becomes clear that, absolute advantage may not permit development and healthy growth of trade in the international sphere. Take for example, two countries China and United Kingdom, where China may appear to be inferior in terms production of goods like clothes and aircrafts. In this case, China does not have absolute advantage like United Kingdom, and therefore, the question that can be asked in such scenario, is what China can do, what UK can do, and of course according to absolute advantage theory, there is no way out (Branch 2006). However, another theory that attempt to address this dilemma, which has evolved to become critical in international trade, is the theory of David Ricardo developed in 1817, and the theory is known as comparative advantage theory (Peng 2010). Using the two examples of China and United Kingdom, comparative advantage theory postulate that, though UK may have absolute advantage in production of clothes and aircraft, this does not rule out China as an able country that cannot produce such goods. China may exhibit some efficiency and capabilities in the production of both goods ((Branch 2006)). As a result of having ability and capability of some sought, China may decide to specialise in the production of one of the goods in the most efficient and effective way (Peng 2010). For instance, China may choose to specialise in the production of clothes in which it has shown some comparative advantage (Hunt and Lautzenheiser 2011). From the above example, comparative advantage is defined as, “the relative and not absolute advantage in one economic activity that one nation enjoys in comparison with other nations” (Peng 2010, p.152). Comparative advantage theory is built on the understanding that opportunity cost has to be realised in order for any country to specialise in the production of a particular good (Pierre and Steward 2010). In this case, opportunity cost is perceived to be the cost of pursuing one activity at the expense of another activity given the alternatives (other opportunities) (Peng 2010). The understanding of Ricardo is that, if one country (A) has absolute advantage in the production of a particular good over another country (B), country B may not be incapacitated to an extent of not having absolute advantage in the production a particular good than country (A). In such a case, the two countries may gain a lot from trading from each other in the good that the countries do not produce themselves. By using the two examples of China and UK, it can be postulated that, a country is only perceived to have comparative advantage when it has ability to produce the product it specialises in at lower unit cost then the other country. China for instance can make clothes at lower unit cost as compared to UK; while on the other hand, UK may be able to make aircrafts at lower unit cost as compared to China. As a result, this situation wills results into international exchange of commodities between China and UK specifically under the free trade conditions (Aswathappa 2010). As a result, it benefits both China and United Kingdom if the former is specified in the production of clothes while the latter is specified in the production of aircrafts. Moreover, the comparative shows that, even if one country is superior to the other one in the production of two commodities, free international trade can still continue or take place and also benefit the two countries. Comparative advantage theory base its argument on the understanding that, each country is endowed with different kinds of natural resources, but even in presence of these natural resources, no one particular country can produce to maximum output. As a result, countries can evaluate their capability in terms resource endowment and identify the particular country they partner with in the international arena to trade with. Some of the natural resources countries are have included labour, land, capital, and inputs. Therefore, the understanding is that, if each country uses what it has to specialise in only those goods and services it can produce, where they have advantage, then there is big chance that total output and economic welfare of the countries can be increased under certain conditions (Peng 2010). This understanding is true even when one nation is considered to have absolute advantage over another country they may be trading with. The major advantage of this theory may be explained in terms of relationship that exist between developed and developing nations in terms of forming and facilitating trade after analysing the specific resources they are endowed with. As a result, most developing nations have been able to acquire those goods they do not produce at relatively cheaper price as a result of facilitating international trade partnership. What is needed for comparative advantage to be successful? Comparative advantage is a concept that is seen to change and as a result, it is not fixed. With time, it is likely to change and countries may just find out that, comparative advantage they enjoy in a particular product may change under certain conditions such as competition and entry of new competitors. As a result, there are certain factors that have been identified which have ability to determine relative costs of production. Some of these factors are discussed below. First, in order for countries to have successful comparative advantage, there is great need for the countries to create and have qualitative and quantitative factors of production that enable the country to have a productive relationship with another trading partner country (Asheim 2011). In this case, countries have to put in place strategies and effort that is geared towards increasing the size of the available resources that can support production and ensure the efficiency of the resources is appropriate and adequate. As a result, the country can pay attention to aspects like increasing the efficiency of its labour force, increasing the capital in factory development and equipment, and increasing the capacity of land utilization. When such initiatives are undertaken, the country may be able to increase and expand the capability at which its industries and other production units can increase their potential and thus have an advantage in particular area. The second key requirement is for countries to invest heavily in research and development activities. With globalisation, research has become important and source in which countries can create and have comparative advantage. Innovation in production and overall performance of the company become possible when appropriate investment in research and development has been undertaken. For instance, one a country has developed particular knowledge and has patent for such development and innovation, the patent can become key aspect in promoting trade development between the country and another country that may have no advantages to the innovations and development. As a result, research and development has been identified as another key area that can facilitates comparative advantage in international trade. Third key requirement or aspect that has to be considered in ensuring comparative advantage theory succeeds is the, shift in the exchange rate. Exchange rate is particularly sensitive in international trade, and a country is likely to succeed in international trade largely by considering how its exchange rate performs in the larger international market. In most cases, when there is an appreciate of exchange rate, there is tendency for exports from a particular country to increase and when this happens, the country may become less competitive in the international markets and as a result, it may not fully benefit with regard to international trade. As a result, in most cases it is prudent for a country to ensure it works on its exchange rate so that it does not appreciate to a level its exports become expensive and less competitive in the international market. Another factor has to do with rates of inflation especially in the long-term. When countries are differentiated in terms of long-term rates of inflation, then the competitiveness of a country may be determined by the level of competitiveness. For instance, if there are two countries, A and B, and that, country A has an inflation rate of 6 per cent and country B has an inflation rate of 9 percent over a relatively long period of time, then it may become clear that goods and services that country A produce may become relatively more expensive as compared to products produced by country B over a specified period of time. When this happens, then the competitiveness of country A is reduced and the results may be switch in the comparative advantage. At the same time, there have been studies that have been conducted with regard to import controls such as the tariffs and quotas. The observation made is that, when a country has efficient import controls such as tariffs and quotas, then it is likely to use such aspects to create comparative advantage for a country with regard to its domestic production. However, this is not to say, international agreements between countries regulating and guiding trade are ignored, since they remain important as part of international trade agreements. The last aspect that has to be considered, which of course is important, has to do with non-price competitiveness of producers. In most cases, non-price competitiveness of producers can be realised in aspects such as the design of the product, the reliability of the countries and product development, quality of after-sales support the country may have. Critique of comparative advantage theory There has been some level of critique directed at the comparative advantage theory by a number of economic authors. For example, writing in 1962, Raul Prebisch, observed that, majority of countries that have comparative advantage in agriculture and as a result are agriculture exporters may not benefit from comparative advantages because of the possibility of the declining terms of trade (Hauner and University of Missouri 2008). As a result, the author advise developing societies not to concentrate much on the comparative advantage theory but to diversify their domestic production and exports to increase the share of manufactured goods. The reason for this is that, the agricultural markets resemble perfect competition and firms have no power over the pricing issue. Kemp (1962) on the other hand, showed how the issue of free trade was not beneficial to all people (Hauner and University of Missouri 2008). Using mathematical models, the author noted that, there are winners and losers in international trade and free trade may not necessarily maximize income, consumption, and utility possibilities for persons or factors within any given country (Hauner and University of Missouri 2008). As a result, some groups in the country or within the trading partnership may suffer as a result of free trade (Mehmet 1999). Problems with comparative advantage theory Although comparative advantage theory has become largely credited with growth of trade and development between countries, it can be postulated that, the theory rests on the assumption that there has to be certain aspects present and when these aspects are not present, and then the countries may not really have comparative advantage. One aspect that the theory fails to incorporate in its analysis is that, not all countries have natural endowment of natural resources. Some countries are largely landlocked and as a result, transport costs especially to the nearest seaport are regarded to be high. In a simple observation, which of course may be true, is that, if transport costs are high, international trade becomes unattractive especially with relative to domestic production. At the same time, it has been observed that, when transport costs differ sharply with regard to products, they may drive the commodity composition of a country’s international trade and push other determinants such as factor of production and technological level into the background. The second problem with the theory has to do with its postulation that all countries have almost equal number of goods and factors of production (Marinova and Marinov 2003). However, when the real reality is analysed, it becomes clear that there are more goods than factors of production, for instance, human and physical capital, labour, and natural resources. As a result, some economists have noted that in such case, it becomes difficult to predict which specific goods a country can export under free trade (Best 1990). Take for example, the cases that is presented by this understanding, it is possible to state that each country may be a net exporter, specifically through its international trade in goods, of the services of those factors of production with which it is better endowed than the rest of the world (D’Cruz and Fleck 1985). However, this statement does not directly translate into comparative advantage for particular goods that a country may have. The third observation is that, comparative advantage theory fails to put into consideration the non-traded goods and this omission is particularly relevant to a country that experiences a resource boom (D’Cruz and Fleck 1985). The understanding is that, export prices of natural resources are higher than production costs by the amount of resource rent. With a rapid increase in foreign exchange revenues from exports, the domestic currency tends to appreciate, making non-resource exports less competitive and at same time making imports cheaper. When this case happens, factors of production will therefore shift from the production of non-resource exports and import-competing goods to the production of non-tradable (Dijck and Verbruggen 1987). Another unresolved issue with this theory is that, factors of production are assumed to have inability of moving across borders (D’Cruz and Fleck 1985; Dwivedi 2002). However, the true reality is that, the large number of labour migrants from one country especially developing country to a developed country may take place. This happens because, when goods are expensive to trade due to geographical and policy-induced barriers, it becomes easier for people to move in response to international wage differentials (Srinivasan 2009). As a result, there are instances when economic effects of greater opportunities for migration are similar to a natural resource boom. At the same time, it is clear that remittances from workers abroad are typically spent not only on imports but also on domestically produced goods and services. The scenario, will results into an increased demand for non-traded goods that will lead to real appreciation of the domestic currency, cheaper imports, and less competitive goods exports. Therefore, the true fact, although figures may be hard to authenticate is that, many people from countries that have less resources and are poor are likely to move to countries that have favourable conditions of working. Conclusion Comparative advantage theory has been largely embraced by both economists and politicians across the world, and when compared to the absolute advantage theory, the theory attempt to provide clear understanding and development of international trade. Evidence of the application of the theory can be cited in different countries of the world, and some of the benefits of the theory can be associated with some of the increased trade partnerships that have been experienced across the world. However, even with its numerous advantages and benefits it has resulted into, comparative advantage theory has been criticized to exhibit some weaknesses especially with regard to assumptions it makes. Nevertheless, the overall observation that can be made is that, comparative advantage theory has indeed been the reason for increased international trade among countries. Reference List Asheim, B. T., 2011. Handbook of Regional Innovation and Growth. London: Edward Elgar Publishing. [Online]. Available from: http://books.google.com/books?id=wLNH1QHw1bcC&pg=PA237&dq=benefits+of+comparative+advantage+theory&hl=en&sa=X&ei=thlyT9mGJcWp8QOXz8Vb&ved=0CF8Q6AEwBzgK#v=onepage&q=benefits%20of%20comparative%20advantage%20theory&f=false [Accessed 26 March 2012]. 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