Intelligent Brains in the Fields of Economics - Case Study Example

Global Economics According to the theory of comparative costs trade is mutually beneficial to all the trading partners engaged in free trade. Discusswhy do individual countries protect their economies from free trade. Multiple theories have been provided which state the advantages of free trade over protectionism. Intelligent brains in the fields of economics have always suggested that it is prudent not to create differences between the residents of various parts of the world by protectionist policies, thus treating the entire world as a common global hub which in turn is beneficial to every member of this common hub. The important theories in this regards are:- 1. Adam Smith’s theory of Free Trade. 2. David Ricardo’s Theory of Comparative Costs. Adams’ Smiths Theory:- Adam Smith justified that the interest of consumer be given the priority over the interest of producer and if the interest of producer has to be attended, that interest should be helping to work for the interest of consumer in some way or the other. He proposed the concept of “invisible hand” which says that there should be no interference from the government or any other authority in the smooth functioning of the market and the market would correct itself automatically with the help of a pure demand and supply logic. Any artificial curbs or restrictions on the market hamper the smooth functioning thereby a delay in the realization of correct prices of the goods or commodities. He analyzed that different individual although may appear working for their interest, but, at the end of the day are contributing for the welfare of the society. Smith (The Wealth of Nations, 1776) suggested that if the quantity of any commodity brought to the market is short of the actual demand, and all the potential consumers for the commodity cannot be supplied with the commodity, then there will be a competition emerging in between various consumers and thereby the market price for the commodity will rise. Conversely, if the quantity brought to the market is higher than the actual demand, then there will be a competition amongst the different sellers of the same commodity to get their purchased lot sold in the market thereby leading to a reduction in the prices. David Ricardo’s Theory of Comparative Costs:- David Ricardo also analyzed that if look in the absolute terms then the free trade is much better for the global economy as compared to the restricted economy. He deducted that the Gross product in terms of the quantity will be much higher in the case of free trade. His theory could be explained with the help of the following hypothetical example. Consider a hypothetical case in which China can produce both wheat and rice more cheaply than France (ie it has an absolute advantage in both commodities). What David Ricardo suggested was that it still would be mutually beneficial for both countries to develop an expertise and trade. Table 1 Country Wheat Rice   Cost Per Unit In Man Hours Cost Per Unit In Man Hours France 15 30 China 10 15 In Table 1, in France with same number of men deployed, two units of wheat could be produced for every unit of Rice. This means that production of every unit of rice, results in the decline of production in the wheat by two units (i.e. the opportunity cost of a unit of rice is 2 units of wheat). In China, this ratio is 2:3, much better than 1:2 in the case of France. That is the opportunity cost of a unit of rice is 1.5 units of wheat in China. Now since the relative cost or the comparative costs differ therefore it is mutually beneficial for the two countries to engage in trading activities even though China has an absolute advantage in both commodities. Since, China is relatively better at producing rice than wheat therefore China is said to have a COMPARATIVE ADVANTAGE in the production of rice. France is relatively better at producing wheat than rice: so France is said to have a comparative advantage in the production of wheat. Table 2 shows how trade might be advantageous. Costs of production are as set out in Table 1. France is assumed to have 270 man hours available for production. Before trade takes place it produces and consumes 8 units of wheat and 5 units of rice. China has fewer labour resources with 180 man hours of labour available for production. Before trade takes place it produces and consumes 9 units of wheat and 6 units of rice. Total production between the two economies is 17 units of wheat and 11 units of rice. Table 2 C o u n t r y Production Before Trade After Trade Wheat Rice Wheat Rice France 8 5 18 0 China 9 6 0 12 T o t a l 17 11 18 12 If both countries now specialize, China producing only rice and France producing only wheat, total production is 18 units of wheat and 12 units of rice. Specialization has thus enabled the world economy to increase production by 1 unit of wheat and 1 unit of rice. If we apply the same logic to the entire economy of the world the production will increase by a gigantic amount. There are a few assumptions in the simple theory of comparative advantage which are as follows:- No transportation cost is attached.. Costs are constant and there are no economies of scale. Only two economies are involved in producing two goods. The theory assumes that traded goods are homogeneous (i.e. exactly identical). Factors of production are assumed to be perfectly mobile. There are no tariffs or other trade barriers. There is perfect knowledge, so that all buyers and sellers know where the cheapest goods can be found internationally. However there are a certain factors because of which countries try to introduce the trade barriers generally in the form of import duties some of which are as follows:- 1. Favorable balance of trade and reducing the fiscal deficit. 2. In order to protect a specific industries/class of people. 3. Anti dumping duties 4. Public Psychology 5. Policies created to woo vote banks generally in democratic form of governments. Favorable balance of trade and reducing the fiscal deficit:- Fiscal deficit is a major reason for which most of the government introduces the protectionist policies. Fiscal deficit is given by the formula:- Fiscal Deficit= Imports - Exports Countries try to reduce their fiscal deficit as far as possible. In their attempt to reduce import they try to minimize the imports into their country by introducing entry barriers on goods and commodities which are getting imported from other countries in the form of import duties. The balance of trade (which is also the difference between exports and imports) is said to be favorable when the fiscal deficit is negative that is when exports are higher than the imports. Every country wants the balance of trade to be in its favor by exporting more and importing less. The countries try to introduce an entry barrier thinking that the other nations will still keep on importing the goods supplied, which is highly improbable. If a country resorts to curb in imports by adding import duties, its counterpart will also resort to the same measure and if every country does so the fundamental of globalization will vanish and hence the gross production of the world will come down significantly causing the economies to suffer. In order to protect a specific industries/class of people:- Generally the developing countries have a certain segments of society who are poor and their interest needs to be protected against the market competition. Therefore the government protects their interest either by giving them subsidy or by protecting their interest by introducing import barriers. For an instance, some of the developed countries give agriculture subsidies to their farmers, who are financially weak, so that they could earn their livelihood by engaging themselves in their family business of farming. But, it should be understood that subsidy should be introduced only for the financially weaker class and not the already profit generating segment and the subsidy policies should be reviewed time to time Antidumping duties:- Some nations argue that owing to free trade, other nations may dump some of the products in their market, thus creating a collapse in their economy. In order to prevent this, they have an option of introducing anti dumping duties which are another entry barrier used to prevent free trade. Public Psychology:- There have been recent incidents of protectionist policies by US trying to reduce outsourcing by passing a law which is favorable to the companies that do not outsource owing to the psychology of the people that outsourcing creates a dent in their job. Intelligent brains however argue that outsourcing results an increase in profit for the organization which in tern is also passed to the consumers not only in the form of reduced price but also generation of more jobs in their own country itself. Owing to a similar kind of public psychology, albeit in terms of import of foreign goods, Indian government adopted protectionist policies until as late as 1992 and was considered as underdeveloped economy of the world. The condition of the country had deteriorated so much that the government of the country was forced to open their market and finally after around 16 years it is amongst the fastest growing countries of the world. Policies created to woo vote banks generally in democratic form of governments:- Although there are limited number of cases, but it has been seen in some instances that in order to woo vote banks from a particular section of society, the government introduces entry barriers and thus find increased number of people backing their policies. What so ever may be the case, the economists across the globe agree that in normal circumstances the free trade is the only manner in which we could develop a world which has every part of it growing. So lets try and make this world barrier free!!! References: Bouare, Oumar. An Evaluation of David Ricardos Theory of Comparative Costs. Policy Innovations. Available from: [Accessed 28 March 2009]. Introduction to the Global Economy. (2008). Available from: [Accessed 26 March 2009]. Mulligan, AC. Rod Hay, Tony Brewer. David Ricardo and Comparative Advantage. iang.org. Available from: [Accessed 26 March 2009]. Porter, Michael. (1998) The Competitive Advantage of Nations: With a New Introduction. Free Press. Sloman, John. (2007). Essentials of economics. Harlow [u.a.], Financial Times Prentice Hall. Worse Recession since 1930s. (2009) recession .org. Available from: [Accessed 25 March 2009]. WTO sees 9% global trade decline in 2009 as recession strikes. (2009). World Trade Organisation. Available from: [Accessed 26 March 2009]. Read More