Laws of Comparative Advantage - Essay Example

Critically analyze laws of comparative advantage (David Ricardo) Ricardo comparative advantage theory of international trade serves both to predict patterns of trade (a positive aspect) and to show the benefits of free trade over protection (a normative aspect). This paper has discussed law of comparative advantage theory by David Ricardo. It discusses the basic theory that assumes that all the factors of production are immobile and that both (all) countries have the capacity to produce both (or all) goods. Further more I have illustrated through theory example of labor matrix, besides those concepts like Opportunity costs, Demand and Trade impediments has also been discussed. Introduction The theory of comparative advantage formulated by English economist David Ricardo in the early nineteenth century1. Ricardo encouraged each country to specialize in producing commodities for which it is best suited and then trade with other countries to obtain a wide variety of goods. The increased efficiency of production within each country makes greater worldwide consumption possible. This theory suggests that all nations have an interest in opposing restraints on trade. If less developed countries (LDCs) remain isolated and closed to foreign trade and investment, they lose opportunities to benefit from the technology, capital, and consumer goods offered by industrialized nations (Barry Clark, 1998). The Traditional Theory of Comparative Advantage The theory of comparative advantage, of course, argues that unrestricted exchange between countries will increase the total amount of world output if each country tends to specialize in those goods that it can produce at a relatively lower cost compared to potential trading partners. Each country then will trade some of those lower-cost goods with other nations for goods that can be produced elsewhere more cheaply than at home. At the end of the day, with free trade among nations, all countries will find that their consumption possibilities lie outside their domestic production possibilities. The basic theory assumes that all the factors of production are immobile and that both (all) countries have the capacity to produce both (or all) goods. Any imports are perfectly balanced by an equivalent-valued export flow; thus, neither country incurs a trade deficit, which must he financed. Further, it is assumed that perfect competition, and not monopoly production prevails and that all resources in each country are fully employed. The last is an especially important assumption, particularly for less-developed nations, since with less-than-fully employed resources, tariffs or other forms of protection (including subsidies) to block imports and to increase domestic employment could well be the preferred policy. With less-than-fully employed resources, the key allocative issue becomes an internal mobilization of domestic resources to their full use, rather than a reallocation among alternative uses. To be reasonably confident in applying the basic Ricardian analysis and its conclusions to any country or situation, it seems sensible, in practice, to inquire to what degree the assumptions of the theory conform to the reality of the economy under investigation. (James M. Cypher, James L. Dietz, 1998) While these are important considerations having to do with the validity of assumptions in practice, there are other concerns about a blanket endorsement of the comparative advantage argument and free trade recommendations for less-developed nations. Joan Robinson's comment on the real-time effect of following free trade and specialization, at least as far as Portugal was concerned in Ricardo's original example, remains provocative and presages our reformulation. (James M. Cypher, James L. Dietz, 1998) . . The imposition of free trade on Portugal killed off a promising textile industry and left her with a slow-growing export market for wine, while for England, exports of cotton cloth led to accumulation, mechanization and the whole spiraling growth of the industrial revolution (Robinson 1978, 103). This passage provides us with a valuable historical and dynamic hint about the impact of pursuing comparative advantage. It may not be specialization per se that is so important for a country's future as is the choice of what to specialize in. The production of some goods may be more likely to have expanding world demand in the future; as England did with cloth production at the time Ricardo formulated his example. Some types of production may be more likely to benefit from the application of science and technology over time. And, what is the impact of the trend of the terms of trade for a country on the gains from specialization It is this more dynamic approach to the theory of comparative advantage and to the nature of the ensuing path dependence that accompanies decisions to produce particular goods or services for the world market that forms the basis of our argument. (James M. Cypher, James L. Dietz, 1998) Origin of Comparative advantage Britain was the least-cost producer of cloth and America the least-cost producer of food, and the opportunities for trade were obvious enough. What, however, if one country-Britain, say,-were more efficient in the production of both goods Absolute advantage would suggest that both goods should be purchased from Britain2, but this could not be a long-term solution, because Britain would not wish to buy anything from America in return. Writing some forty years after Smith, Ricardo (1817) was the first economist to analyze this situation formally, with his justly famous law of comparative advantage. Suppose our matrix of labor requirements were: Labor per unit of output in Britain America Food 5 6 Cloth 2 12 Although Britain now requires less labor than America in both industries, this does not preclude profitable trade. In Britain under autarky 1 unit of food trades for 2 units of cloth-each is equivalent to five men's output. (The relative price of food and cloth depends only on the relative labor inputs provided that (i) both goods are produced and (ii) labor productivity is independent of the level of output in each industry.) Similarly, in America 1 unit of food trades for a unit of cloth-both the product of six men. When we open trade between America and Britain, the different relative prices provide scope for profitable trade. For example, if American relative prices prevailed in the trading world, a Briton owning 1 unit of food could swap it in Britain for 2 units of cloth and then, selling these in America, realize 5 units of food an overall profit of 4 units of food. Similarly, if British prices prevailed, an American entrepreneur initially employing twelve men to produce 1 unit of cloth could switch to producing 2 units of food, and, selling these in Britain, receive 5 units of cloth again a profitable trade. At intermediate relative prices, both countries would gain, although not by as much as in the examples given. An alternative view of international trade is as a form of technical innovation. By increasing the choice of methods for transforming food and cloth, it cannot harm society (the new method need not be used), and may benefit it if the new method is an improvement on the old. Clearly for Britain, international trade offering 2 foods for 1 cloth is a substantial improvement over the autarkic possibility of food for 1 cloth. Hence Britons will seek to obtain food by switching factors of production from food to cloth and then transforming the resulting cloth into food through international trade, rather than by using the factors directly in food production. For Americans, the opposite incentive would apply. Thus, each country shifts towards the good in which it has a comparative advantage. Britain is comparatively more efficient in cloth than in food, whereas America is more efficient (less inefficient) in food. In the simple Ricardian two-by-two model either: 3 4 (i) Just one country specializes and gains from trade. The terms of trade settle at the other (non-specializing) country's autarky price ratio and that country gains nothing by trade; or (ii) Both countries specialize and both gain by trade. The terms of trade depend on demand patterns, but must lay between the two autarky price ratios. Which of these outcomes occurs depends on both the size and efficiency of the countries and on demand patterns. Given the latter, the smaller a country's output the greater the probability that it specializes. Thus it seems that large or efficient countries have less to gain through trade than small countries, since trade is less likely to expand their consumption sets. If this seems somewhat counter-intuitive, it is because the model does not fully reflect reality. In order to produce the outcomes described, we must have perfectly competitive good and factor markets and the government must not intervene at all in international trade. Large countries, however, are often felt to gain from trade because they have market power: by threatening to withdraw from or hinder trade they (or their large companies) can threaten to damage small partners, and hence appropriate some of the latter's gains to them5. Analysis of the Ricardian Model and The assumptions International trade takes place because goods are available more cheaply from abroad than at home. Ricardo's model explains the pattern of trade by relating prices to certain fundamental features of the economies concerned6. This requires several assumptions: (i) There is only one factor of production-labor. (ii) Its productivity-i.e. the production technology-differs between countries, but no explanation is give for these technological differences. (iii) Labor is perfectly mobile between industries within a country but perfectly immobile between countries. (iv) There are constant returns to scale in each industry-i.e. unit costs are independent of the level of output. (v) There are no impediments to trade such as tariffs or transport costs. Assumptions (iii) and (iv) ensure that each country's transformation curve between cloth and food is a straight line. The rate of transformation is quite independent of the composition of output-e.g. it is always 1 food for cloth for America. Hence there is only one price ratio consistent with the production of both goods in America this is 2 cloth for 1 food; any other price ratio causes producers to specialize, because then 1 unit of labor can earn more money in one branch than the other. Thus, labor productivities determine costs (rates of transformation), which determine the direction of trade when it occurs. In Ricardo's model, therefore, the assumptions ensure that the direction of trade is determined solely by comparative labor productivities. 7 As with nearly all trade theory, the immediate cause of the direction of trade is relative prices. Ricardo's assumptions determine relative prices by relative labor productivities; other theories postulate other determinants, but the basic approach remains the same 8. Opportunity costs Ricardo expressed his theory in terms of the labor theory of value-labor was the only factor of production. This was an expositional convenience rather than a statement of fact, but it nevertheless took many years for trade theory to escape from this strait-jacket. The latter was accomplished by Haberler (1936), who re-expressed the theory in terms of opportunity costs. The opportunity cost of good X is the amount of good Y that has to be surrendered in order to obtain a unit of X. In Ricardo's theory this transformation occurs by shifting labor from one industry to another, so opportunity costs are naturally defined in terms of relative labor productivities. However, it is obvious that a similar concept would apply even when there were several factors of production. Provided that these general opportunity costs were constant, the whole of the above theory would follow without change. Demand The Ricardian theory is a supply theory of international trade: it is differences in supply conditions that give rise to the possibilities of trade, and trade occurs even when, as above, demand conditions are identical across countries9. This is not to dismiss demand, however, for it explains much of the detail of the final outcome10. In any case, the analysis may be completed without the assumption of identical demand without any fundamental differences. Trade impediments In a two-country model, trade impediments that involve only extra costs-for example, tariffs and transport costs as opposed to subsidies-can change the point at which the chain of comparative advantage is broken, but not reverse the ordering of goods within it. For example, B's tariffs may prevent A from exporting good 1 in chain, and thereby oblige it to export good i, where in the absence of tariffs i would have been imported. However, they cannot change the fact that all A's imports must lie to the right of its exports in chain; good 1 would merely become non-traded. Similarly, transport costs can insert a band of non-traded goods into chain but again not mix up the ordering of imports and exports; if a round-trip costs 10 per cent of the value of trade (that is, swapping 100 of exports for 100 of imports costs 10), there will be a band of goods covering a 10 per cent range of relative productivities that will be non-traded. However, A will still export from the goods to the left of the band and import from those to the right. Thus, while with only two countries trade impediments might complicate the results, they do not fundamentally reverse them. Once the model is generalized to many countries and many goods, however, or to allow for traded intermediate goods (inputs into the production of other goods), trade impediments can destroy the chains of comparative advantage11. Hence, while the basic notions of comparative advantage certainly still help to explain trade patterns in these more realistic cases, totally specific and unambiguous predictions about who exports what are not always possible12. Testing Ricardian Theory Economists put much effort exploring the implications of various assumptions in the Ricardian model. The Ricardian theory was first formally tested by MacDougall (1951)-134 years after its inception13. MacDougall considered the UK's and the USA's trade in 1937. Since UK-US bilateral trade was distorted by tariffs and was small relative to their total trade, he generalized the Ricardian theory to argue that a country with a comparative advantage in some good would have a relatively large share of third-country markets in that good. Strictly, the theory states that generally only one country will export any good, so that comparative advantage will be associated with 100 per cent shares and disadvantage with 0 per cent shares. However, if we allow for transport costs, differences in quality, etc., MacDougall's assertion seems reasonable. Using data for twenty-five manufactured products, MacDougall found that the UK/US export ratio to third markets was strongly negatively related to both the ratio of UK to US physical labor requirements and the ratio of UK to US labor costs. This seems to confirm the basic thrust of the theory: where productivity is comparatively high so too are exports. Interestingly, however, MacDougall found that, where UK and US labor costs were roughly equal, exports were not equal but rather the UK's were more than twice the USA's. This he attributed to the UK's reputation for high quality and to Imperial Preference. These results have been broadly corroborated on many different industries and years (Bhagwati, 1964); although through time the extent of the UK's advantage in the equal-cost case has been declining. In fact, MacDougall's basic results have never really been challenged14. Bhagwati (1964) has, however, seriously challenged their interpretation on theoretical and empirical grounds. Theoretically he objected (a) that Ricardo said nothing about third-country markets, and (b) that, while for any one good a relative cheapening of UK supplies by 10 per cent may increase the UK share by, say, x per cent, it does not follow, when comparing two goods one of which has a lower UK/US cost relative by 10 per cent, that the relatively less costly good will have an x per cent higher market share. That depends on the goods' demand curves. Nevertheless, by lumping all goods into the same cross-section regression equation. MacDougall is implicitly assuming that a given cost advantage translates into the same market share benefit for all goods. This is plainly not precisely true and can only be countered by observing that, theory notwithstanding, the results has received sufficient support for us to accept the approach as a reasonable approximation. On empirical grounds, Bhagwati's criticism is also interesting. The causal chain of the Ricardian theory runs from labor costs to autarky prices to the direction of trade. Given the imperfections in trade that we postulated above, however, post-trade prices in each country should partly reflect autarky prices (imperfections prevent US and UK prices being wholly equalized). Hence we would expect correlations between relative (post-trade) export prices and export shares-which MacDougall found-and also between relative costs and relative prices15. Bhagwati, however, could find no evidence of the latter and therefore argued that, since the causal chain could not be established, the Ricardian theory should be rejected even though its ultimate prediction appeared to be corroborated. Certainly we must suspect predictions whose mechanisms are not explicable, but in this case the bulk of the Ricardian theory may be salvaged. Conclusion Different industries earn different rates of profit owing possibly to different degrees of monopoly or capital costs. Prices may then be independent of labor costs, but costs are still important because the lower are costs the higher are export profits and hence the greater is the incentive to export. Thus, with independent prices, industries with comparative cost advantages will still export relatively more owing to the stronger incentives to supply exports. This breaks with the Ricardian model by introducing an additional element of costs, but in Ricardo's other writing profits are fully recognized and may differ between industries except in the very longest of runs. To conclude, therefore, while the specific predictions of Ricardian comparative advantage theory are not supported by the data-especially the prediction of almost complete specialization-the general tenor of the results is that comparative advantage can explain broad trade patterns and that relating comparative advantage to relative labor requirements (or costs) is not grossly misleading. Work Cited James M. Cypher, James L. Dietz; Static and Dynamic Comparative Advantage: A Multi-Period Analysis with Declining Terms of Trade, Journal of Economic Issues, Vol. 32, 1998 Barry Clark; Political Economy: A Comparative Approach Praeger Publishers, 1998 MacDougall, G.D.A. (1951), 'British and American exports: a study suggested by the theory of comparative costs', Economic Journal, vols 61, 62, pp. 697-724, and 487-521. Robinson, Joan. Aspects of Development and Underdevelopment. Cambridge: Cambridge University Press, 1978. Bhagwati, J.N. (1964), 'The pure theory of international trade: a survey', Economic Journal, vol. 74, pp. 1-84. Bhagwati, J.N. et al. (1971), Trade, Balance of Payments and Growth, North Holland, Amsterdam. Little, I., Scitovsky, T. and Scott, M. (1970), Industry and Trade in Some Developing Countries: A Comparative Study, Oxford University Press, Oxford. Bulow, J. and Rogoff, K. (1989), 'Sovereign debt: is to forgive to forget', American Economic Review, vol. 79, pp. 43-50. Capie, F. (1983), 'Tariff protection and economic performance in the nineteenth century', in Black and Winters (1983), pp. 1-24. Learner, E.E. (1984), Sources of International Comparative Advantage, MIT Press, Cambridge, Mass. Foot Notes Bulow, J. and Rogoff, K. (1989), 'Sovereign debt: is to forgive to forget', American Economic Review, vol. 79, pp. 43-50. Little, I., Scitovsky, T. and Scott, M. (1970), Industry and Trade in Some Developing Countries: A Comparative Study, Oxford University Press, Oxford. Davenport, M. (1990), 'The Charybdis of anti-dumping: a new form of EC industrial policy', Discussion Paper No. 22, Royal Institute of International Affairs, London, Byrne, W.J. (1982), 'Evolution of the SDR, 1974-81', Finance and Development, vol. 19(3), pp. 31-5. Deardorff, A.V. (1979), 'Weak links in the theory of comparative advantage', Journal of International Economics, vol. 9, pp. 197-210. Deardorff, A.V. (1980), 'The general validity of the law of comparative advantage', Journal of Political Economy, vol. 88, pp. 941-57. Heller, H.R. and Knight, M. (1978), Reserve Currency Preferences of Central Banks, Princeton Essay in International Finance, No. 131, Princeton University, Princeton, NJ. Heller, P.S. (1976), 'Factor endowment change and comparative advantage: the case of Japan, 1956-1969', Review of Economics and Statistics, vol. 58, pp. 283-92. Calvo, G.A. and Rodriguez, C.A. (1977), 'A model of exchange rate determination under currency substitution and rational expectations', Journal of Political Economy, vol. 85, pp. 617-25. Hindley, B. and Smith, A. (1984), 'Comparative advantage and trade in services', The World Economy, vol. 7, pp. 369-90. Capie, F. (1983), 'Tariff protection and economic performance in the nineteenth century', in Black and Winters (1983), pp. 1-24. Amacher, R.C., Haberler, G. and Willet, T.D. (1979), Challenges to a Liberal International Economic Order, American Enterprise Institute, Washington, DC. Baillie, R. and McMahon, P. (1989), The Foreign Exchange Market: Theory and Econometric Evidence, Cambridge University Press, Cambridge. Bhagwati, J.N. et al. (1971), Trade, Balance of Payments and Growth, North Holland, Amsterdam. Learner, E.E. (1984), Sources of International Comparative Advantage, MIT Press, Cambridge, Mass. Read More