The Law of Comparative Advantage - Essay Example

?THE LAW OF COMPARATIVE ADVANTAGE AS A BASIS FOR UNDERSTANDING INTERNATIONAL TRADE s Abstract This paper analyzes the influence of comparative advantage law as a basis for international trade. The paper is based on Ricardian and Heckscher-Ohlin trade theories. An empirical case study of the automobile production in Japan has be analysed and contrasted with aircraft manufacture sin US. Despite evidence demonstrating that comparative advantage influences international trade, review of different works has revealed that its influence may be limited by factors such as trade barriers and economic similarities between countries. In addition, comparative advantage as a basis for understanding international trade is limited by the distance between the trading partners thereby increasing the transaction cost. Introduction Since the law of comparative advantage was introduced by David Ricardo in 1817, it has been used as a basis for understanding international trade. The law explained that countries should concentrate in producing what they best and let others do what they do best. The law is based on the premises that different countries have varying endowment and therefore those countries less endowed on production of a certain good should buy from more endowed countries thereby leading to more gains in trade. Ricardo demonstrated this law by giving the example of cloth and wine production between Portugal and England. Portugal is highly endowed in the production of the two and therefore Portugal would have to export the two. On the other hand, England would have to import the two goods thereby failing to gain from trade. Given that comparative advantage is based on relative operation costs, doing some things is comparatively more beneficial than others ("Comparative advantage: Doing what you do best", 2011, p. 32). In addition, Ricardo argued that all countries must have their comparative advantage in something and should concentrate in doing what they do best. To support his law, Ricardo presented a numerical explanation showing that that in case England specialized in production of the one of the product leaving Portugal to produce the other, output for both products would increase and thereby giving both countries a chance to benefit from trade (Kilduff and Ting, 2007, p. 82). Although comparative remains a critical determinant of trade, OECD countries are more similar economically and therefore trade based on comparative advantage may not find application in current international trade ("Comparative advantage: Doing what you do best", 2011, p. 32). Despite the economic similarities among OECD countries, there are some differences which can drive trade based on comparative advantage. Moreover, there are remarkable differences between OECD countries and non-OECD countries and between non-OECD. Consequently, applicability of the comparative advantage could be more pronounced in North to South trade and South-South trade rather than it is for the North to North trade ("Comparative advantage: Doing what you do best", 2011, p. 32). In addition to the only one factor of production proposed by Ricardo, productive of the country is influenced by physical capital, level of education and availability of credit. Heckscher-Ohlin contradicts the argument of Ricardo and argues that varied comparative advantage among countries emerges due to differences in the abundance of factors and the intensity with which the goods rely on those factors (Morrow, 2010, p. 139). This paper seeks to analyze seeks to analyze the application of Ricardo’s and Heckscher-Ohlin law of comparative advantage to influence international trade and assess the extent to which international trade is affected by comparative advantage. International trade and comparative advantage based on Ricardo’s and Heckscher-Ohlin trade theories Production levels world over demonstrate heterogeneity and specialization (Kamery, 2004, p. 115). For instance, US produces over 35 percent of total aircraft exports on the other hand China supplies a merely 0.1 percent of the aircraft exports (Kamery, 2004, p. 115). Despite its supremacy in exporting aircrafts, USA only supplies 2.4 percent of the global clothing and apparel exports while China produces about 25.8 percent in this sector. This clearly demonstrates that each country concentrates in producing what they can produce well giving to other countries to produce what they are specialized in. The specialization between countries can be explained using the Ricardian model and the Heckscher-Ohlin theories of international trade. Ricardo law model predicted that countries concentrate in the production of goods having the greatest relative advantage in terms of total factor productivity (TFP) (Chor, 2010, p. 152). While supporting the comparative advantage, Heckscher-Ohlin model does not consider the differences in the productivity of factors of production arguing that each country has similar production function in any given industry (Chor, 2010, p. 153). However, the differences in the comparative advantage come from differences in the abundance of factors and the intensity with which a factor is relied upon in the production of some goods (Fazeli, 2008, p. 105). Heckscher-Ohlin trade theory therefore postulates that countries that use their comparatively abundant factors intensively produce more goods than the rest. To clearly understand the comparative law as explained by Ricardo and Heckscher-Ohlin, an empirical case study comparing production of two products in Japan and America will be used. In the two countries, the prices, productivity and cost of labour are differing in the two countries. 1994 saw the automobile production top the manufacturing activities with total annual revenue of $ 875 billion (Kamery, 2004, p. 115). Japan top is the highest producer of vehicles in the world and its total vehicle production in 1993 being estimated at 24 percent of the total world automobile production. The United States follows Japan with its total global automobile output in 1993 estimated at 20 percent. In spite of the significant performance of the America’s automobile sector, the country’s motor vehicle trade deficit has been rising steadily and in 1995; it was estimated to have reached $ 39. 4 billion (Kamery, 2004, p. 115). To fill this gap, USA is the largest export market for the Japanese vehicles. Previously, United States was the single most producers of automobiles but was overtaken by Japan. This demonstrates that the comparative advantage previously enjoyed by USA is currently favouring Japan. According to (Kamery, 2004, p. 115), the factors that which characterize Japan’s comparative advantage in the automobile sector include technological advancements and strong emphasis on export market. Moreover, continuous search for improvement and performance based on head to head competition have enhanced the comparative advantage enjoyed by Japan in the automobile industry. To enhance its comparative advantage, Japan imported the technology needed in the automobile manufacture and labour and management skills while developing a home market for their automobile (Kamery, 2004, p. 118). According to Kamery, a combination of factors such as low cost of skilled labour and less expensive raw materials helped Japan achieve comparative advantage. Given that the domestic market for cars in Japan demanded small cars due to narrow streets and also fuel efficient cars given the high cost of gasoline (Kamery, 2004, p. 119). Implementation of these changes helped enhance Japan’s ability to market its products. Japans success in exporting vehicles to the rest of world was pegged on the manufacturers’ capability to make gains in the productivity of labour by introduction of new manufacturing processes. In addition, the automobile company began offering incentives to employees based on their productivity to boost the productivity of labour. In contrast to Japan’s comparative advantage in the automobile sector, USA enjoys comparative advantage in the aircraft export. Between 1989 and 1995, US aircraft exports to Japan contributing to about 21 percent of the machinery and transport equipments. US comparative advantage in aircraft sector in relation to Japan is based on two main factors; geographic and demographic variations between Japan and USA (Kamery, 2004, p. 117). In Japan, the main transportation system is a countrywide transit system. On the contrary, such a system is impracticable in USA given the size of the country and the dispersed nature of the cities. Consequently, most people in US rely on aircraft compared to those in USA. Moreover, the geographical elevation in Japan creates a major obstacle on reliance of aircraft (Kamery, 2004, p. 119). He explains that about 70 percent of Japan is mountainous making aircraft use dangerous. Moreover, there are more airports in USA than are there in Japan and as a substitute good; the two have to be balanced (Kamery, 2004, p. 120). This case study demonstrates that comparative advantage of a country in the production of some products is majorly influenced by other factors as outlined in Heckscher-Ohlin business theory. There are various determinants of the level of international trade including the utility of a product in a given country and the prices of the commodities. To assess the impacts of comparative advantage international trade various aspects are considered. Taking a case of the global market having ‘N’ countries and ‘K’ industries; the utility of a country is given by: Un=(Q0n)1-n(?k/?(?10(Qnk(jk))? djk)?/?)n/?; , ?, ?, n € (0; 1) and where (Qnk(jk) represents the amount of product jk produced by industry k and being consumed in country n (Chor, 2010, p. 153). The utility from the marketable products aggregated through a nested elasticity of substitution constant (CES). ?= 1/(1- ?) greater than 1 is taken as the elasticity of substitution of two varieties of a similar industry and elasticity of substitution between varieties produced by different industries is represented by ?= 1/ (1- ?)>1 (Chor, 2010, p. 158). Given that a consumer maximizes utility and is always constrained by their budget, as shown: Q0n +?k/?(?10Pkn (j) Qnk (j)dj)= Yn Where Yn is income of the specific country and pkn (j) represents the price of a product in the country, j refers to the variety while k is the specific industry (Chor, 2010, p. 159). The demand for each variety will be: Qnk(j)={(nYn(Pkn) ?- ?)/ ?k/?1(Pkn)1- ?)}* Pkn(j)-E, k?1 Given that the prices of goods are competitive and firms produce using constant returns to scale technology and therefore all the firms sets the prices at an average cost. Assuming all countries has the ability to produce variety j and the price that country i charges country n to export goods is represented by pkni; then the price of export will be given by equation: pkni(j)=ckidkni/Zki(j) where cki represents to unit production cost of the exporter while dkni ?1represents the transport cost. Zki(j) represents the Ricardian productivity of an exporter and it is equal to the units of a specific variety that can be produced by a country using the same combination of factors under similar technological power (Chor, 2010, p. 160). However, in a set-up of three countries, it is cheaper to transport goods between two neighbouring countries and directly to a country rather than through a third state. From this, it is clearly that comparative advantage may not fully influence international trade (Heath, 2006, p. 32). Another application of Ricardian and Heckscher-Ohlin trade theory is that countries productivity may be affected by legal frameworks operating with each country. For instance countries that implement contracts are generally more productive than other industries exposed to tussles of employees and supplier delays (Lutz, 2008, p. 150). Such countries facing less delay in production are more likely to have lower production cost and therefore they can price their goods at a lower price. This means that the flow of goods will be from such countries to other countries. The effectiveness of using comparative advantage in explaining international trade is limited to some countries. OECD countries may enjoy more comparative advantage in many factors of production such as technology, skilled labour and capital investment thereby leading to imbalance of trade with the developing countries. In addition the differences between two the developed countries in terms of factors of production is diminishing and therefore specialization is being hampered. Pullen (2006, p. 59) argues that comparative advantage in trade is more pronounced between North and south countries, South to South trade than it is witnessed in the Sub Saharan countries. Moreover, trade barriers hamper the influence of comparative advantage as held by WTO and therefore calls for harmonization of the international tariffs (Bernhofen and Brown, 2005, p. 223). Conclusion The comparative advantage laws postulates that different countries enjoy varying factors which makes them able to produce more of a specific variety of good than others and at a lower cost and therefore countries should concentrate in producing what they can produce best. The law argues that if countries were able to adhere to this law it would result to gains in international trade. The law has been supported by various empirical studies a case in point being production of automobile and aircraft in Japan and US respectively. Different countries may enjoy various factors which make it cheap to produce a certain good such as is the case in Japan where technological advancement cheap skilled labour and raw materials makes it possible for the country to enjoy comparative advantage over US in production of vehicles. On the other hand, given that use of aircraft in US is more, the country has specialized in their production and gained comparative advantage. The comparative advantage is important in international trade since countries can divert some of the other resources in the production of other products. However, the influence of comparative advantage to international trade may be hampered by trade tariffs, economic differences between countries and geographical locations between the trading partners. Bibliography Bernhofen, D.M. & Brown, J.C. 2005, "An Empirical Assessment of the Comparative Advantage Gains from Trade: Evidence from Japan", The American Economic Review, vol. 95, no. 1, pp. 208-225. Chor, D. 2010, ‘‘Unpacking sources of comparative advantage: A quantitative approach’’, Journal of International Economics, 82 (2): 152-167. "Comparative advantage: Doing what you do best", 2011, Organisation for Economic Cooperation and Development.The OECD Observer, , no. 286, pp. 32-32. Fazeli, R. 2008, "Alternative Perspectives on Trade, Productivity and Global Competition", Journal of Global Business Issues, vol. 2, no. 2, pp. 105-114. Heath, W.C. 2006, "Teaching Comparative Advantage and International Trade: Pitfalls and Opportunities", Journal of Economics and Economic Education Research, vol. 7, no. 1, pp. 29-39. Kamery, R.H. 2004, "The U.S. and Japan: Comparative Advantage between Automobiles and Aircraft", Allied Academies International Conference.Academy of Legal, Ethical and Regulatory Issues.Proceedings, vol. 8, no. 2, pp. 115-120. Kilduff, P. & Ting, C. 2007, "Analysis of comparative advantage in the textile complex", Journal of Fashion Marketing and Management, vol. 11, no. 1, pp. 82-82. Lutz, M.A. 2008, "Revisiting the Relevance of International Trade Theory", Forum for Social Economics, vol. 37, no. 2, pp. 147-164. Morrow, P. 2010, ‘‘Ricardian–Heckscher–Ohlin comparative advantage: Theory and evidence’’, Journal of International Economics, 82 (2): 137-151. Pullen, J. 2006, "Did Ricardo really have a law of comparative advantage? A comparison of Ricardos version and the modern version", History of Economics Review, , no. 44, pp. 59-75. Read More