Arguments in Support of the Theory of Comparative Advantage - Term Paper Example

Introduction According to Suranovic (2003), the theory of comparative advantage is "perhaps the most important concept in international trade theory." Comparative advantage exists when a country has a margin of superiority in the production of a good or service i.e. where the opportunity cost of production is lower (tutor2u 2005). It's most basic contention is that it is in the interests of all economies to engage in international trade insofar as they all must have a comparative advantage in producing particular goods while also experiencing comparative disadvantage in producing others (Kitching 2001, p.255-256). If a country is relatively more efficient in the production of a good than another country then it has comparative advantage in production of that good (Kili 2002, p.3). However, the theory itself is also one of the most commonly misunderstood principles (Suranovic 2003). Suranovic lists that one of its sources of "misunderstandings" derives from its property of being counter-intuitive, that is, many results from its formal model are contrary to simple logic. Secondly, the theory is easy to be confused with another concept regarding advantageous trade, known in trade theory as the theory of absolute advantage. This confusion between these two concepts leads many people to believe that they have understood comparative advantage in full when in reality, it is absolute advantage that they understand. Finally, the theory of comparative advantage is all too often presented only in its mathematical form. The use of numerical examples or diagrammatic representations is extremely useful in illustrating the basic results and the deeper implications of the theory. However, it is also easy to see the results mathematically, without ever understanding the basic intuition of the theory (Suranovic 2003). The theory on comparative advantage was first described by Robert Torrens in 1815 in an essay on the corn trade where he concluded that it was to England's benefit to exchange various goods with Poland in return for corn, even though it might be possible to produce that corn more cheaply in England than Poland. However, the theory is attributed to David Ricardo, who explained it in greater detail in his 1817 book The Principles of Political Economy and Taxation and explained the concept on foreign trade in an example involving the same two countries. The theory has been developed in the context of Ricardo's labour theory of value. The following table shows Ricardo's 1817 example of foreign trade production functions on cloth and wine for England and Portugal in one year's time: Output/Country Wine Cloth England 120 100 Portugal 80 90 According to Ricardo, if England is circumstanced that in order to produce the cloth may require the labour of 100 men in a year and if this country attempted to make wine, the labour of 120 men will be needed at the same time. Ricardo quotes that it would be in England's best in interest to import wine and to purchase it through the exportation of cloth.1 On the other hand, to produce the wine in Portugal, the labour of 80 men will be required for one year while producing cloth in the same country will need the labour of 90 men for the same time. According to Ricardo, it would be therefore best for Portugal to export wine in exchange for cloth. In Ricardo's words: "This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she (Portugal) could make the cloth with the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital (the labour employed) in the production of winethan she could produce by diverting her portion of capital from the cultivation of vines to the manufacture of cloth." According to Feucht (2002, p.3), the reason for comparative advantage is that even if the costs for all products may be lower in one country than in its trading partner, there is still the one product where the relative cost saving compared to all other products is maximum. Hence, it would be reasonable to specialize on this product as much as possible. From the above example, when we "compare advantages", we see that England comes out better in cloth while Portugal better in wine. Bernhofen and Brown point out that the differences in factor endowments is the source of comparative advantage (2004, p.3). Highlights of the Ricardian Model of Comparative Advantage. The Ricardian model is constructed in such a way that the difference between the trading countries is in their production technologies only. All other features are assumed identical across countries in the model. Since trade would occur and be advantageous, the model highlights one on the main reasons why countries trade, that is, the dissimilarity in their technology. Moreover, the gains of trade will still accrue to both trading countries "even when a country has no absolute advantage whatsoever" (Feucht 2002, p.2). Given that an unequal distribution of factors of production across all economies, these economies will have comparative advantages and disadvantages in production (Kitching 2001, p.257). Secondly, despite the fact that most models on trade conclude that some parties would benefit and some lose from free trade, the Ricardian model shows that everyone could benefit from it. However, a reason for this result is the model's simplifying assumption that there is only one factor of production (Suranovic 2003). Also, Ricardo showed by using a simple numerical example that even a technologically inferior country can benefit from free trade. That is, technological superiority is not enough to guarantee continued production of a good in free trade. Finally, a developed country can compete against some low foreign wage industries. The Ricardian model shows the possibility that an industry in a developed country could compete against an industry in a less developed country even though the industry in a less developed country pays its workers much lower wages (Suranovic 2003). Furthermore, in the Ricardian model on foreign trade, the general rate of profit in a country can only be raised by a significant reduction in real wages. Despite the fact that foreign trade is beneficial to a country as it increases the amount and diversity of the goods available, as well as in terms of affordability because of the abundance and the cheapness of commodities together with incentives to savings and capital accumulation, foreign trade, according to Ricardo, "has no tendency to raise the profits of stock, unless the commodities imported be of that description on which the wages of labour are expended" (Penguin 1971, p.151). Moreover, the rate of profits is never increased by better labour distribution, the invention of machinery, as well as by the establishment of canals and roads. Even though that these factors may cause to operate on the price level of the commodities, these have no effect whatever on profit (Penguin 1971, p.152). Assumptions of the Theory. The theoretical model assumes that there are two trading countries, producing only two goods (a barter economy), and using one factor of production, particularly, labour (Kili 2005, p.4), and that the model is a general equilibrium model in which all markets (i.e., goods and factors) are perfectly competitive (Suranovic 2003). There is the absence of tariffs and other trade barriers (Kili 2002, p.4). The goods produced are assumed to be homogeneous across countries and firms within an industry. Goods can be costlessly shipped between countries, that is, no transportation costs are felt (Suranovic 2003, Mehta ). Moreover, costs incurred are constant and economies of scale are absent. Labour is also set to be homogeneous within a country but may also have differences in productivities across countries, further implying that the production technology is different between the two countries, and production exhibits constant returns to scale (Kili 2002, p.5). Labour can freely move across industries within a country but is immobile across countries which means that labour cannot move to other countries in search for higher wages (Suranovic 2003). Also, real wages around the globe are taken to be equal or approximately equal. Finally, full employment of labour is also assumed and consumers (the labourers) are assumed to maximize utility subject to an income constraint. Early Criticisms to the Theory. Kitching cites Freidrich Lists' (1841) critique on the Ricardian doctrine of comparative advantage that the theory, in essence and based on the England-Portugal example, is a perfect justification for Britain to maintain its world monopoly over trade in cloth manufactures and to convert the rest of the world into a supplier of food and raw materials for Britain during that time. However, Kitching stresses that Ricardo's argument on free trade is founded on relative advantages of some types of economic activities over others within individual economies and not between different ones but also comments that Ricardo's comparative advantage doctrine is not necessarily applicable only to primary activities but also to other sectors as well (e.g. services). An example is that across the globe, there will be attractive locations due to cheap labour compared to other economies (absolute advantage). However, within that cheap-labour economy, there will be comparative advantages on the use of that labour under free trade conditions in particular kinds of activities such as clothing manufacture over large-scale crop production. Similarly, in areas with expensive labour costs, there will also be comparative advantages in particular activities (such as banking and financial intermediation) compared to others (e.g. agriculture) (Kitching 2001, p.258). The Ricardian Model in the Contemporary Times. A major blow against the theory on comparative advantage is that its assumptions are easily assailed as unrealistic. Particularly, the model assumes only two countries producing two goods using just one factor of production and that there is no capital or land or other resources needed for production. Second, each market is assumed to be perfectly competitive, when in reality there are many industries in which firms have market power (Suranovic 2003). Finally, the model assumes that technology differences are the only differences that exist between the countries. In reality, other factors come into play particularly initial factor endowments. As pointed out by Bernhofen and Brown (2004, p.3) it is in the differences in factor endowments that comparative advantage emanates from. Research by Yeaple and Golub (2002, p.33) showed that infrastructure strongly affects both absolute and comparative advantage. Infrastructure provision affects the location of production for internationally mobile factors of production, hence affecting the productivity differences across countries. An important criticism regarding the theory is its incapacity to determine which of the trading countries will be able to gain the most from the exchange of goods. To quote (Chapter 2 Labor Productivity and Comparative Advantage, p.10): "A shortcoming of Ricardo's principle of comparative advantage is its inability to determine the actual terms of trade. It only provides the outer limits within which the terms of trade would fall. This is because the Ricardian theory relies solely on supply conditions in explaining trade patterns. It ignores the role of demand." Using the Ricardian assumptions on free movement of capital and goods across the globe, the production of goods that require advanced technologies from its initial place of development (say, PC production in the US) could expand to other areas in the globe through capital investment. Workers may also come freely from other parts of the globe not in search for higher wages but to further expand their production activity from their initial location (Kitching 2001, p.261). Jacobson and McDonough (1997) enumerates the following comments on the comparative advantage theory as scrutinized by development economists: that (1) the assumptions upon which comparative advantage theory is based, such as perfect competition and perfect mobility of resources, do not hold, and therefore the theory itself does not hold; (2) that comparative advantage theory is static, and does not allow for dynamic effects, as in the case of planned, created comparative advantage and the important role of leading industries; (3) the theory does not take into consideration distribution effects, such as the extent to which inter-industry specialisation within an economy may reduce the welfare of those whose livelihood depended on the good whose production is cut back; and, (4) among relatively less developed countries (LDCs), a dualism can emerge as a result of trade with more developed countries (MDCs), in which there is an advanced, wealthy, high employment sector and a technologically backward, poor, high unemployment sector, with little relationship between them. Next is on the assumption that the factors of production (other than labour) are perfectly mobile across sectors. Full employment is assumed, when clearly workers cannot be immediately and costlessly transferred to other industries, that workers are identical implying that when a worker is moved from one industry to another, he or she is immediately as productive as every other worker who was previously employed there. (Suranovic 2003). Kilkenny (2003) comments: "While it is not so farfetched to imagine a world where people are so well-educated that they could be just as productive in one career as another, it is very hard to imagine that this, plus the physical mobility implied to work in any industry, would be costless." Another criticism on comparative advantage has also branched from the Leontief Paradox. Leontief, in the 1950s and 1960s undertook research on US trade patterns. However, results showed that the US seemed to export labour intensive products when in fact the US is a capital-intensive country, implying that it should export capital rather than labour-intensive goods (Jacobson and McDonough 1997). Labour productivity is also taken as fixed, when in fact it changes over time, perhaps based on past production levels (Suranovic 2003). According to Bernhofen and Brown (2004, p.3) the Ricardian model is a one-factor model where comparative advantage is described by country-specific differences in fixed labour-output coefficients. Empirical studies of comparative advantage by MacDougall (1951), Stern (1962) and Balassa (1963) showed a statistically significant positive correlation between the relative labour productivities and the relative export performance of the United States relative to Britain. Although these studies showed strong empirical regularity between relative labour productivities and trade flows, they do not provide hard support for the Ricardian comparative advantage model. This is because labour productivity and trade are both endogenous, at least from empirical standpoint. According to Bernhofen and Brown, "the focus on a single factor of production is misleading since country-specific differences in labour productivities are the result of differences in the use of capital" (2004, p.3). Also, labour productivity, according to Yeaple and Golub (2002, p.2) can be a misleading indicator of technological differences, particularly in comparing developed and less developed countries, as it could merely show differences in capital-labour ratios. Simply put, Bernhofen and Brown (2004, p.3) cites that this single factor outline is too simple as a guide for empirical work as reality consists of many countries producing many goods using many factors of production. Also, the relationship between labour productivity and trade is not exclusive to the Ricardian model as studies done by Ford (1967) and Falvey (1981) showed that this could also be derived in a Heckscher-Ohlin framework. Conclusion Despite the criticisms that it has faced for over nearly 200 years, the theory of comparative advantage still remains an important milestone in economic history. For one, despite the "oversimplifications" its critics posit, the theory in itself is milestone of man's search for the most "rational" means of production. However, it must be particularly noted that as the global production process becomes more complex, that is, as it involves more factors of production and labour becomes more specialised across all sectors, the assumptions that the theory of comparative advantage holds (i.e., workers' productivity are the same regardless of where they are located) in turn continue to weaken. Reference List Bernhofen, D, and Brown, J 2004, Comparative Advantage: From Theory to Data, On the 75th Anniversary of the Opportunity Cost Formulation of Comparative Advantage, 2005 AEA Meetings in Philadelphia. Retrieved 8 May 2006 from http://www.aeaweb.org/annual_mtg_papers/2005/0107_1430_1003.pdf#search='criticisms%20to%20the%20theory%20of%20comparative%20advantage'. Chapter 2, Labor Productivity and Comparative Advantage (Notes), Department of Economics, University of California. Retrieved 7 May 2006 from http://www.econ.ucdavis.edu /faculty/asschea/ECON162/notes/Chapter2.pdf#search='problems%20with%20the%20Ricardo%27s%20theory%20of%20comparative%20advantage'. Feucht, M 2002, Introduction to Ricardo's Theory of Comparative Advantage, Lecture in International Finance, Winter Term 2002/2003, Finanz - und Rechnungswesen. Retrieved 9 May 2006 from http://www.fh-augsburg.de/feucht/Ricardo.PDF #search='Ricardo%27s%20theory%20on%20comparative%20advantage' Jacobson D and McDonough, T 1997, Irish Industry, International Trade and European Integration, No. 27 DCUBS Research Papers. Retrieved 7 May 2006 from http://www.dcu.ie/dcubs/research_papers/no27.html. Kili, R 2002, Absolute and Comparative Advantage: Ricardian Model, Department of Economics, Michigan State University. Retrieved 9 May 2006 from http://www.msu.edu/course/ec/340/snapshot.afs/Kilic/lecture3.pdf#search='Ricardo%27s%20theory%20on%20comparative%20advantage'. Kilkenny, M 2003, Comparative Advantage, Department of Economics, Iowa State University. Retrieved 10 May 2006 from http://www.econ.iastate.edu/classes/ econ376/Kilkenny/Comparative%20Advantage/Comparative%20Advantage.htm. Kitching, G 2001, Seeking Social Justice Through Globalization, Penn State, Philadelphia. Ricardo, D 1817, 'On Foreign Trade' from The Principles of Political Economy and Taxation in Penguin (ed) 1971, Chapter 7 (On Foreign Trade), Harmondsworth. Suranovic, S 2003, 'The Ricardian Model of Comparative Advantage' in International Trade Theory and Policy, The International Economics Study Center. Retrieved 9 May 2006 from http://internationalecon.com/ v1.0 /ch40 /40c000.html. Outline of Lectures, Fall 2004, Department of Economics, Rutgers University. Retrieved 8 May 2006 from http://econweb.rutgers.edu/rockoff/327outs01.html. Yeaple, S and Golub, S 2002, International Productivity Differences, Infrastructure, and Comparative Advantage, University of Pennsylvania and Swarthmore College. Retrieved 10 May 2006 from http://www.columbia.edu/cu/economics/infrastructure.pdf#search ='Labor% 20Productivity%20and%20Comparative%20Advantage' Read More