How New Theories of Trade Influence Comparative Advantage - Essay Example

How New Theories of Trade among Industrial Countries Influence Comparative Advantage Conventional models of comparative advantage don’t give sufficient account of world trade in manufactured goods trade. Both at microeconomic, macroeconomic and technological perspective, it is difficult to reconcile what is seen in manufacturing trade with the assumptions of standard trade theory. Most of world’s trade in manufacturing occurs between industrial nations with similar relatively low resource endowment and involves a duo exchange of good manufactured in a similar way. It is therefore difficult to determine the comparative advantage (Krugman, 343). Moreover, most manufacturing industries experience increasing returns especially if dynamic scale economies associated with Research and Development. Coincidentally, these countries face imperfect competition. This raises several questions such as how a model that assumes constant returns, exogenous technology and perfect competition give enough guidance for trade policies in these industries. Economists developed new models to respond to the questions raised by the conventional model such as the ‘product cycle view.’ The view stresses on endogenous innovation and diffusion of technology to achieve comparative advantage. This will draw the focus of industrial countries from economies of trade to comparative advantage that boosts trade better than economies of scale. Currently, economist theorists apply methods drawn from the theory of industrial organization to international trade in order to develop new genre of trade models. These models offer new perspectives to viewing trade especially manufactures trade among industrial countries (Krugman, 344). The new models rely on special assumptions that will facilitate tractable analysis. Assumptions are inevitable because of the inherent complexities of the world. The economists developed theories that use special assumptions to explain how industrial countries can diversify technology and endogenous innovation in order to gain comparative advantage. Two theories that will help industrial countries achieve comparative advantages include theory of intraindustry trade and the theory of technological competition. The theory of intraindustry trade incorporates economies of scale and comparative advantage as key causes of trade and gains of trade. In trade explanations, theories suggest that increasing returns can be alternative to comparative advantage. Economists suspect that increasing returns play a key role in manufactures trade, perhaps, more important than natural endowments. These suspicions have not been proved because it is difficult to introduce economies of scale into formal trade models. Traditionally, this was achieved by assuming that increasing returns are entirely external to firms. Models that resulted from this assumption have no influence because external economies are too vague to appeal in explaining trade patterns (Krugman, 344). The limitations of the traditional approach are addressed by the intraindustry theory. The theory uses a simple basic idea of differentiating intraindustry trade which is based on comparative advantage and intraindustry trade based on economies of scale. According to the theory, a country’s production industrial structure is determined by its factor endowments. Each industry has a vast variety of potential products, each having increasing returns. Each country only produces goods under conditions of increasing returns. Due to increased economies of scale, each country produces a limited subset of products due to intraindustry specialization. This way, each country produces what it is naturally advantaged to produce according to its natural resource endowment and achieve comparative advantage (Krugman, 345). The trade implication for this practice is that each country becomes a net exporter in some industries where it has comparative advantage. However, due to intraindustry specialization, each country imports and vice versa. The theory is simple but it must deal with the problem of market structure, resulting from the fact that existence of unexhausted economies of scale results in imperfect market competition. The markets are faced with chamberlinian monopolistic competition. This hinders product differentiation-cum-scale economies. Market imperfections may interfere with economies of scale and specialization, making it difficult to attain comparative advantage. The theory explains the empirical puzzles posed by manufacture trade in industrial nations. For example, the theory explains why similar nations trade so much and why their trade is two way exchange of similar goods. It gives new insights on the effects of trade on welfare and distribution of income. Traditional models have strong distributional effects. Although trade liberalization makes the economy better, the movement of income is enough to ensure a fall in real income of scarce factors of productions. However, availability of scales of production produces extra gains that are translated to longer production runs and more product varieties. Where the income distribution isn’t wide, the advantages of a wider market outweigh the distributional effects of trade. Therefore, distribution of trade is dependent on its causes (Krugman, 345). If economies of scale are unimportant, and countries differ much in resource endowments, scarce factors lose in trade. However, economies of scales matter and resource endowments are similar, all factors will gain from trade. Therefore, the theory proposes that each country will gain in trade by using technology and its factor endowment to specialize in producing specific products that it has a comparative advantage to manufacture. The theory of technological competition seems to suggest that trade between manufacturing countries is benign and unlikely to cause adjustment problems than other trades and therefore easier to liberalize. However, current trade policies in these countries such as protectionist/ interventional polices may hinder liberalization. The theory adopts a single industry view of trade and assumes that an industry has only two firms, one domestic; the other foreign. If the two countries can compete technologically, investing in Research and Development lowers their production costs. The amount invested on research and development determines their competitive position in actual product (Krugman, 345). The research and development may apply to product/process improvement, its results may be certain or uncertain, products may acquire a winner- take-all elements or allow for second prizes etc. However, for an industry with many firms, each firm’s optimal investment in research and development will decline with the other’s investment. The theory of technological competition suggests that investment in technology can be used to gain a comparative advantage and trade efficiency. It explains that firms that invest in technology innovates new products and processes that lower their production costs and increase their products varieties. The firms, under lower production cost, can utilize their factor endowment optimally in order to increase production and gain advantage over their competitors. Technological competition means that if a firm invests in technology to increase its returns and other countries do the same to increase returns of specific products, the returns of the first firm will drop. Therefore, firms have to constantly use superior technology to others so that they gain a comparative advantage of producing products cheaply, using its natural factor endowments (Krugman, 346). The theory suggests that countries use technological superiority to achieve comparative advantage especially where they produce similar products. The country that manages to update its technology and make it superior to others get the comparative advantage of producing quality products cheaply, using its factor endowments. The article successfully explained how new theories of trade assist countries achieve competitive advantage. The author used simple language and examples to explain how economists studied the limitations of the conventional trade theory to develop new theoretical models that credibly explains new developments in international trade. For example, the theories explained clearly how countries can leverage on economies of scale and technological advancement in utilizing factor endowments to achieve competitive advantage (Krugman, 346). The author explained how historical view of international trade in relation to manufactures industry has changed over time, leading to new models and theories that increase trade gain. The article simplifies the concept of comparative advantage and international in its theoretical framework. The author did a marvelous job in summarizing the concept of comparative advantage and trade theories in his short article. The article covers the topic comprehensively, giving clear thoughts and insights. His work has academic authority because he used credible current academic sources to develop thoughts in the article. The article was helpful in explaining how trade theories contribute to comparative advantage. The theories are applicable in real life situations. For example, the technological competition theory has been used successfully in countries such as Japan to gain comparative advantage over their competitors in the automobile industry. Japan leverages on its ability to innovate new car products and accessories quicker than its competitors in order to produce a variety of quality vehicles at the lowest cost. This strategy keeps it ahead of its competitors because it is able to maintain superior technology at all times. Intraindustry theory manifests itself in countries that produce consumables in that they focus on economies of scale and use of exogenous technology to achieve comparative advantage (Krugman, 346) The country that is able to achieve economies of scale and specialize in specific areas within given industry, gain more from international trade. This is because specialization makes them focus on particular areas where they have factor endowment and therefore can produce the goods cheaper than other countries less endowed with factors of production. Conclusion Comparative advantage is an economic concept that explains the potential gains from international trade for firms or countries that arise from differences in their factor endowments or technological advantages. In economic models, a country may have a comparative advantage over another country in manufacturing a given product if it produces that good at a lower relative opportunity cost or lower marginal cost prior to trade. The monetary costs of productions between countries are not compared. However, opportunity cost is compared to determine which country has comparative advantage to produce that good. There are theories of trade that explain how countries can gain comparative advantage over their competitors. This paper discussed two theories of trade and how they offer countries comparative advantage of trade. The theory of intraindustry trade incorporated economies of scale and comparative advantage as key causes of trade and gains of trade. The technological competition theory focused on technological advancement and superiority as a source of comparative advantage. Therefore, countries can focus on these aspects to gain in international trade rather than lose. Work Cited Krugman, Paul. "New theories of trade among industrial countries." The American Economic Review (1983): 343-347. Print Read More