International Trade: Is the Theory of Comparative Advantage Obsolete - Assignment Example

International Trade: Is the Theory of Comparative Advantage Obsolete? of the of the International Trade: Is the Theory of Comparative Advantage Obsolete? Introduction Ever since mankind formed the first nomadic tribes, there has been a need for barter and trade with other tribes and villages. Maybe one man’s catch was better than another, or he had found a better way to preserve it, or cook or cure it. Whatever the reason, it was the real or perceived advantage that one man or village had over another that formed the basis of trade and exchange. To some extent, barter exists in some form in undiscovered territories across the globe even today. The disadvantages of barter are well known. For one thing, there is no standard of measure and one has to rely on the intensity of need for the product desired by the counter party before a basis of trade could be established. There may be lack of storage as well, because the item of trade may be perishable and therefore has to be consumed in record time or be wasted. But all these disadvantages notwithstanding, barter still has its place in villages and jungles and surprisingly can form a part of international trade as well. It is just necessary that the terms of trade be drawn up in advance and be adhered to by both parties- seller and buyer. If there are no further legal impediments, trade via barter can take place in today’s world as well (Siddiqui, 1994). The Need for and Importance of International Trade But obviously, why take the risk of losing by giving up more in value than you are receiving? One of the prime advantages of money is that it serves as a medium of exchange as well as a measure and store of value. One can at any time observe the value of one’s home currency in terms of another country’s by looking at the foreign exchange rates being quoted via the banking system. This forms the basis of exchange for the value of goods and services being traded between different countries from time to time. It seems hard to imagine that these exchange rates too, are dependent on the ratio of imports to exports that one country has with another and vice versa. This is called bilateral trade, and when it extends to more than two countries, multilateral trade. These days most countries are known to have bilateral and multilateral trading agreements with each other. We have even evolved the concept of economic and regional trading zones and agreements such as NAFTA, SAFTA and SAARC are well known. A country having a preferred status with another is likely to be given an MFN or Most Favoured Nation status in respect of a certain commodity or service. This can be because of long standing trade relationships or favourable trading rates or both factors. The fact remains that in today’s modern world no economy can exist as an island state forever or lock its doors to international trade. We see that God or nature has given some nations an absolute or comparative advantage over others when it comes to the production of some commodity. For example oil is a much demanded commodity all over the world and it is well known that the Middle East has a considerable advantage over others in its quantum of oil reserves. We have to trade with the Middle East if we want oil to run our factories and furnaces and cars. We can exchange other goods of value to the Middle East in exchange for their oil. As a country progresses from an agrarian economy to an industrialised one, and later on to a post industrial nation, it has to change the focus of its production goals. First we exchange agricultural surpluses, then go on to establish small and later large industrial complexes, finally moving to the advanced or post industrial stage, where large industrial items like large scale machinery and related services become more important. At each stage we have added value to the goods that we have exported. The Production-Possibility Frontier The traditional view put forward regarding the production of goods and services in any nation of the world is that its resources are finite; this can be defined through the concept of a production possibility frontier. In the classical example, the nation is producing two goods, guns and butter. They can produce only X number of guns or Y amount of butter in a given time period. They can of course decide to produce more guns in the event of a war, or more butter in the case of a food shortage, but the added production will only be possible if they are prepared to give up some number of guns to get the additional vats of butter and vice versa. Hence even a nation producing just two types of outputs has to make a choice as to which is more important or needed in a given situation. Thus economics deals with how an individual or a nation makes choices regarding what to produce, how to produce and how much to produce given a limited amount of resources that have alternative uses (Samuelson & Nordhaus, 2005). Production-Possibility Frontier Curve Can the production-possibility frontier be extended? Yes, not in the short run but in the long run. As society and the owners of the factors of production invest more in capital goods like guns and butter making machinery, they can in the long run devote more resources to the production of additional output. In this case the production-possibility frontier will expand and move outward. This is one way a nation increases its productivity. Another way is to train its population in skills which are in demand in various parts of the world, and then send them abroad to earn valuable foreign exchange. This can in turn be invested in the infrastructure and capital goods that are desired in the nation. Remittances from abroad are a key factor in strengthening the foreign exchange reserves of a country, especially in developing nations. The Factors of Production and Factor Costs Let us now proceed to a discussion of the economic factors of production and the factor costs. There are four factors of production namely land, labour, capital and enterprise. In a finite world, all of these resources are limited. Land cannot be extended unless a country goes to war with another, reclaims land from the sea or usurps its neighbours supply. Similarly a nation will have to wait for some time till its population of today grows into the labour force of tomorrow. Capital and investment in the tools of production depend on the rate of interest prevailing in the economy, the safety and security of life and property, whether the policies of the Government are investment friendly or not, and if tax holidays and other benefits such as investment in infrastructure have been given to the industrialists. The rate of saving and investment and the cost of living is also an important factor, as we have to battle the menace of inflation and constant increases in the factor costs do not make it profitable for the capitalists to invest. The decision to invest capital in a business venture and make it work falls to the lot of the entrepreneur, who is the fourth factor of production. He or she will only invest if he foresees that an investment in a particular venture will be profitable. In the event that he or she is wrong, the business will go into losses which again have to be borne by the entrepreneur. So now we can see that the costs of the factors of production are as follows. Land commands rent, labour commands wages, capital commands interest and profit is the return given to the entrepreneur for assuming the risks of business. Land is finite and labour is perishable- it is either spent or wasted, but capital and enterprise will most likely wait for favourable conditions before they are employed. Determining Factor Substitution Costs and the Least Cost Estimates Economists have determined that the lowest cost occurs in the case when the marginal cost of factor of production A is equal to the marginal cost of factor of production B and so forth. An owner of a factor of production is likely to substitute more or less of one factor or another till the marginal rate of substitution (MRS) of all four factors is equal. He will get the least total cost at this point (Samuelson & Nordhaus, 2005). The Theory of Absolute Advantage and Its Critique It was the economist Adam Smith who first documented the theory of absolute advantage as an explanation of the reasons why one nation has an advantage over another in terms of producing a certain commodity. Taking the example of cotton production, one can see that India has certain climatic advantages in the growth of cotton that are not available to other countries of the world, thus it would be to the benefit of India to produce and export more cotton to the rest of the world and earn valuable foreign exchange or import other goods that it needs in exchange. It is the availability of these natural or man-made factors like localization of industry in a certain place, reduction in growing and transportation costs and other such elements that accrue advantages to India in producing and exporting more cotton at a cheaper cost. But as we have seen, this is not an adequate explanation of the reasons for international trade because certain nations that do not have such absolute advantages over others are also able to carry on sizeable import and export transactions with other countries. Obviously we have missed something here. The Theory of Comparative Advantage and Its Critique To answer this apparent anomaly, there came in the economist David Ricardo with his Theory of Comparative Advantage as an explanation of why even countries with no absolute advantage are able to carry on international trade with other nations. Ricardo maintained that even if a nation had only a comparative advantage in producing a commodity over another nation, it should produce and export or exchange that commodity and seek to import another commodity in which it had a comparative disadvantage. This is the new basis for international trade. Thus we see that even some nations that have no absolute advantages over others in the production of commodities and services exporting these to countries which have a comparative disadvantage in the production of these goods or services. Is the Theory of Comparative Advantage Obsolete? Since the last decade or so, economists like Paul Krugman, Cooke and Grimwade have rewritten the theory of international trade and have tried to explain how nations engage in trade with each other on the basis of locational, associational and other bases. Krugman argues that in each country there are two opposing forces at work regarding the localization and diversification of industry. These are called centripedal and centrifugal forces. The first is responsible for causing localization of industry while the second for its diversification aspects. For example, a large local market for a product can create both backward linkages-preferred locations for similar businesses affording economies of scale, and forward linkages-lowering costs for producers of intermediate goods if they are conveniently located nearby. The concentration of skills or resources to be used in that market is similarly accomplished. As the market becomes more and more concentrated and its fame grows outside, business opportunities and contacts are also established in this economic trading zone and it is likely that efforts to improve infrastructure and transportation are also enhanced. These can be termed as external economies of scale. As regards the opposing centrifugal forces that favour dispersement of economic activity, there is a limit to concentration of trade or production activities in one area as it drives up the cost of land and other resources. It also leads to congestion and too much competition which forces producers and businessmen to relocate to another place where conditions are more favourable (Fujita, Krugman & Venables, 2005). Let us take the example of a region in which two types of economy operate-one manufacturing and the other agricultural. If we assume that the skill of labourers is such that they can alternatively shift to either manufacturing or agricultural activities, the only inducement that would shift them from one place to another is a higher wage rate. The cost of relocation is the only other factor that will be considered. In some aspects, this theory accounts for the establishment of a manufacturing zone at the core of a region, surrounded by a periphery of agricultural activity, so commonly seen in early American history (Krugman,1998). This two-economy example is however inadequate to explain modern international trade and we shall have to resort to another example involving three or more economies, which we shall do so below. Towards New Theories of International Trade Let us now consider some of the new theories for the basis of international trade that have been put forward by the modern day economists and social thinkers. Going forward from the basic two-economy model suggested by Krugman, Fujita and his students have suggested the existence of a central city location is possible with backward and forward linkages to the periphery where land rents decline from their highs at the central location to normal at the extreme points of the periphery. It has been postulated that the houses of specialised labour shall lie almost in a straight line from the central point of the industrial zone. Fujita and Mori (1996) have also made a study as to why transportation nodes become anchor points for the establishment of cities. They state that the concentration of trade and commercial activities in these areas is often the reason behind their becoming hubs for market efficiencies and thereby becoming favourable for the establishment of cities. Venables and others (1996) have noted that factors of production are more mobile between different regions of a city than between cities and countries. Venables has made a case for the establishment of economic and industrial zones in a country where there is a core manufacturing base at the centre- however, economies of scale are to be had by producers who have set up their shops downstream to take advantages of proximity to the main centre. Tasteful and pleasant changes are likely to be in evidence as we move from the periphery to the centre. We can have the grounds for the establishment of many industrialized zones in this case. It seems that the world is a conglomeration of industrial and agricultural zones where trade, business activity and wages have interlinked to form cities and neighbourhoods. In the latest case of Mexico City, the central hub has lost its importance as facilities were made available towards the peripheries and markets could be replicated there. If we look at the history of development of cities in Germany and Japan for example, we could easily see how this theory has an empirical application. Is Free Trade Passe? Continuing into this question whether the existence of free trade was an outdated phenomenon in today’s world, Krugman suggests that the existence of the theory of comparative advantage as the basis for international trade was on the premise of increasing returns to scale. This means that with few inputs one was able to get more than proportional outputs because of favourable climatic conditions, soil or superior inputs and tilling methods. So trade was possible only to the extent that superior returns were produced and exchanged for cash or commodities. Ohlin, Samuelson and Hecksher have pointed out that trade between countries has been possible because of a difference in factor endowments. Of course, any thoughtful economist could further prove that international trade could also be made possible due to international specialization causing increasing returns. In fact, increasing returns to scale formed the basis of monopolistic and other forms of imperfect competition, where extra profits were to be had from controlling the supply and production of the goods and thereby maintaining a sale price. So increasing returns to scale could also form the basis of a comparative advantage and thereby international trade. Increasing returns to scale in a particular area could lead to the establishment and localization of industry or production in that area or geographical location of a country. Each country with factor endowment advantages would have developed its own geographic areas where such productivity and skill was encouraged. When a specialization aspect results in a comparative advantage of one area in a country, it can be likened to oligopolistic competition and superiority (Stonier & Hague, 1972). The notion of increasing returns to scale and imperfect competition thus strengthens the case for international trade. It even suggests that while countries can benefit from complementary differences in trading and technology, they need to build home based advantages in the manner that they can specialise in the manufacture of certain goods and try to achieve increasing economies of scale while maintaining a diverse selection of goods for export as well. By expanding markets and creating new ones, further opportunities for trade can be created. Government intervention to improve infrastructure, give tax holidays and other such incentives will further solidify the impact. Once all these new precepts had been established, economists now began challenging the previously held view that international trade was based on comparative advantage. They agreed that international trade is driven to a large extent by economies of scale rather than competitive advantage, and that imperfect competition was a necessary part of international trade. Concerning these newfound concepts, we see that Governments can intervene to tilt the oligopolistic environment from favouring foreign to local firms. Governments should favour and protect industries where local know-how is passed down from generation to generation, so that the skill cannot be replicated easily. We take the instance of oligopolistic competition, whereby there are only two producers of a good, America and Europe. The good is a passenger airplane, and in each of the given nations there is only one producer of the good. Let us suppose that there is no local demand for the airplane, so demand is strictly from abroad i.e. other countries. The conditions are however that it is only profitable when one firm produces the airplanes, not both, because the overall demand is low. If America decides to produce the airplane before Europe does, and can effectively deter Europe, it will earn a profit. However if the Government of Europe intervenes and decides to subsidize production of at least 10 airplanes, it can upset the plans of the American producer. If both firms go ahead with production, one will end up facing losses. There is thus a good argument for a Government to protect the interests of local industry. In the case of externalities, this is all the more needed. If the knowledge of making a good can be restricted to one nation, then unless the other reverse engineers the process, it can serve as a good case for Government protection. In the world today, we find that nations are even competing as to who gets to use these externalities (Clarke, 2000). The Competitive Advantage of Locations Let us now move to what another thinker says about the competitiveness of firms in an industry. Michael Porter states that international trade is based on the competitive advantage of locations and uses something called Porter’s Diamond to determine the degree of success that companies could have using locations to their competitive advantage. He has defined a concept called clusters and he states that a cluster has the advantages that make a location successful. Porter starts by saying that today with the rapid advances in technology, more open markets and reduction in transportation costs could diminish the role of location in competition. Yet we find that time and again, certain industries have localised in certain regions of the world. The wine industry of France concentrated in the South West of the country around Bordeaux and the tile industry of Italy are some good examples. Porter defines a cluster as a critical mass of unusual competitive success in a certain field. For instance, Silicon Valley attracts computer geeks and Hollywood attracts actors. Porter mentions that the role of Government should be to nurture the needs of clusters (Porter, 1988). Clusters are geographic concentrations of inter-connected companies and institutions in a particular field. Their linkages are important to competition. The extent of a cluster is determined by the linkages across industries and institutions that are most important to competition. Clusters are usually found within countries, but they may even be regional and cross national borders. A cluster may be regarded as a new form of combination, because if all the firms agree to a certain set of principles in dealing with the outside world, they have considerable clout and bargaining power. Porter states that clusters affect competition in three ways: (1) by increasing the productivity of companies located in the area; (2) by driving the pace and direction of innovation and (3) by stimulating the formation of new businesses, to add to the strength of the cluster. Clusters help boost productivity by providing better access to suppliers and employees, its members have access to specialised information and it benefits from complimentarities. Access to institutions and public goods may be improved, and clusters may also provide better motivation and measurement of performance. The success of clusters may induce a businessman to try to replicate their success in another location. The formation of clusters may depend on location benefits such as soil’s productivity or have another similar historical context. It has been noticed that companies also locate their businesses in cluster locations to take full advantage of the benefits available to the firms in that cluster (Porter, 1988). Porter’s Diamond Porter’s diamond consists of the following elements: Factor Conditions, Demand Conditions, Firm Strategy, Structure and Rivalry, and Related and Supporting Industries. Government efforts and actions and the element of luck or chance plays an important role in the development of the cluster. At times a cluster can also break up due to unfavourable conditions. For example, it is being seen that Australian wines have reduced in demand due to low productivity and bad taste so they are not being ordered so much anymore. The Limits to Globalization Michael Storper has approached this query and makes some very valid points. He states that the proportion of traded goods in the world output has been increasing steadily over the past several years. This increasing export specialization is evident if we look at specific products exported by the advanced industrial nations. Storper maintains that such specialization cannot be explained by the usual theory of comparative advantage, nor entirely by the new trade theory based on economies of scale. In fact, a significant proportion is probably due to technological or absolute advantages on the part of the specialized exporter, and a significant dimension of technological advantage is product-based and renewed through learning, giving rise to dynamic economies of variety as a source of export specialization. Firms characterized by such product-based learning and absolute advantage tend to have important developmental effects on their host economies because they earn quasi-rents. Such firms also tend to be organized into production networks combining the advantages of specialization and flexibility, which are the key to technological learning. Such export-oriented absolute advantage industries tend to be found in one or a few regions of their host countries (Storper,1992). In this way, the global economy may be thought of as consisting of a series of technology districts. Storper concludes with the idea that unlocking the organizational secrets of technological learning in these districts is now a key task for understanding the dynamics both of these localities and of the global economy as a whole (Cooke & Morgan, 1998). Agglomeration and Economic Geography In their paper, Ottaviano and Thisse (1993) make a good case for the establishment of firms in favourable locations and the formation of clusters or localization of industries to get competitive advantage. Distribution of populations over the land comprising a nation is most likely on the basis of some advantage such as food or work opportunities. For example in the days of old, farmers would stay put on productive land and cultivate it for their needs. When the Industrial Revolution came along, people relocated to the places near factories, mines and quarries, where work was to be had. But this is still not an adequate explanation for the establishment of modern industrial centres, which have not always followed a readily recognizable pattern such as the industrial heart of Tokyo or the USA’s Silicon Valley (Grimwade, 1999). Ottaviano and Thisse make use of Krugman’s new economic geography as the basis of their explanation. They conclude that a marketplace is the core of a region’s economic activity. More specifically they use the term HME or home market effect to illustrate that the home market is the main hub of activity for a particular product and that some degree of trade goes on even between the home market and the smaller markets around in the periphery. If labour is mobile, it will move to the new location without much fuss (Van Marrrewijk, 2002). Even so, the size of a market is determined by its internal and external linkages which have been created over time. In fact these are likely to increase as the popularity of the market expands. However they also find that the cost of living is higher in cities than in towns and villages. This is because cities demand more rent for their dwellings. Given that once a person has relocated to the city, he is more inclined to stay there because of better civic amenities, and he will not relocate to the town or village because of higher costs, but try to work hard and earn more while continuing to live in the city. Sellers will congregate in a city according to Hotelling’s Principle of Minimum Differentiation. Price competition is a strong dispersion force. Regarding purchase and sale behaviour, it is seen that buyers always prefer to buy from the same seller and vice versa. Even a producer is more comfortable selling to the same middleman. This is called the law of gravity. Firms will prefer their setup in such an area where there are more workers available, and less competition from other firms. Workers will prefer to purchase a house in that location where they are close to the places of work and market etc. In this way the forces of demand and supply in a labour market interact with each other (Krugman, 1997). From ancient times it has been noticed that the establishment of granaries etc were not more than ten miles from the fields and water resources. This is because it would have been difficult to transport inputs and outputs more than ten miles in the ancient world. Thus as seen in Krugman’s thesis, there are some forces working towards a concentration of resources and skills in a certain area; there are other forces working towards dispersion of such resources. The advantages of low cost production and specialization are concentrating forces; the cost of transportation and shipping are dispersing forces. If one would like to calculate the distances at which the location of cities would spring up, it may be estimated as the trade-off distance between the cost of transportation and the fixed cost of setting up a business unit- it would emerge at the point where both of these are minimized (Oxley & Yeung, 1998). To summarize, firms will set up shop where other people have already set up establishment because they assume that this calculation has already been made by earlier business entities. In a perfectly competitive modern market, firms would locate themselves where 1) supply equals demand for each commodity;(2) each firm maximizes its profit using the latest technologies; (3) each consumer maximizes his utility given his budget constraints. Thus, economic space is the outcome of a trade-off between various forms of increasing returns and different types of mobility costs; (2) price competition, high transport costs and land use foster the dispersion of production and consumption; therefore (3) firms are likely to cluster within large metropolitan areas when they sell differentiated products and transport costs are low; (4) cities provide a wide array of final goods and specialized labour markets that make them attractive to consumers/workers; and (5) agglomerations are the outcome of cumulative processes involving both the supply and demand sides (Williamson & Milner, 1998). Sticky Places as an Explanation for Attraction of Technology and Infrastructure The economist Ann Markusen has come up with the concept of sticky places as an attraction for much of today’s concentration of effort in developing an industrial or economic trading zone. She states that as advances in transportation and information obliterate distance, cities and regions face a tougher time anchoring income-generating activities. In probing the conditions under which some manage to remain sticky places in slippery space, her work rejects the new industrial district (NID) in both its Marshallian and more recent Italianate form, as the dominant paradigmatic solution. In fact Markusen identifies three additional types of industrial districts, with quite disparate firm configurations, internal versus external orientations, and governance structures: i) a hub-and-spoke industrial district, revolving around one or more dominant, externally oriented firms; ii) a satellite platform, an assemblage of unconnected branch plants embedded in external organization links; and iii) the state-anchored district, focused on one or more public-sector institutions. The strengths and weaknesses of each have also been reviewed. The hub-and spoke and satellite platform variants are argued to be more prominent in the USA than the other two. Her findings suggest that the study of industrial districts requires a broader institutional approach and must encompass embeddedness across district boundaries. These research results however suggest that a purely locally targeted development strategy will fail to achieve its goals. Casaneuva and Gonzalez (2004) suggest that there is a network of social and business connections that exist between small and medium sized firms within an industry. Information relations make for the transfer of know how between firms and the diffusion of innovations. Such overlaps can exist because of commercial interchanges and social relations between networks of small firms. They opine that the stronger the links and the closer the relationship between particular firms means that positive and negative snippets of information are transmitted quickly between them making them strong in the face of competitive power of buyers or suppliers, for example (Wignaraja, 2003). Conclusion We have reviewed quite a number of theories and explanations of the theory of international trade, both of the old classical economists like Adam Smith and David Ricardo as well as the new breed of thinkers like Krugman, Venables, Porter, Markusen, Ottavino and Thisse, regarding the new explanations of international trade and the establishment of city centres and cluster locations of specialised industries. While it would not be technically correct to say that the theory of comparative advantage is totally obsolete, we may conclude that the new economic geography using the concepts of externalities and economies of scale is the new explanation as to the reasons why international trade is conducted across the world. Economies of scale and the costs of transportation also have an impact on the location of trade and industry and are an explanation why clusters of economic activity in a specific industry exist at various point along the globe. 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