Trade Liberalization and Comparative Advantage - Assignment Example

Trade liberalization and comparative advantage: Before industrial revolution in Great Britain different countries were conducted by the mercantilist viewpoint. It was believed that the countries should promote the merchants to sell more domestic good over the world and accumulate precious metals from foreign countries. It was Adam Smith who first theorized a mutually beneficial nature of trade through his theory of ‘Absolute Advantage’. (Wykstra, 1971, 641-643) Later on David Ricardo modified the concept of the conditions in which trade can be mutually beneficial by his famous theory “Comparative Cost Advantage”. Ricardian theory of comparative cost advantage is explained in two countries, two commodity and single factor framework. In this theory it is mentioned that if a country exhibits lower opportunity cost of one commodity in terms of other than the other country then the former enjoys a comparative cost advantage in the production of that commodity and vice versa. In such a situation free trade and complete specialization according to comparative advantage would be the best policy, which would maximize the social welfare of each trading country as well as the global welfare. Heckscher Ohlin theory argued that free trade of commodities would act as indirect trading of factors and hence there would be equalization of factor rewards across the globe. Moreover, a technologically backward country would be able to reap the benefit of technological progress in an advanced country through the process of trading. (Caves, Frankel and Jones, 2002; Husted and Melvin, 2007) Latin American Dependency School and Terms of Trade Decline: Theory of dependence emerged with the writings of Baran. In his work Baran made a division of the world into capitalist and underdeveloped economies. He tried to emphasize the interrelation between development and underdevelopment processes in a world-centered approach. He was the first one to mention the technology and international division of labor as the major determinants of the famous center (developed) and periphery (underdeveloped) approach. This theory argues that in this relationship the center produces for itself and the periphery and the periphery produces mainly for the center. In the periphery there is the existence of a large subsistence sector. According to the dependency explained by Baran, the stagnation in the periphery is the result of the emergence of global capitalism. The process of development is supposed to be related to capital accumulation, which is actually dependent upon surplus extraction. According to Baran, in the process of global trade the underdeveloped country the surplus extracted in the underdeveloped countries are used to purchase foreign luxurious goods instead of investing them. That obviously leads towards huge export drive to the developed countries inducing higher dependence. On the other hand the situation of the rural subsistence sector remains the same or it may worsen due to lack of investment on those sectors. Those sectors are neglected, as those cannot produce the exportable. (Baran, 1957) The theory of dependency can be the best one to explain the Latin American countries. Dependency theory mainly established underdevelopment as a historical process. In this theory the metropolitan satellite relationship in the pattern of trade between a developed north and underdeveloped south is examined. If an underdeveloped economy like Brazil or Peru or Argentina is considered the economy is characterized by the simultaneous presence of modern urban and traditional rural sector (Todaro and Smith, 2008). The capitalists make investment on industrial sector but as agriculture occupies the major share of the national income of the economy the proportion of investment with national income is significantly low. In such a situation while economic liberalization takes place the industrial sector of the country can’t compete with the highly efficient industrial sector of the developed countries. So the underdeveloped economy has to play the role of the exporter of the primary goods. On the other hand the LDC has to import machineries and secondary goods. In this way a dependent or center periphery trading relationship is established. This relationship is characterized by the dependence of the periphery (underdeveloped) on the center (developed). (Frank, 1992, 125-139; Dos Santos, 1970) Towards a New Policy by LDCs: FDI and Technology Transfer Now we consider the case from a different perspective. Once the countries like Brazil, Argentina, Peru etc and other developing countries with large size are entrapped in the quagmire of the declining terms of trade they require thinking some alternative way out in an open economic system to solve the problem of declining terms of trade. There are different economists with different policy prescriptions. There are some groups of economists who argue in favor of Foreign Direct Investments (FDI) to be an optimum solution of the economy – “Foreign direct investments have played an important role in many but not all of the most successful development stories in countries such as Singapore and Malaysia and even China” (Stiglitz, 2002, 67). According to their version while an underdeveloped economy adopts the policy of allowing foreign direct investment in the country it would supplement the domestic saving and utilize its productive capacity efficiently. Moreover, the import export gap can be wiped out by the foreign direct investment. The foreign direct investment can transform a primary good exporting country into a secondary good exporting country by the transfer of technology and technical knowledge by providing training. Hence the economy may face a sustained growth by the impact of liberalization. This was theoretically proved by the work of Jones. (Jones, 1965, 551-572) The course of development of different countries bears testimony to the immensely important role of inflow of foreign capital (in form of foreign direct investment and technology transfer) in the process of economic development. Since the mid 1970’s it is found that the foreign capital in the form of direct foreign investment has contributed to technology transfer and fostered export growth in the economies like Brazil and Mexico. Shift of focus: Towards Competitive advantage In the recent times, the emphasis has shifted towards firms rather than countries. Porter suggests that the firms of a country decide the specialization and patterns of trade. Unlike the orthodox trade theory which focuses mainly on the differences in factor cost and relative factor endowments in producing the same good in different nations, competitive advantage focuses on technological change which can change the factor intensity and status of factor scarcity of a particular line of production in a nation very fast. The role, played by economies of scale, differentiation of products and differences in consumer preferences have not been attended with enough importance. Again the assumptions on which the traditional theory of trade is based on have been invalidated to some extent by the changes brought about by globalization. Globalization indicates that firms compete not on a national but on a global scale. They try and find lowest cost locations and shift their production base accordingly while sell in the world markets, which yield high profits. Whether a nation is capital intensive in a line or production or capital scarce is not a constraint on a firm because it can raise its capital from anywhere in the world. It is at this point where the role of FDI comes. Therefore instead of considering comparative advantage, one should consider competitive advantage enjoyed by firms. To project it straight, competitive advantage of a nation is judged from the level of success of MNCs in that nation and why the MNC has not been able to achieve that same level of success in any other nation. Given a set of choices if an MNC is successful in nation ‘A’ (say) compared to the others then ‘A’ has a competitive advantage over the other nations in that particular line of production. The strategies employed are product differentiation, economies of scale and technological innovation. The process of competition is dynamic rather than static and certain firms will fail in areas where others will see success. Again a nation might lose or develop competitive advantage in a particular production line depending on the response of the firms in that nation. The factors determining competitive advantage are: Factor conditions: a country needs to have proper infrastructure facilities for the foreign firms to invest and a pool of skilled labor. This will help the nation attract FDI and invite foreign firms to set up offices Demand conditions: The demand conditions at home might be able to provide incentive to the production of a particular commodity. Related and supportive industries: supplier and relative industries present in a country make sit internationally competitive in that line of production. Firms’ strategy, structure and rivalry: the distribution of firms in an industry, their organization and management are responsible for the competitiveness of the nation. (Grimwade, 2000, 156-158) Concluding remarks: Chance and governments also play a role in the framework suggested by Porter. Chance may refer to the declaration of an emergency, a sudden outbreak of war, an unexpected invention, etc and government policies might also affect the competitiveness of the nation. Porter’s theory may be structured therefore in a framework, which is popularized as the ‘diamond of national competitive advantage’. The competitive advantage approach draws its strength from the fact that firms have a place of importance rather than nations. However this theory does not make the nation insignificant either. The success of the nation depends on the success of the firms producing the particular product. The increasing level of outsourcing in recent times especially the US firms outsourcing to India, prove the validity of his theory. The development of the modern day’s MNCs has led to another form of trade known as intra firm trade where exchanges take place within firms. Although comparative advantage still exists, it is actually the competitive advantage of the firms, which determine the patterns of trade and specialization trend. References 1. Baran, P. A. 1957. The Political Economy of Growth: New York Monthly Review, 1968 2. Caves, R. E. Frankel, J. A and Jones, R.W. 2002. World Trade and Payments. London: Pearson Education 3. Dos Santos, T. 1970. The Structure of Dependence: American Economic Review, 60 (2), May 4. Frank A. G. 1992. Latin American Development Theories Revisited: A Participant View; Latin American Perspectives. Issue-73. Vol, 19. No. 2, Page: 125- 139 5. Grimwade, N. 2000. International Trade: New Patterns of Trade, London: Routledge 6. Husted, M. and Melvin, S. 2007. International Economics, London: Pearson 7. Jones, R. W. 1965. The Structure of Simple General Equilibrium Models; Journal of Political Economy, 73: 551-572 8. Stiglitz, J. 2002, Globalization and Its Discontents, New York: Norton and Co  9. Todaro, M. and S.C. Smith, 2008. Economic development, London: Longman group 10. Wykstra, R. A. 1971, Introductory Economics. New York: Harper & Row 11. Read More