The Law of Comparative Advantage - Literature review Example

The Law of Comparative Advantage An Answer to Mercantilism The theory of the comparative advantage can be thought of as an answer to an economic philosophy developed in the countries of England, Spain, France, Portugal and the Netherlands around seventeenth to eighteenth century: the mercantilism. Composed of merchants, bankers, government officials and philosophers, the mercantilists believed that the way to a nation's wealth and power is to export more than it imports (Salvatore). The economic goal of the country, then, is to have an export surplus which will be a gain in terms of precious metals such as gold and silver. In a sentence, mercantilists believed that one nation can only benefit from trade at the expense of other nations, so that economic nationalism would involve government control of all economic activities such as import restrictions. Because the theory failed to understand the laws of absolute and comparative advantage, which advocates that trade, may not necessarily be a zero-sum game, mercantilists regulations were gradually removed in Britain in the course of eighteenth century after the government has fully embraced Adam Smith's concept of laissez faire (Wikimedia Foundations, Inc). An Enhancement of the Theory of Absolute Advantage The greatest challenge to mercantilism was Adam Smith's theory of absolute advantage. It is said that Smith's publication of the book The Wealth of Nation in 1776 has ended the rule of mercantilism as an economic philosophy. In contrast to the necessity of government control in the mercantilists' philosophy, Adam Smith advocated the laissez faire system, with limited government intervention in the economy. Particularly, Smith believe that trade would be beneficial to both countries through specialization. In practical terms, when one country is more efficient than another country in the production of one commodity but is less efficient in the production of another, then both can gain by specializing in the commodity in which it has the absolute advantage. This would create surplus production which in turn can be traded for the surplus of the other country. According to Adam Smith, this system would increase production of both commodities which will benefit all nations involved in trade (Salvatore). As trade is deemed beneficial to all, restrictions are discouraged and limited government intervention is advised. An Unchallenged Theory An enhancement and definitely a higher notch than the theory of absolute advantage is the law that says that one country can benefit from trade even if it is less efficient in the production of both commodities. It is the law of comparative advantage: an impetus for small nations to actively participate in trade as it is believed to benefit both the big and the small countries. Introduced by David Ricardo in 1817 through his book On the Principles of Political Economy and Taxation, comparative advantage posits that trade can create value for both countries even if one has the fewer resources in the production of all goods. Using the production possibilities frontier, Ricardo was able to prove this, achieving a significant breakthrough in the field of international economics. Practically, Ricardo believes that given the situation, both countries can still gain by having the less efficient country specialize in the production and exportation of the commodity in which its absolute disadvantage is smallest and import the product in which it has its greatest absolute disadvantage. The commodity in which one country has the least absolute disadvantage can be thought of as one in which it has the comparative advantage. The gains are realized as both countries specialize in the production of commodity in which it has the least opportunity cost (Mankiw). The Gains from Trade: A Simple Numerical Example To facilitate understanding of the gains from trade, we cite the example from the Principles of Macroeconomics book of N. Gregory Mankiw. Given that it takes 20 hours for farmer to produce 1 lb of meat and 10 hours to produce 1 lb of potato, and 1 hour for rancher to produce 1 lb. of potato and 8 hours to produce 1 pound of meat, we construct the table for a 40-hour work schedule. Source: Mankiw, N.Gregory. Principles of Macroeconomics. Orlando, Florida: Harcourt Brace College Publishers, 1998. Obviously, the rancher has the absolute advantage in the production of both meat and potatoes. The rancher may advice the farmer to produce potato alone, while he does meat production at longer hours than production of potato. The table below shows the beneficial trade between the two. Source: Mankiw, N.Gregory. Principles of Macroeconomics. Orlando, Florida: Harcourt Brace College Publishers, 1998 In this particular example, the rancher (assume this represents one country), decided to work on cattle raising for 24 hours and 16 hours on growing potato, while allowing the farmer to work on potato production the whole time. The terms of trade says that the farmer needs only 1 pound of potato to compensate the rancher for 3 pounds of meat. This leaves only 3 pounds of potatoes for the farmer since his total produce after 40 hours is 4 pounds of potatoes. His consumption of meat however is added by 3 pounds which all came from the production of the rancher. In total, the farmer gets 3 pounds of meat and 3 pounds of potatoes, giving him a gain of 2 pounds of meat and 1 pound of potato compared to not trading at all. If this has become beneficial to the farmer, will it also be beneficial to the rancher The theory of comparative advantage says that yes, it can benefit both, even if one has the absolute advantage in both commodities. The table shows that trade earns the rancher 1 pound of potato, while losing 3 pounds of meat. Is this trade disadvantageous to the rancher No! Looking at the table, we will see that the rancher was able to gain 1 more pound of meat and .5 pounds of potatoes now that he has traded. These figures can be easily verified by comparing the consumptions without and with trade. Assuming the countries will only be willing to enter into a trade agreement if it makes them better off, this model shows that trade indeed seems attractive to countries (Simon Bromley). In a high-income and low-income country comparison, the book, Making the International: Economic Interdependence and Political Order highlighted that in a two-commodity example of food and pills, specialization will benefit both as each will be producing the commodity with the least opportunity cost, simply saying that trade can help increase income for the low-income countries (Simon Bromley). An Asian country, Bangladesh has apparently benefitted from its clothing industry. The country has apparently experienced an enormous expansion of its clothing industry when it was opened to trade in other countries with the largely developed countries as its market (Audio program 1 (2004) Trade and state). The Application in the Real World To distinguish the gains from trade of each country, it is very important to know the terms of trade. It is simply defined as the price of a country's exports relative to its imports (Simon Bromley). It is such an essential thing so that even if in terms of volume one's production is comparable to its imports, a relatively lower price for its products would mean that its exports would not be enough to cover for its imports. The effect of declining prices can affect the developing countries much more than the high-income countries. This is due to the fact that the products in the high-income countries are diversified so that a reduction in the price of one of its products can be offset by the gains in other products (Simon Bromley). On the other hand, the low income countries have relatively narrow product variety, which divests them of a cushion in case one of the prices declines sharply. A real-world example of this was the sharp decline of coffee prices in the world market in the years 1995 - 2000. The decline was more than 50% in 10 of the 14 least developed countries, giving a stain to the promise of free trade which is supposed to uplift the lives of these farmers. Since most coffee is grown in agricultural developing countries, it is them that were hurt the most. Some of the countries hurt by the decline in coffee prices are Nicaragua and Colombia. The plummeting of coffee prices in some provinces in Colombia has left children starving has endangered progress promised by trade (Jeffrey). Promising as it may seem, the world has witnessed the excellence of the theory of comparative advantage. The belief that free trade will benefit all countries, even and especially the poor ones have in a way given hope to those who are aiming for development and progress. It is inevitable though to witness mass rally against globalization and free trade, especially in the low income countries, the party that should theoretically be gaining the most from the trade, not just in terms of monetary returns but a chance to uplift their lives and their spirits. Why does the WTO find a lot of opposition rather than support from a lot of people, even from the high-income countries Examining where the theory has failed and answering why the promise of all-winner status has failed so that there remains to be losers, and worse the losers are those who have had less from the beginning Integrating both Economics and Political Science as disciplines sheds light to the real world scenario. Basically, we see that even though the International system might seem diverse, it is structured with power and inequality (Audio program 1 (2004) Trade and state). Who Losses and who gains from the trade The apparent power and inequality that each trading country exhibits is shaped by its history. Some very important factors of production such as machineries and equipments are not considered initial endowments, rather they are a product of the country's effort to invest, which are shaped over time (Simon Bromley). Therefore an understanding that the theory of comparative advantage is not s static, rather a dynamic one, which changes over time and influenced by the countries' efforts and policy would be a key in analyzing the likely losers and gainers from trade (Simon Bromley). Economists would often use the term, leveling the playing field to mean that the countries are not on the same level in terms of resources. Simply put, those who have the advantages of being able to produce more given its history of investing in machines and technology, and those who are dynamic to adjust to the needs of free trade stands at an advantage and are likely to be winners in trade. The Necessary Adjustments Given that the comparative advantage is a dynamic model, what are the necessary adjustments needed by countries to ensure its success Even if the exporting country is low income, it can gain from free trade if it has large number of population who are willing to move production (despite its lack of capitals) and there is a proper backing of industries needed in exporting the goods (Simon Bromley). On top of all the economic theories, the success of trade would lie on the strength of the country's political system to initiate changes where changes are necessary, even though they are unpopular and face strong opposition (Simon Bromley). There are losers and winners of trade within a country and automatically this will create conflict of interest. The infant industry argument for example is one of the most widely used excuses for liberalizing trade, with the excuses of local industries to compete with established foreign brands. A strong republic would be able to still powerfully initiate the change necessary and challenge its local industries to face the competition. The losers from trade can be a small group in a country or can be the entire economy (Simon Bromley). Countries might find itself in a poverty trap. This is so because the bulk of the produce of the country are non-oil products which are not necessarily drivers of growth. With this situation, Bromley suggested than countries be more eager to rapidly expand diverse market for manufactured goods rather than primary commodities. Works Cited Audio program 1 (2004) Trade and state. 2004. Jeffrey, Paul. "NCR Online." 7 February 2003. www.natcatch.com. 2009 March 07 . Mankiw, N.Gregory. Principles of Macroeconomics. Orlando, Florida: Harcourt Brace College Publishers, 1998. P. 48-52 Salvatore, Dominick. International Economics. New York: Macmillan Publishing Co., Inc., 1983. P. 16-19 Simon Bromley, Maureen Mackintosh, William Brown and Mark Wuyts. Making The International: Economic Interdependence and Political Order. Virginia, USA: Pluto Press, 2004. P.46-64 Wikimedia Foundations, Inc. www.wikipedia.org. 5 March 2009. 6 March 2009 . Read More