Ricardian Trade Theory and Development - Essay Example

Ricardian Trade Theory and Development Introduction Ricardian trade theory explains why nations engage intrade given that some enjoy absolute comparative advantage over other countries. According to Ricardo, comparative advantage does not necessitate exchange of goods, but it is the opportunity and marginal cost of production that determine what a nation can trade relative to other countries. In addition, the Ricardian theory takes into account the size of the country as a contributing factor to the difference in trade volumes among nations. Moreover, technology change ensures import technical knowledge that minimised the cost of production. The theory explains the effects of technology transfer, as well as income distributions and innequlity. Ricardian Trade Theory The Ricardian trade theory assumes that trade happens between two nations. He distinguishes them as the home and the foreign countries. He further argues that these nations are characterised by competitive market and firms produces homogenous goods. The theory hypothesis labour as the only factor of production and that it is mobile within a nation, but immobile to foreign countries. Ricardian trade theory corrected Adam Smith ideas that trade between nations occur only when each country has comparative advantage in production of goods that other do not have. Therefore, issue of absolute comparative advantage does not give one country advantage over the other (Dwivedi, 2002, p. 579). This was wrong, and Ricardo proved that two countries could have gainful trade even if one has a comparative advantage for all goods except one. Ricardo argued that absolute advantage or disadvantage does not always hinder trade. Thus, countries can engage in trade even if they have comparative advantage in productions of commodity (Dwivedi, 2002, p. 580). However, the theory presumes that a country produces products that it has comparative advantage and which it has minimal opportunity cost over other production line. This situation allows for specializations that lead to increased trade and innovation in new technology. In discussing technology, Ricardo argues that it enhances the production of commodities. However, he disagrees that technology transfer alters the comparative advantage of the rich country. Ricardo assumed that, even if there were technology transfer, the importing country would continue to specialize in non-technological industries. Thus, technology transfer does not shift change a countries main production units. This is similar to the proposition of immobility of labour. However, these are the flows of Ricardian trade theory. It is evidenced that technology transfer can lower the cost of productions. Thus, agricultural nations can become industrial hub through by use of innovative technology. This is what happened to Europe when the continent established trade ties with America. Ricardian trade theory suggests that there is only one factor of production, labour. The others including capital and land are assumed insignificant in Ricardo model. Moreover, Ricardo assumed that all countries has a homogenous labour supply (Dwivedi, 2002, p. 580). In addition, Ricardo assumed that the supply of labour is constant, and countries operate at full employment. However, this is not the case because countries produce at below average and few operate at full employment. Ricardo used the labour theory of value to support the trade theory. He argued that the value of commodities and the exchange rates are determined by the cost of labour. The theory fails to take account other costs involved in the production process. Moreover, it presupposes that the prices of goods are determined by the hours of labour utilised to produce say a pair of shoes. For example, if company X produces a pair of shoes in 2 hours, while company Y produces the same pair of shoes for 4 hours, then company X has a comparative advantage over company Y. Thus, the difference in the labour cost determines the prices of goods and the exchange rates for trade between nations. However, the theory draws criticism because it disregards other fundamental factors in determining the price of goods. For this reason, the Heckscher-Ohlin theory of international trade details the circumstances of trade between countries (Subasat, 2003). Heckscher-Ohlin model argue that countries engage in trade because of dissimilar factor endowment. The developing countries trade labour intensive commodities for capital goods from developed countries (Subasat, 2003, p. 151). This differs with the Ricardian trade theory. Ricardian trade theory presupposes a two countries two-commodity scenario. For example, England and Germany, which produces, wine and shoes. Thus, assuming that England efficiently produces both wine and shoes, then it has an absolute comparative advantage. However, this does not mean that Germany will be importing both wine and shoes from Germany. Ricardo disapproves absolute comparative hypothesis as it discouraged trade between countries. He questions what will happen if one country export all of it goods without importing. To address the problem, Ricardo figures out on the concept of opportunity cost. He argued that nations with absolute comparative advantage would lose considerable output when they produce all of their commodities. However, if nations specialize in commodities that they are better off compared to other countries, and then trade would be viable. Therefore, opportunity cost is the cost of the forgone opportunity in production of goods and services. Table 1 Labour Cost Country Wine Shoes England 25 50 Germany 52 70 In England Thus, 1 unit of wine requires 25 unit of labour while 1 unit of shoes requires 50 unit of labour. In Germany Conversely, production of 1 unit of wine requires 52 units of labour and a pair of shoes consumes 77 units of labour. Thus, the opportunity cost of producing a unit of wine in England is 25/52 (0.48) while the opportunity cost of producing it in Germany is 52/25 (2.08). On the other hand, the opportunity cost of producing a pair of shoe in England is 50/70 (0.71) while marginal cost of a pair of shoe in Germany is 70/50 (1.4). Thus, considering the data, it would be efficient for England to produce wine and import shoes from Germany than producing both commodities. On the other hand, it would be efficient for Germany to produce shoes given that it has a lower opportunity cost compared to production in England. Therefore, Ricardo argued that absolute advantage does not govern the conducts of international trade, but rather the concept of opportunity costs supersede that of comparative advantage. However, Ricardo assumed that trade can only be possible when it is free from any interferences. To this end, Ricardo trade theory is justifiable given that the world thrive in a capitalist completion free from government control. The controlled economies corrupted and vilified free market economy. Effect of trade on inequality in developing countries Ricardo argued that free trade allocate resources equitably. However, this idea seems to contradict the real situation in the world. The nations of the world are divided into two groups, the developed comprising the rich nations and developing countries. Nevertheless, trade has increased since the start of trade liberation in the 1980s (Meschi & Vivarelli, 2007, p. 1). Ricardian trade theory also suggests that trade among nation is supposed to reduce the income disparities among developing nations. However, though he argued for fixed labour, he supposed that technology is mobile. For this reason, there has been increased technology transfer from the developed country to the third world nations. This has reduced the cost of production by and thus increased income for industries while leaving people with low incomes. Thus, technology transfer has widened inequality among poor countries. However, some scholar argues that increased trade minimised inequality among developing countries. They say that trade rewards unskilled labour with higher wages without affecting the wages of the skilled labour force. In this case, trade help in bridging the gap between the rich and the poor. This is the case with Brazil, the largest developing economy (Green, et al., 2004). Moreover, the inequality between nations has reduced significantly. However, it has widened within developing world. In the last two decade, Sub-Saharan Africa Gini index increased by 9% compared to China, which increased by 34% for the past 20 years (Williamson, 1997). This contradicts Ricardo predictions. According to Ricardo, poor countries are expected to experience higher wages for the unskilled labour. This is because it is highly demanded in the local market while high-skilled labour would be less demanded given that their demand is in the developed world. This is the case with Europe in the 18th Century (Rourke & Williamson, 1999). The start of the trade between America and Europe decreased inequality that has characterised Europe for many years. The similar situation has not happened to develop countries in the 21st Century (Rourke & Williamson, 1999). The Ricardian theory, therefore, is limited to explain the effect of trade on inequality in developing countries. The assumption does not suit the current trend in local and international trade. Ricardo preference on free trade may be the reason for increased inequality in developing countries. The small company in the third world nations do not compete competitively with international companies. Therefore, the multinational only exploit cheap labour to produce goods and services in foreign nations at the expense of local companies. If Ricardian trade theory were to hold, developing countries would thrive in agriculture and other labour intensive industries (Rourke & Williamson, 1999). Conclusion Ricardian trade theory has stood the test of time until the 19th Century. However, its application has been challenged because of the flows of its assumption. It has drawn criticism from liberalism for lack of explanation to the increased inequality within a nation and exclusion of capital and land as factors of productions. Moreover, the theory lacks account of the effect of transfer of labour. These challenges need to me revisited to understand well the issue of trade among nations as well as within country borders. References Dwivedi, D. N., 2002. Microeconomics: Theory And Applications. New Delhi : Pearson Education. Green, F., Dickerson, A. & Arbache, J., 2004. Trade Liberalisation and Wages Developing Countries. Economic Journal, 114(493), pp. 73-96. Meschi, E. & Vivarelli, m., 2007. Trade Openness and Income Inequality in Developing Countries. CSGR WOrking Paper Series 232/07, July, pp. 1-35. Rourke, K. H. & Williamson, J. G., 1999. THE HECKSCHER-OHLIN MODEL BETWEEN 1400 AND 2000: WHEN IT EXPLAINED FACTOR PRICE CONVERGENCE, WHEN IT DID NOT, AND WHY. NATIONAL BUREAU OF ECONOMIC RESEARCH, November, pp. 1-41. Subasat, T., 2003. What Does the Heckscher-Ohlin Model Contribute to International Trade Theory? A Critical Assessment. Review of Radical Political Economics, 1 June, pp. 148-163. Williamson, J. G., 1997. “Globalization and Inequality, Past and Present,” World Bank Research Observer 12, pp. 117-35. Read More