Comparative Advantage in Economics - Essay Example

Comparative Advantage Introduction Comparative advantage is used in economics to refer to a party’s ability to produce a certain service or good at a diminished opportunity and marginal cost over the other (Karp, 2005). There are cases where one country may be more efficient in total production of goods compared to the other, which is known as absolute advantage. Even in such a situation, both countries stand to benefit from trading with one another as long as their relative efficiencies are different. Gains from trade are the net benefits each country enjoys from bilateral trade. Comparative advantage theory is one of the most important concepts in the theory of international trade and is first mentioned by Adam Smith in his book ‘The Wealth of Nations’. He implied that it is better to buy a commodity from another country if it would cost less than manufacturing it locally, giving the buyer some advantage. According to Deardorff (2005), David Ricardo formulated the law or model of comparative advantage. The ‘Ricardian model’ was formalized through a simple but compelling numerical example investigating in detail the relative/alternative opportunity as well as advantages, which involved Portugal and England. This was outlined in his book ‘On the Principles of Political Economy and Taxation’ published in 1817. Portugal has potential in cloth and wine production using less labor as compared to producing the same amounts in England. Remarkably, production’s relative costs for the two commodities differ in both countries. Wine production is difficult in England but cloth production more viable. Portugal has ease of production for both commodities. Portugal can produce excess wine and trade it for English cloth. The cost of cloth in England is covered by the cheaper price at which, England obtains wine from Portugal. The conclusion here is that each country stands to benefit through specialization in the good over which, it has comparative advantage by trading it for the other. Article Review Arnaud Costinot (2009) proposes a simple theory to relate to the origins of comparative advantage through international trade where endogenous productivity differs across countries. His core analysis is in determinants of division of labor. Considering a world economy that is composed of two countries that have a continuum of goods as well as a single production factor, which is labor, he asserts that complexity characterizes each good. This complexity in short is the number of tasks to be performed for production of a single unit. Performance of every task increases returns to scale creating gains because of specialization coupled with uncertainty in enforcement of every contract that creates costs of transaction. Free trade provides that countries with larger teams should specialize in goods that are more complex. Costinot (2009) comes up with a model where the country specializing in complex goods has larger human per worker capital and product of institutional quality. This denotes that the country will have comparative advantage in complex industries complemented by workers that are more educated and are from better institutions. The premise of this analysis is that largely the division of labor determines productivity. Division of labor is determined through channels whose emphasis is on two forces, transaction costs, as well as benefits from specialization (Costinot, 2009). Comparative advantage is gained in this model by the country with a better workforce in addition to possessing good technology for production of complex commodities. This proves that on top of aggregate factor endowments, dispersion of factors such as skills and specialization are sources of comparative advantage affecting trade flows across countries. According to Alan V. Deardorff (2005), comparative advantage plays a role in a Ricardian trade model, which has intermediate inputs. Where such exist, there are several ways of defining and gauging comparative advantage depending on whether the basis of comparison is choice of prices, labor requirements for every dollar of added value, or total production costs for the commodities. It is easy to derive standard predictions pertaining to patterns of trade in terms of comparative advantage by utilizing actual prices prevailing with trade and value added to the goods. The implication of these factors is on patterns of specialization whose basis is ‘chains’ or rankings of comparative advantage. The hindrance that renders these comparisons less informative than in Ricardian models, which have final goods only, is the lack of price stipulation and dependence on barriers to trade. Deardorff (2005) asserts that trade patterns where intermediate goods are involved are very sensitive to costs of trade. This makes any form of comparison that predicts trade in certain goods to be somewhat minute. Despite this, gains from trade are more defined or specified in such Ricardian models where imported inputs act as additional sources of gain from trading. Intermediate inputs account for the split in processes of production across international sites through means such as FDI (foreign direct investment) and outsourcing. It is against this background that their role cannot be under estimated especially in the current international trade with comparative advantage forming the core of trade dealings among countries. Bernard C. Beaudreau (2011) is of the opinion that the concept of comparative advantage is operationally and empirically weak even though it is pitted as trade theory’s cornerstone. The articles on comparative advantage have done little to describe it in detail aside from testing and measuring it thoroughly. In examining the problem associated with comparative advantage, Beaudreau (2011) explores recent findings that touch on the implicit nature of trade and increasingly global value chains. He explores alternative modifications to defining and applying comparative advantage in international trade. The 2*2 model, which is the most popular and simplest, focuses on gains from trade in asymmetrical situations, not conducive to trade. The idea that a country can have absolute advantage and still engage the lesser country in gains from trade is not explicitly explained. According to Beaudreau (2011), vertically integrated multinationals and global value chains necessitate adjustment of conventionally measured and defined comparative advantage. Countries need to evaluate their weaknesses and strengths in light of heightened economic activity especially regarding trade. In lieu of vertical comparative advantage, horizontal comparative advantage for final products is deconstructed along lines of value chain (Beaudreau, 2011). Here, value chains get broken down into individual activities/links and analysis carried out on each. Vertical comparative advantage for a region or country gets to be defined with regard to specified links in value chains. Such could be endowment in different specific fields like research scientists giving the country vertical comparative advantage in the link of knowledge generation for most value chains. Richness in resource gives a country vertical comparative advantage in the link of resource extraction for relevant value chains. Larry Karp (2005) further explores the different aspects linked to comparative advantage in making the Ricardian model more credible by engaging sector-specific factors. His study reveals that recent research portrays imperfect property rights attached to natural resources pose as possible sources of comparative advantage. Weaker property rights are modeled as attracting labor, which is the single mobile factor, to the resource sector thereby increasing the comparative advantage for that country/region in that sector. In cases where capital is mobile as well, and benefits of capital cannot be excluded, deterioration of property rights produces ambiguous effects on equilibrium rental/wage ratio and comparative advantage. This is aided further if property rights degree is endogenous. Karp (2005) asserts that factor endowments as well as differences in technology are proven sources of comparative advantage in trade theory. In a resource intensive sector, weaker property rights weaken comparative advantage. The reason for this is that imperfect property rights to natural resources increase difficulty in capturing all returns to intermediate investments utilized in the sector. Most of the studies on comparative advantage use two-commodity models, two-country variants and labor as the mobile factor. The resource based sector has imperfect property rights resulting in excessive amount of labor. This translates to increased comparative advantage where all other factors held constant, the country with weaker property rights gets to export the resource based commodity. Robert Maseland and Albert de Vaal (2011) look at comparative advantage, which arises in development and trade when individual decision making is affected by poverty. They develop a two-sector model linking schooling decisions as well as production under poverty to analysis of standard neo-classical trade. Households decide whether to acquire skills or work depending on their attainment of subsistence levels of income. This implies that a country’s income level is important in establishment of trade patterns and comparative advantage. Liberalization of trade tends to be allocative efficient though it has to be timed well for determining the speed at which countries industrialize. Maseland and Vaal (2011) highlight instances where stalling liberalization of trade serves to develop the country industrially. According to Maseland and Vaal (2011), poverty has severe implications on trade and comparative advantage. Using a two-region model (North and South) where the North is endowed with more fertile land, they demonstrate comparative advantage through relative price of manufactures over food. With less fertile land, the South specializes in manufacturing and gains its comparative advantage then when trained labor stocks and training levels are equal. This may switch to food in case of unequal training possibilities. Using this model, they illustrate that comparative advantage develops over time with oscillations in different factors changing the nation’s comparative advantage until a steady state is achieved. The assertion made is that as long as growth in the exogenous (untrained) labor force surpasses outflow into trained labor (endogenous), then that country is bound to stay at the subsistence level. In this case, poverty plays a role in limiting economic choices for the masses depriving the country of comparative advantage. Discussion and Conclusion In analyzing the comparative advantage model, the primary concern is the effects of trade (Maseland & Vaal, 2011). These are outlined when a country moves from autarky or a position of no trade to free trade with another country or countries. The main points of consideration involve welfare effects individually as well as nationally, incomes and wages, each country’s consumption levels, patterns of trade (who imports and who exports what), levels of employment in every industry, goods’ production levels, as well as effects of trade on price of commodities in each country. Various models have been developed and are being used to portray that each country produces an amount of every commodity in autarky. Differences in technology mean that the two goods have different relative prices between the countries. The price of a country’s commodity in which it has comparative advantage is always lower than price of the same commodity elsewhere. For a country with absolute advantage in producing both commodities, real wages of workers (wages’ purchasing power) are higher in all industries as opposed to the inferior country (Costinot, 2009). This denotes that workers in countries with technological advancement automatically enjoy higher living standards because of basing wages on productivity. These differences in technology also affect prices directly and occasion trade in the Ricardian model. Firms that seek profit are apt to export the good, which fetches more revenue abroad or the one with a comparative advantage. Although, it does not imply that industries in less developed countries (LDCs) cannot compete at the international level. Comparative advantage in production of a commodity is necessary in guaranteeing continuous production in free trade, leveling the playing field for stakeholders in international trade. References Beaudreau, B. C. (2011). Vertical comparative advantage. The International Trade Journal, 25 (3), pp. 305-348. Costinot, A. (2009). On the origins of comparative advantage. Journal Of International Economics, 77 (2), pp. 255--264. Deardorff, A. V. (2005). Ricardian comparative advantage with intermediate inputs. The North American Journal Of Economics And Finance, 16 (1), pp. 11-34. Karp, L. (2005). Property rights, mobile capital, and comparative advantage. Journal Of Development Economics, 77 (2), pp. 367-387. Maseland, R. & Vaal, A. D. (2011). Trade, development, and poverty-induced comparative advantage. The Journal Of International Trade & Economic Development, 20 (2), pp. 153-174. Read More