COMPARATIVE ADVANTAGE ON INTERNATIONAL TRADE

COMPARATIVE ADVANTAGE ON INTERNATIONAL TRADE

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Introduction

Most countries maintain a liberalized external trade. Trade is as old as civilization itself, but it is the most dynamic aspect of the economy. The existence more trade opportunities across the world resulting from technological aspects and availability material, has led to disparity in the efficiency of production of good among countries.  Competitive advantage is a theory developed by David Ricardo in 1817 with an aim of explaining why individuals, firms and nations engage in external trade. Ricardo’s theory is about potential trade gains that rise from disparity in technological advancement or factor of endowment (Andrea 1998, p.67). In Ricardo’s concept, a nation or a firm can have a comparative advantage if she can produce a certain good at a lower relative autarky price like lower marginal cost. The theory does not put much consideration on the actual cost of production but to the opportunity cost. Comparative advantage has been applied by most firms and nations for a century. Although it is often related to absolute advantage, it is independent from any other theory.

The heckscher-ohlin theory is a variation of Ricardo’s theory was developed by Eli huckster who was a Swedish economist. It states that a country will import goods or services that use its abundant factors intensively and export goods that use its scarce factors extensively. The assumption of the theory is that two countries are equal except for differences in resources.

Comparative advantage occurs when country A produces goods and services at a lower opportunity cost than country B. The comparative advantage theory states that if countries specialize in producing goods where they have a lower opportunity cost then there will be an increase in economic welfare. On the other hand even if one country is efficient in production of all goods (absolute advantage) than the other, the two countries can gain by trading with each other so long as they have different efficiencies.

How the theory of Comparative theory forms the basis of international trade

No country or region is going to be left out in international division of labor; for the law states that even if a country is poor she can still trade. In this regard, this paper further focuses on reviewing Ricardo’s theory juxtaposition ally with Eli huckster and discuss its applicability in the modern trade fare.

Assumptions and weaknesses of Ricardian theory

The most dominant assumption of Ricardian theory is the assumption that two countries produce a certain product, both countries using only labor as a factor of production. There are significant aspects like technology and raw materials that may have significant effect on the cost of the final products. The theory also assumes that all nations maintain a liberalized external trade where trade is no tightly pound by government regulation and treaties. Countries may produce goods cheaply but the cost of trade may be way too high to the point where goods are no longer price competitive. Governments have favored local brands by heavily taxing imported cheaper goods. This regulation makes the model to fail achievement of anticipated results. Ricardian model assumes that labor is heterogynous across countries but homogenous within a nation.

Another assumption is that the goods here dealt in are homogenous.  In today’s industry that is driven by invention and innovation, goods have lots variation. Ricardo’s assumption that goods can be transported freely and costless across nations (suranovic 2013, p.98) can hold for neighboring nations but where voyages are long across the seas, the assumption if taken cannot show a true picture. Cost of transportation sometimes cost more than the entire cost of production. In a classical trade situation, the cost will include exportation expenses like transportation and custom duties.

Another assumption is that labor and be freely relocated around the country across industries. Product market is also assumed to be perfectly competitive in both nations. Firms are assumed to make maximum profit while workers maximize utility.With lengthy specialization of production of certain product, the nations will meaningfully engage each other in trade.

Results of Ricardian model

Monetary cost of producing goods is into considering ration.  When the opportunity cost is the base of decision making, it means that results are immediate and specialization (maintaining production of certain product). Within a free trade, a nation or a firm (agent) produces more that he can consumes less of good to which he got a comparative advantage (Dixit, Avinash and Norman 1980, p.103). Ricardo in his theory suggested that if two nations engage in business, even when one nation has capabilities of producing  all items cheaply that than the other, the consumption exponentially goes up for the two nations (O’sulivant Arthur 2002, p.54). In the short run, increased in consumption is evident. The ultimate effect is specialization and economic status improvement. Ricardo pointed out that comparative advantage is the motive behind external trade.

If a country receives a higher price for a comparative good, then it may want to specialize in that particular good. This will force labor to move from the disadvantaged industry to the comparatively advantaged industry. For that reason one industry in a particular country has to go out of business. But then the workers will be immediately employed in other industries.

When opening free trade, no matter how superior one country is in technology it is not a guarantee of continued production of a good. In that regard a country must have a comparative advantage rather than an absolute advantage in order to be able to assure continued production.

Comparative advantage may survive in another country while it completely doesn’t work in another country, even though the workers in the other country have low wages. It implies that low wages in a particular country in a particular industry is not enough to let us know which countries industry will perish. So free trade may not result in industry decline simply because the firms pay their workers lowly. In the case of the Ricardian model trade is always a win-win scenario. Everybody benefits from free trade. From the below example;

Cost of production (labor time)

Country a	Country b
Glass(1 unit)  1 hour	2 hours
phones(1 unit) 2 hours	6 hours

Comparing the two countries, country A and B, country B is productively inefficient. Its workers will need a lot more time to produce a unit of glass. This may result from a number of reasons. Country A has absolute advantage in production of both goods.

Significance of Ricardian model in international trade

Adam smith in his 1776 book the wealth of nations alluded the principal of comparative advantage model. Comparative advantage model has a bigger role in today’s international trade.

"If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage. The general industry of the country, being always in proportion to the capital which employs it, will not thereby be diminished ... but only left to find out the way in which it can be employed with the greatest advantage" (Smith 1776, p.56).

Later in 1817 Ricardo published his theory in the book on the principles of political economy and taxation. The theory is commonly known as comparative model theory. International trade is guided by principles conforming to the comparative theory and the effects of such economic engagement are specialization, increased consumption and improvement of life standard. 

Critical Analysis

With current advancement in technology, labor is no longer a major factor of production because machines have replaced humans. Labor forms a very small portion of input.  Without considering aspects like technology independently may not give a true perspective of opportunity cost especially one technologically advanced nation is compared to a third world country. Although labor may be cheaply available in developing countries, the introduction of machines into production of goods May create an imbalance that give an absolute advantage to the technologically processed country.  Absolute advantage will give results that are more immediate and the anticipated results of Ricardo’s model will be overtaken. Maximizing total output in the world we should either, employ fully all resources, allocate the resources to each other countries industries, and allow the allocated countries to freely trade.

Ricardian model in contemporary world

Dynamics in trade in today’s world and advancement in technology that affect labor, to some extent weakness the labor base that Ricardian model is dependent on. The assumption that goods move freely with no cost across borders of the two nations engaging in free trade, is not a common phenomenon because governments have their own interests including protection of their local companies and this may translate to higher taxes to imported goods. A nation can engage in free trade with any nation despite the industrial development of one nation.

Some modern technology is a replacement of human labor and should therefore be put into consideration by any model that seeks to represent the contemporary business environment. Although most nations are engaged in a free trade, interests of agents and governments affect the terms of engagement, and therefore the principle of free liberalized external trade may not uniformly hold across the two nations.   Treaties signed by governments also affect terms of engagement and keeping a pure comparative model environment is difficult. Technological disparity has been defended by that countries do not compete in international market. Technology increases efficiency hence high quality and low price.

Heckcher-ohlin theorems assumption

The critical assumption that has been translated into a weakness is thetwo countries engaging in trade are equal in technological; and labor intensity but different in resource endowment. This assumption hold presumed that after the World War II, all countries will have the same technology. This is not the case in the contemporary world and there is a big disparity in technological advancement. The price of capital intensive products in the country with abundant country will be lower compared to prices of goods in the other nation and the price of goods in a labor abundant nation will be lower that goods in capital abundant nation.

Results of Heckcher-ohlin theorems

After the two nations open a free trade, firms will take their products to the market. The market price will be initially higher and the end is that, the labor intensive goods will be exported by the country with abundant labor and the nation with abundant capital will export goods of intensive capital.

Heckcher-ohlin theorem in contemporary business environment

Heckcher-ohlin theorem do not  contradict any economic models and has not had a lot of criticism but in contemporary business environment, countries with abundant capital  do not necessarily import labor intensive goods as found out by Wassily Leontief in 1951. United States of America despite being the most capital abundant country in the world did not import labor intensive goods but actually exported labor intensive and imported capital intensive good (Leontief  1954, p.69). This contemporary situation contradicts heckcher –Ohlin theory. If labor is however divided to skilled and unskilled, the theorem becomes more reliable.

Conclusion

Ricardian model can be easily dismissed because of its assumption; only two nations engaging in trade, a perfectly competitive market while there are many industries and assuming only one factor of production.  The model was developed when there was no technology that could replace human labor and the dynamics of trade and arrival of new products make the principal inapplicable in the contemporary business world. Today’s external trade is motivated by thing which differs from the expectation of Ricardian model. New motive may include balance of trade and balance of payment, fulfillment of treaties and agreement. Change of nature of goods and purpose of businesses has made the Ricardian model inapplicable especially where technologically advanced nations are involved.

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