Theory Of Comparative Advantage And Resource Allocation In Global Economy

Absolute and Comparative Trade Model

Theory of comparative advantage; how scarce resource are allocates, produced and consumed globally

The essay aims at discussing the allocation of scarce resources in the global economy. In this context importance of international trade is discussed and analyzed in light of existing and evolving trade theories.

International trade and resource allocation:International trade theories provide the basis for commodity exchange among different nations. The theory suggests trade between two nations initially guided by existing difference in cost of production arises due to difference in technology, factor endowment or any other factor. In order to make maximum utilization of resource eacg nation should speicialize in production in which is enjoys a cost advantage. When countries specialize in one particular good then it can produce the good excess of the domestic need (Baumol and Blinder 2014). This excess production should be exported. In exchange of exported items, nations import goods for which it faces a higher cost. The line of specialization explains trade patterns among nations across the globe. Different trade theories have evolved gradually by examining differenr trade pattern among nations.

Abolute and comparative trade model: Adam Smith suggested that interantional trade primaril occur following difference in cost of production in abosolute terms. The absolute advantage of a country is identified in terms of country’s ability to produce one good at a lower absolute cost than another country. Then this country should specialize and export this good in exchange of some other good that has a higher abosolute cost (Begg and Ward 2013). The following example can explain the abosolute cost differece and basis of trade between nation.

Suppose there are two nations China and Brazil. Each produces rice and Wheat using labor input. The table below summarizes unit of output for rice and Wheat produced using one unit of labor.

Output using 1 unit of labor	Rice (Units)	Wheat (Units)
China	100	50
Brazil	50	100

In China, 1 unit of labor can produce 100 units of rice and 50 units of Wheat. In Brazil, however 50 units of rice and 100 units of Wheat can be produced with 1 unit labor. The example shows China is able to produce more rice than Brazil using same labor input. China thus enjoys an absolute advantage in rice while Brazil has an absolute advanatge in producing Wheat.

The theory of absolute advantage is simple and easy to interprete. Nevertheless, the theory has a very limited use as in real world one nation might has a absolute cost advantage in all commodities.  In thius situation the dimension of trade is determined by difference in opportunity cost. David Ricardo pionnered the trade theory explaining trade pattern by relative cost difference (Cohen 2016). The theory of realtive cost differenve is known as the theory of comparative advantage.

International Trade and Resource Allocation

The example below expalins the theory of comparative advantage and trade relation between nations. The following table provides an hypothetocal situation where one nation has absolute advantage in both the goods and realtive cost ratios are considered to explain trade between the nation.

Output using 1 unit of labor	Rice (Units)	Wheat (Units)
China	20	8
Brazil	4	8

As shown from the above table, China has an abosolute advantage in production of both Rice and Wheat. China by using only 1 units of labor can produce more Rice and Wheat than Brazil can. Follwed from absolute cost theory, there is no frasible trade pattern. In such a situation the ratio of relative costs shuld be conidered to determine soecualization and trade.

Relative cost ratio	Rice (Units)	Wheat (Units)
China	8/20 =0.4	20/8= 2.5
Brazil	8/4 = 2	4/8=0.5

The table above showsthe opportunity cost that the two nations face in producing the respective goods. The production of 1 unit of rice in China requires sacrfice of 0.4 units of wheat. This is the opportunity cost of rice. The same for Brazil is 2. Therefore, it is beneficial for China to specialize in rice. The similar argument holds for wheat suggesting that Brazil must specialize in Wheat because of a lower opoortunity cost ( 0.5 < 2.5).

Ricardo showed that is is mutually beneficial for nations to specialize in goods in which it has a lower relative cost. With specialization resources are shifted to a particular industry enhancing efficiency of production.  It is seen that world output increases after trade providing a wide variety of goods for consumption (Grant 2013). The aggreagate welfare increases after trade.

The theory of absolute and comparative advantage are considered as two basic theories of trade. The theories are however are based on number of assumption most of which are unrealistic in modern world. The production cost is based on only labor cost in both the theory. In addition to labor, there are a number of factors that influence cost of production. Both the theory assumes labor is homgenous across nations. This is the most unrealistic assumption of the these theories. The ignorance of trasportation cost is another drawback the theory. 

The Heckscher-Ohlin trade model begins from the ending note of Ricardo’s comarative cost theory. The Ricardian theory states country trades depending on difference on relative costs. However, this theory does not exaplain origin of these cost differences. The H-O model suggests that the origing of comparative cost difference lies in difference in relative factor prices (Ito, Rotunno and Vézina 2017). The relative factor price again depends on avaibility of factor inputs.The factor that is abundant in a nation has a lower cost while the scarce factor has a relaively high factor price. The commodities are then classfied accordinf to relative intensity of factor and countries are categorized according to the abundance of factor inputs. The specialization is then determined by factor intensity of the goods and country’s relative abundant factor. For example, a labor-intensive nation should produce a good that is produced with a higher labor-capital ratio. Goods that involve high capital-labor ratio should be produced in a capital rich nation (Baldwin and Robert-Nicoud 2014)

Heckscher-Ohlin Trade Model

Any theoreticial model is subject to empirical test to make the model more realistic. Some contradictary trade pattern is found when HO model is tested using real world data. The contradictary trade pattern first found for United State. In 1947, industrial data of  US was used to identify trade pattern. Among the 50 sectors taken for testing purpose 38 sectors were involved in transaction in the international market (Simas, Wood and Hertwich 2015). The following result was obtained from analysis

Table 1: labor and capital requirement for producing export and import bundles worthing one million dollar

 

(Source: Kohli 2016)

K_X = a_Kx/ a_Lx = $14,300 (Exports)

Km = a_Km/a_Lm = $18,200 (Imports)

The finding suggested that espite being one of the capital rich nation of world the imports od US were more capital oriented than export did. The paradoxical trade pattern is known as Leontief paradox follwing the name of professor Wassily Leontief. The trade pattern of Canada also constitutes an inconsistency with H-O theory (Simas, Wood and Hertwich 2015). Canada’s exports are mostly capital intensive in nature and exports are mainly delivered to US market.

Another trade pattern popularizing in modern world is the intra industry trade among countries. This is the trade commodities belonging to same industries from one nation to another. The intta industry trade are again classified into three major groups – Trade of homogenous good, trade of horizontally differentiated goods and trade of vertically differentiated goods (Baldwin and Lopez?Gonzalez 2015). The high income economies often involve in intra-industry trade. US is one example of such economies. United State both export and imports autos. The table below summarizes some of the largest categories of import and export in US.

As shown from the table in the all the above mentioned categories US is both a substancial importers and exporters. As per Bureau of Economic analysis, in 2014 US imported  autos worth of $327 and exported the same valued $146. Intra-industry trade accounts approximately 60% share in US total trade (Mankiw et al. 2016). There are two main reasons exaplaining benefits of intra industry trade that is largely taking place in European Union, United States and Japan. One is benefits of division of labor resulting in innovation, learning and unique skills of existing labor force and other is benefits derived from economies of scale.

Raymond Vernon developed a theory to explain the pattern of trade that HO model has failed explain. The theory is widely known as Product Life Cycle Theory. Every product passes through four different stages – introduction, growth, maturity and decline (Besanko et al. 2013). At the intriductary stage the product is just introduced in the market. This stage is associated with a smaller profit and a small number of competitors. Gradually sales of the product increases raising competitors in the market. This the second stage. At the maturity stage the product has developed completely and has a large customer base. After reaching the saturation point the product enters in the phase of decline. This is the phase where the product has lost its economic feasibility (Tolentino 2017). According to product life cycle theory at the initial production stage labor and other necessary inputs belong to the area where it was invented. After passsesof time the product become known to the world market and move away from its origin. If might be the case that the orgin country itself becomes the importer of the product at some later stage of production. The model is particularly applicable to products that are labor saving and capital using in natute and associated with high income groups.

Intra-Industry Trade

 

Figure 1: Product life cycle

(Source: Jian, Cai and Chen 2017)

One example nation for product life cycle theory is United State. At the intial stage, US produces capital intensive good like computer. However, in the later stages of production, the production moves to the developing countries raising US import share of these items.

 

Figure 2: Product life cycle theory for United State

(Source: Tolentino 2017)

The national comparative advantage is explained by Porter diamond model of trade. Michael Porter, an American professor first developed this model. The factors determining the comparative advantage of a nation is presented in the shape of a diamond and hence, the model is known as Porter Diamond model of trade (Fainshmidt, Smith and Judge 2016). The model assumes that the competitiveness of a business is associated with performance of the related industries. Additionally, other important factors are considered together in the model and tied to a value added chain important in regional or local context.

 

Figure 3: Porter’s diamond trade model

(Source: Chung 2016)

The main essence of Porter Diamond model is that comparative asvantages enjoyed in the home country is gradually transmitted to the international scale. The four basic factors of the model include conditions of factor input, deamnd in the domestic market, growth of supportive industries and finally structure, strategy and rivalry amonf firms. The factor condition implies availability of natural resource and advanced infratructure. The domestic demand condition helps to determine the level of success in the domestic market (Chung 2016). This is related to aspect like development of product and level of innovation. The supported industries in the model refers to existing supply chain and related markets. The action of government often plays an important role in expansion of the business in home and abroad. There isa chance factor that implies opportunity of a concerned firm in undertaking new operation.

In addition to above mentioned theories of trade Paul Krugamn has posited the New Trade Theory. The new theory has emphasized on retirn to scale in determining feasibility of trade. Countries by producing one speific commondity reap the benefit of economies of scale and thus becomes more competitve in the international market (Erdogan 2014). This however does not limit consumption choice of people as countries import a variety of goods by exchanging the good of specialization.

The essay has done a critical assessment of existing trade theories. All the theories though depict a different trade pattern, the end objective is same that is to allocate scarce resources in an efficient way.  

References list

Baldwin, R. and Lopez?Gonzalez, J., 2015. Supply?chain trade: a portrait of global patterns and several testable hypotheses. The World Economy, 38(11), pp.1682-1721.

Baldwin, R. and Robert-Nicoud, F., 2014. Trade-in-goods and trade-in-tasks: An integrating framework. Journal of International Economics, 92(1), pp.51-62.

Baumol W.and Blinder A., 2014 Economics: Principles and Policy, International Edition, 15th ed. Cengage

Bea.gov. (2017). BEA: News Release: U.S. International Trade in Goods and Services. [online]Availableat:https://www.bea.gov/newsreleases/international/trade/tradnewsrelease.htm [Accessed 14 Mar. 2018].

Begg, D. and Ward, D, 2013 Economics for Business, Berkshire, McGraw Hill

Besanko D., Dranove, D., Shanley, S. and Schaefer, M., 2013, Economics of Strategy. 6th ed. US, John Wiley.

Chung, T.W., 2016. A Study on Logistics Cluster Competitiveness among Asia Main Countries using the Porter’s Diamond Model. The Asian Journal of Shipping and Logistics, 32(4), pp.257-264.

Cohen,I.K, 2016 Economics for Business – A Guide to Decision Making in a Complex Global Macroeconomy, London. Kogan Page.

Erdogan, A.M., 2014. Bilateral trade and the environment: A general equilibrium model based on new trade theory. International Review of Economics & Finance, 34, pp.52-71.

Fainshmidt, S., Smith, A. and Judge, W.Q., 2016. National Competitiveness and Porter’s Diamond Model: The Role of MNE Penetration and Governance Quality. Global Strategy Journal, 6(2), pp.81-104.

Grant, R. M, 2013 Contemporary Strategy Analysis, 8th ed. Blackwell

Ito, T., Rotunno, L. and Vézina, P.L., 2017. Heckscher–Ohlin: Evidence from Virtual Trade in Value Added. Review of International Economics, 25(3), pp.427-446.

Jian, X., Cai, S. and Chen, Q., 2017. A study on the evaluation of product maintainability based on the life cycle theory. Journal of cleaner production, 141, pp.481-491.

Kohli, M.C., 2016. Leontief and the Bureau of Labor Statistics, 1941-54: A Unfinished Chapter in the History of Economic Measurement. Bureau of Labor Statistics, https://www. bls. gov/ore/pdf/st020190. pdf.

Mankiw, N. Gregory, Taylor, M.P., Ashwin, A, 2016, Business Economics, 2^nd ed., Cengage.

Simas, M., Wood, R. and Hertwich, E., 2015. Labor embodied in trade. Journal of Industrial Ecology, 19(3), pp.343-356.

Tolentino, P.E., 2017. Technological innovation and emerging economy multinationals: the product cycle model revisited. International Journal of Technology Management, 74(1-4), pp.122-139.