Comparative Advantage Theory by Ricardo

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Since Ricardo invented his comparative advantage theory, it has been very instrumental in international economics. The idea has persistently been used to rally for the opening up of economies to allow free trade between nations. This has mostly been in the aim of convincing the less developed countries against shutting their doors to work with their more developed countries (Thompson, 2006). The theory has shown that states need not hold some absolute advantage to open up for trade with other nations. A country can be absolutely disadvantaged against another country but nevertheless establish a profitable business where each country derives benefits from trading.

Ricardos theory was based on the relative differences in labor productivity between nations as the primary source of comparative advantage. However, although his approach showed that different countries have different levels of labor productivity, his comparative advantage theory did not offer a theoretical explanation as to what really caused such productivity differences. As such, Eli Heckscher and Bertil Ohlin rose up to the challenge and, between the 1920s and 1930s, formulated a theory that identified different relative factor endowments among nations as the source of comparative advantage (Carbaugh, 1995). They argued that the cross-industry differences in factor intensity and cross-country differences in factor abundance rather than just productivity as was in Ricardian theory were the primary sources of comparative advantage.

Their idea came to be known as the Heckscher-Ohlin model after their names. According to the model, for instance, two countries where one has a relative of land and the other capital will find it advantageous if they opened up for trade against each other. In explaining the basis for profitable business between the two nations, the model postulates that the country with the relative abundance of labor will find it advantageous specializing in producing and exporting a labor-intensive product such as tomatoes or maize and importing a capital intensive good such as vehicles (Carbaugh, 1995). On the other hand, the country with the relative abundance of money will better specialize in producing and exporting capital intensive autos while importing tomatoes or maize from the abundant labor country.

The mechanics behind the argument presented by the model are simple and straight forward. The country with the relative abundance of labor will easily procure cheap labor for the production of labor-intensive products, while the other country will have to pay dearly to procure the same level of work and produce similar volumes of the labor-intensive commodity. On the other hand, the excellent capital country will cheaply have capital intensive autos than her labor abundant counterpart. This means that tomatoes and maize will be relatively expensive in the productive capital country than in her delivery fruitful partner due to high costs of production. The same fate befalls the labor-abundant country in the production of autos. When these two countries open up for trade against each other, those in the tomatoes and maize enterprises in the abundant labor country will find that their produce fetches a better price in the other country and therefore produce more for export.

As cheap tomatoes and maize flood the abundant capital country, those in similar enterprises will have no incentives left to continue growing. On the other hand, those in the auto enterprise in the productive capital country will find that autos fetch better prices in the additional labor abundant country. They will therefore produce more for export and flood the labor-abundant countrys auto market with cheap vehicles, significantly reducing the incentives to continue growing to those on a similar enterprise in that country. The end result is that abundant capital country will tend to specialize in auto production, rendering jobless those previously employed in the tomato and maize enterprises, while the productive labor country specializes in tomato and maize production, rendering jobless those once used in its auto industry. The shift in enterprise due to trade ultimately then affects income distribution in the respective countries.

The H-O model or the factor endowment model did have a lot of significance in explaining international trade patterns but not after Wassily Leontiefs experiment in 1954 challenged its overall applicability in real practice. Famously known as the Leontief paradox, Wassily applied a mathematical input-output model to the US economy to find that actually the capital/labor ratio for US export industries was lower than for import-competing sectors, contrary to what the H-O model would have predicted (Krugman & Obstfeld, 2004). This was later attributed by economists by the multiple factor effect where the US has in abundance relative to its other trading partners research and development input, intense use of skilled labor, and engineering talent.

Later, Staffan Linder, a Swedish economist, with his theory of overlapping demands challenged further the factor endowment theory. Although Linder agreed that the factor endowment theory has considerable explanatory power for trade in primary products and agricultural goods, he faulted its relevance in explaining trade in manufactured goods (Carbaugh, 2009). According to him, trade-in manufactured goods main driving force is the domestic demand conditions. For a country in the first place to consider to start manufacturing a particular product, there must be large enough domestic demand to justify it, which in turn defines the set of goods that the firms will have to sell as they start exporting. Thus a nations exports are an extension of production for the domestic market (Carbaugh, 2009). Further, per capita income dictates the choice of goods a country consumes. Therefore, wealthy nations are likely to have a similar pattern of tastes and consume similar manufactured goods due to overlapping demand and likewise for poorer nations. This means poorer countries will trade more with other poorer nations while developed nations trade more with other developed nations.

Specific tariff, an ad valorem tariff, and a compound tariff

A specific tariff is a fixed monetary unit per physical unit of the imported product. It has the advantages of simplicity and easy to apply but, on the other hand, disadvantageous because the degree of protection it affords domestic producers varies inversely with changes in import prices (Carbaugh, 2009).

Ad valorem tax is a variable duty charged as a percentage on the value of the imported product rather than on the number of physical units. Its main advantage is that it affords uniform protection on domestic producers and that it can be applied to goods of varying quality and quantity relatively easily. Its primary disadvantage is its valuation because there are problems in determining the value of the product as prices keep on fluctuating, and the method and process of the valuation may not always be consistent (Carbaugh, 2009).

A compound tariff is a combination of both specific and ad valorem taxes. Although it lessens the disadvantages portrayed by the former types of tariffs, it still carries some drawbacks, such as valuation problems.

References

Carbaugh, R. J. (1995). International economics, 5th ed. Florence, KY: South-Western College Publishers.

Carbaugh, R. J. (2009). International Economics, 12th ed. Florence, KY: Cengage Learning.

Krugman, P. R., and Obstfeld, M. (2004). International economics: theory and policy. New Jersey: Pearson Education, Inc.

Thompson, H. (2006). International economics: global markets and international competition, 2nd ed. London: World Scientific.

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Comparative Advantage Theory by Ricardo

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