Analysis of the Law of Comparative Advantage

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Table of Contents

Introduction
Origin of the theories of Comparative advantage
Sources of comparative advantage
International capital movement
Tariff and Non-Tariff barriers
Conclusion
References

Introduction

The law of comparative advantage states that two nations or any other parties will benefit from trade, only if there relative cost of productions is different. The two countries can benefit from producing the same products provided there are differences in efficiency of their trading. The law of comparative advantage also refers to the ability of one entity to produce specific goods and services at a minimal marginal cost and opportunity cost than its counterpart (Drabicki, & Akira, 2002, P. 2).

For instance, if using advanced technology, one country can produce a bag of sugar and coffee in six hours, while another country with less technology can produce 2 bags of sugar or four bags of coffee in an hour, each country will benefit from trade between them since their internal trade-offs between sugar and coffee are different.

The less proficient country has a comparative advantage in producing coffee, therefore it will find it more efficient to produce coffee and trade them off with the country which is more efficient in producing sugar (Bernhofen, & Brown, 2003, P. 3).

Without trade, the opportunity cost of producing sugar per coffee is 2; by trading, the cost per sugar can decrease up to 1 coffee depending on the level of trade. Most efficient countries usually experience 1:1 trade offs. The more efficient country has a comparative advantage in sugar and can afford to move some of their labor from coffee production to sugar production and trade more sugar for coffee.

Without trade, the cost of producing a bag of coffee was one bags of coffee. By trading these cost can minimized by half depending on the level of trade between these countries. The net gain received by each country is referred to as benefits of trade (Bernhofen, & Brown, 2003, P. 3-4).

Origin of the theories of Comparative advantage

The theory of comparative advantage originated from the book “On the Principles of Political Economy and Taxation” authored by David Ricardo and was published in 1817. This book highlighted the trade of Wine and clothes between Portugal and England (Drabicki, & Akira, 2002, P. 5). During that era, it was possible to produce both wine and clothes using less labor in Portugal than in England.

In addition, the relative cost of producing the two commodities in these countries was different. In England, the producers had difficulty in making wine, and comparatively hard to make clothes. However, in Portugal it was very easy to produce the two commodities.

Therefore, although production of clothes in Portugal was viable, it was cheaper to concentrate in making wines and trade it off with clothes from England. On the other hand, England will gain from trading with Portugal since the cost of producing clothes would remain constant while it can get wine at a relatively cheaper price, nearer to the cost of clothe.

The book concluded that each country would benefit by specializing in producing goods where they had comparative advantage and trading them with each other (Drabicki, & Akira, 2002, P. 5-6).

Sources of comparative advantage

The main sources of comparative advantage are technology and factor endowment. However, there are also other factors including tastes, market structure, institutions, location, and conditions of trade. Technology dictates the efficiency in production of goods and services.

Countries with advanced technology usually produce goods and services at a lower cost in comparison with those with less advanced technology. Advancement in technology means high volume of production per hour, less labor, and overall efficiency in production. Factor endowment denotes difference in factors of production (labor, land, capital, and management).

The difference in factor endowment determines the level of specialization and trade. If countries differ in relative factor endowment, and then each has a comparative advantage in goods and services that makes reasonably intensive use of the available copious factors (Charles, 2007, P, 10).

Other things equal (Ceteris paribus), countries have comparative advantage in goods and services that are less inclined to the local consumers but are on high demand to the foreign consumers. This kind of trade is normally common among the European nations who are at per in technology and factor endowment but have diverse tastes and preferences among their consumers.

The most recent studies on comparative advantage identified the significance of institution in international trade. Institutional sources of comparative advantage include financial development, security of contract enforcement, and flexibility in the labor market (Charles, 2007, P, 10; Bernhofen, & Brown, 2003, P. 8).

International capital movement

The economic theory of international trade unlike other economic theories emphasizes on international movement of capital and labor (otherwise known as factor endowment). The general pattern in the international trade is that countries with relatively more capital exports capital-intensive commodities and import labor-intensive commodities as demonstrated by Leontief paradox.(Iversen, 2002, P. 4).

A two-country-two commodity-two factor model posits that equilibrium in commodity price can guarantee equilibrium in factor price and factor price can guarantee equilibrium in commodity price only if the marginal productivity depend on the proportion of the in which the factors are combined. For instance, if two countries producing cotton and steel by means of labor and capital, a country which is endowed with labor but has less capital will concentrate in producing cotton which is labor intensive relative to steel and vice versa.

Country endowed with more capital can pump more capital in the poor country to enhance the production of cotton. The capital intensive nation can also import some labor from the labor intensive nation to help in the steel industry (Iversen, 2002, P. 4-5).

Tariff and Non-Tariff barriers

Trade between two or more country is generally influenced by tariff and non-tariff barriers. Non-tariff barriers include quota system, setting of standards for imports, government active participation in local and international trade, bureaucratic custom procedures, and extra charges on imported commodities among others. Tariff is a tax imposed on imports which increases the prices of imported goods.

The reasons of enacting these policies are to protect the local infant industries, safeguarding employment opportunities for the locals, consumer protection, national security and retaliatory measures. There are two main types of tariffs namely Specific tariffs and Ad-Valorem tariffs. Specific tariffs are fee levied on a unit of imported commodity. Ad-Valorem tariff on the other hand is levied in accordance with the value of the commodity (Zhihao, 2000, P.3).

Government benefits from the revenues collected from these trade barriers. Domestic companies benefits from the reduced competition because the process of the imported commodities are inflated. However, the main victims of the tariff and non-tariff barriers are the consumer and local businesses who depend on the restricted commodities.

Trade barriers tend to benefit the producers and negatively affect the consumers. Normally consumers enjoy plenty of a commodity under low prices without the influence of tariff and non-tariff barriers. When these barriers are imposed, the prices of commodities rise and the supply dwindle (Zhihao, 2000, P.4).

Conclusion

The law of comparative advantage states that two nations or any other parties will benefit from trade, on if there relative cost of productions is different. Comparative advantage results mainly from the difference in technology, factor endowment, and other minor factors.

In order to achieve a comparative advantage, countries must specialize on goods they are more efficient in and where factor endowment is abundant. However, international trade is normally restricted by tariffs and non-tariff factors.

References

Bernhofen, D.M., & Brown, J.C. (2003). A direct test of the theory of comparative advantage: The case of Japan. Worcester, MA: Department of Economics, Clark University.

Charles, S. (2007). International Trade and Globalization. Stocksfield: Anforme Inc.

Drabicki, J.Z., & Akira T. (2002). An Antinomy in the Theory of Comparative Advantage. Journal of International Economics, 15: 211-23.

Iversen, C. (2002). Aspects of the Theory of International Capital Movements. London: Oxford University Press.

Zhihao, Y. (2000). A model of Substitution of Non-Tariff Barriers for Tariffs. The Canadian Journal of Economics, 33(4), 1-30.

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