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Comparative & absolute advantage notes

  1. 1. Why Trade & Absolute and comparative advantage International trade now accounts for nearly 25% of world GDP. The liberalisation (opening-up) of trade in goods and services, and the rapid increase in foreign direct investment across national boundaries have been and will continue to be hugely important for the development of the global economy. The virtues of international trade and exchange Economists are normally positive about the economic consequences of trade. Granted there are those who highlight the inequities of the global trading system and in particular, the marginalisation of developing countries who have struggled to build and maintain a competitive advantage in key markets? But taken as a whole, the consensus among economists is that there are significant gains in economic welfare and efficiency arising from the continued expansion of trade and investment between nations. In this section we consider some of the theory of free trade and then analyse and evaluate the arguments for and against import protectionist policies. “If there were an Economist’s Creed, it would surely contain the affirmations “I believe in the Principle of Comparative Advantage” and “I believe in Free Trade”.” Paul Krugman, Professor of Economics at MIT, Cambridge Fist the Theory of Absolute advantage Basically, this theory says that two countries can both if they specialize in what they are good at and then trade. For example… If we assume two countries have the same factor inputs and if they divide them equally between two goods then they can produce the following quantities… Product Y Product Z Country A 50 60 Country B 30 70 Total 80 130 Now, A can produce Product Y more efficiently than country B can. So therefore it should specialize in it’s production. Country B can produce more of Product Z, and so should specialize. Obviously, there is an opportunity cost involved in specialising. The other product will not be made and have to be imported. We now get the following situation… Product Y Product Z Country A 100 0 Country B 0 140 IB Economics notes Trade: An introduction
  2. 2. Total 100 140 Now if Country A trades some of ‘Y’ for ‘Z’ then neither country is worse off in either product, and each is better off in one of them. Happy days! This seems fairly obvious when each country has an advantage in one particular good. The idea holds true when a country is better at producing both goods. See below. The concept of comparative advantage First introduced by David Ricardo in 1817, comparative advantage exists when a country has a ‘margin of superiority’ in the production of a good or service i.e. where the marginal cost of production is lower. Countries will usually specialise in and then export products, which use intensively the factors inputs, which they are most abundantly endowed. If each country specialises in those goods and services where they have an advantage, then total output can be increased leading to an improvement in allocative efficiency and economic welfare . Put another way, trade allows each country to specialise in the production of those products that it can produce most efficiently (i.e. those where it has a comparative advantage). This is true even if one nation has an absolute advantage over another country. So for example the Canadian economy which is rich in low cost land is able to exploit this by specialising in agricultural production. The dynamic Asian economies including China have focused their resources in exporting lowcost manufactured goods which take advantage of much lower unit labour costs. In highly developed countries, the comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and high-knowledge services . Worked example of comparative advantage Consider two countries producing two products – digital cameras and vacuum cleaners. With the same factor resources evenly allocated by each country to the production of both goods, the production possibilities are as shown in the table below. Pre-specialisation Digital Cameras Vacuum Cleaners UK 600 600 United States 2400 1000 Total 3000 1600 Working out the comparative advantage IB Economics notes Trade: An introduction
  3. 3. To identify which country should specialise in a particular product we need to analyse the internal opportunity costs for each country. For example, were the UK to shift more resources into higher output of vacuum cleaners, the opportunity cost of each vacuum cleaner is one digital television. For the United States the same decision has an opportunity cost of 2.4 digital cameras. Therefore, the UK has a comparative advantage in vacuum cleaners. If the UK chose to reallocate resources to digital cameras the opportunity cost of one extra camera is still one vacuum cleaner. But for the United States the opportunity cost is only 5/12ths of a vacuum cleaner. Thus the United States has a comparative advantage in producing digital cameras because its opportunity cost is lowest. Output after Specialisation Digital Cameras Vacuum Cleaners UK 0 (-600) 1200 (+600) United States 3360 (+960) 600 (-400) Total 3000 1600 3360 1800 o The UK specializes totally in producing vacuum cleaners – doubling its output to 1200 o The United States partly specializes in digital cameras increasing output by 960 having given up 400 units of vacuum cleaners o As a result of specialisation according to the principle of comparative advantage, output of both products has increased - representing a gain in economic welfare. Fixing a price For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for anothe r. This will be based upon the opportunity cost of specialising. In the above example, it cost the UK ‘1 digital camera’ to produce 1 more vacuum cleaner. Therefore the UK is prepared to buy the cameras from the US if the price is less than 1 vacuum cleaner. If it is more than they might as well have made them themselves. The cost to the US of partially specialising in digital cameras is (1000/24000) ‘0.416 of a vacuum cleaner’. So, if the US can get more than this price for every digital camera it sells the UK, then it is worth them trading. If the UK is not willing to pay that much then it is not in there interests to trade with the UK, as they can make it cheaper themselves. The UK will only buy if digital cameras are cheaper than a vacuum cleaner. The US will only sell if the price is more then 0.41 of a vacuum cleaner. It would therefore appear that it is possible for them to agree on a price somewhere between the two. The actual price will depend upon the negotiating strength of each side. IB Economics notes Trade: An introduction
  4. 4. If the two countries settle on trade at a rate of exchange of 2 digital cameras for one vacuum cleaner, the post-trade position will be as follows: o The UK exports 420 vacuum cleaners to the USA and receives 840 digital cameras o The USA exports 840 digital cameras and imports 420 vacuum cleaners Post trade output / consumption Digital Cameras Vacuum Cleaners UK 840 780 United States 2520 1020 Total 3360 1800 Compared with the pre-specialisation output levels, consumers in both countries now have an increased supply of both goods to choose from. Assumptions behind trade theory This theory of the potential benefits from trade and exchange using the law of comparative advantage is based on a number of underlying assumptions: 1. Perfect occupational mobility of each of the factors of production (land, labour, capital etc.) -this means that switching factor resources from one industry to another involves no loss of relative efficiency and productivity. In reality of course we know that factors of production are not perfectly mobile – labour immobility for example is a root cause of structural unemployment 2. Constant returns to scale (i.e. doubling the inputs used in the production process leads to a doubling of output) – this is merely a simplifying assumption. Specialisation might lead to diminishing returns in which case the economic benefits from trade are reduced. Conversely, increasing the scale of production can generate increasing returns to scale - in which case the benefits from trade are even stronger than the numerical example we have considered 3. No externalities arising from production and/or consumption – meaning that there is no divergence between private and social costs and benefits. Again this is a simplifying assumption. No discussion about the overall costs and benefits of specialisation and trade should ignore many of the environmental considerations arising from increased production and trade between countries. Some of these assumptions have been heavily questioned of late. What Determines Comparative Advantage? A country's place in the global economy seems neither predestined nor predictable. Comparative advantage is almost impossible to spot in advance. Source: The Economist, April 2004 IB Economics notes Trade: An introduction
  5. 5. Comparative advantage is best viewed as a dynamic concept meaning that it can and does change over time. Some businesses find they have enjoyed a comparative advantage within their own market in one product for several years only to face increasing competition as rival producers from other countries enter their markets and under cut them on price or take market share through non-price competition. For a country, the following factors are often seen as important in determining the relative costs of production: 1. The quantity and quality of factors of production available (e.g. the size and efficiency of the available labour force and the productivity of the existing stock of capital inputs) 2. Investment in research & development (this is important in industries where patents give some firms a significant market advantage) – there is quite strong evidence that an emerging comparative advantage often comes from entrepreneurial trial and error – the never ending process of engaging in research and innovation to find more efficient process and new products 3. Fluctuations in the real exchange rate which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers 4. Import controls such as tariffs, export subsidies and quotas can be used to create an artificial comparative advantage for a country's domestic producers 5. The non-price competitiveness of producers (e.g. covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support) Gross domestic expenditure on Research & Development As a percentage of GDP, data is for 2003, source: OECD 2003 2003 Sweden 3.98 EU15 1.91 Finland 3.48 United Kingdom 1.88 Japan 3.15 Netherlands 1.84 United States 2.68 Norway 1.75 Korea 2.63 China 1.31 Denmark 2.62 Russian Federation 1.29 Germany 2.52 Czech Republic 1.26 France 2.18 Ireland 1.19 Canada 1.95 Spain 1.05 Comparative advantage is often a self-reinforcing process. Entrepreneurs in a country develop a new comparative advantage in a product (either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets). Rising demand and output encourages the exploitation of economies of IB Economics notes Trade: An introduction
  6. 6. scale; higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on. The wider benefits of international trade James Wolfenson on the gains from trade and the costs of protectionism Expanding trade by collectively reducing barriers is the most powerful tool that countries, working together, can deploy to reduce poverty and raise living standards. A growing body of evidence shows that countries that are more open to trade grow faster over the long run than those that remain closed. And growth directly benefits the world's poor. A one percentage point increase in growth on average reduces poverty by more than 1.5 per cent each year. Increased trade also benefits consumers and efficient producers, through lower prices and access to a wider variety of goods. This is because trade encourages greater specialisation - which dramatically lowers costs and more intense competition, which is central to innovation. In sharp contrast, trade barriers can impose high costs on society - and particularly on those that can least afford them. For example, it has been estimated that barriers to imports in the 1990s saved 226 jobs in the US luggage industry, but at a cost to American consumers of nearly $1.3m per year for each job. And taxpayers in the European Union spend over $500m annually to subsidise the production of peas and beans. Source James Wolfensohn, Former President of the World Bank One way of expressing the gains from trade in goods and services between countries is to distinguish between the static gains from trade (i.e. improvements in allocative and productive efficiency) and the dynamic gains (the gains in welfare that occur over time from improved product quality, increased choice and a faster pace of innovative behaviour) Some of the broader gains from free trade are outlined below: 1. Welfare gains – allocative efficiency: Free trade can be shown under certain conditions to lead to significant increases in welfare. Neo-liberal economists who support the liberalisation of trade between countries believe that trade is a ‘positive-sum game’ – in other words, all counties engaged in open trade and exchange stand to gain. 2. Economies of scale - trade allows firms to exploit scale economies by operating in larger markets. Economies of scale lead to lower average costs of production that can be passed onto consumers. 3. Competition / market contestability – trade promotes increased competition particularly for those domestic monopolies that would otherwise face little real competition. For example, Corus faces competition from overseas steel producers and is effectively a price-taker in the world market. The Royal Mail will have to fight hard to maintain its market position during the phased liberalization of the European postal services market between now and 2007. 4. Dynamic efficiency gains from innovation - trade also enhances consumer choice and international competition between suppliers help to keep prices down. Trade in ideas stimulates IB Economics notes Trade: An introduction
  7. 7. product and process innovations that generates better products for consumers and enhances the overall standard of living. 5. Access to new technology: Trade, like investment, is also an important mechanism by which countries can have access to new technologies. Although the importation of new technology may have negative employment consequences for those workers who lose their jobs because of capitallabour substitution, provided that an economy is flexible enough to be able to reemploy these workers, there should be no net loss of jobs as a result. To the contrary, new technology creates new jobs in support industries. 6. Rising living standards and a reduction in poverty - James Wolfeson (Head of the World Bank) has argued that trade can be a powerful force in reducing poverty and raising living standards. A growing body of evidence shows that countries that are more open to trade grow faster over the long run than those that remain closed. And growth directly benefits the world's poor. A one percentage point increase in growth on average reduces poverty by more than 1.5 per cent each year. Virtuous trade “Trade's virtuous effects are of two distinct kinds. First, trade helps countries make the most of what they already have. It frees countries to allocate their resources—whether they be cheap labour, fertile land or educated minds—as efficiently as possible. But, secondly, trade can also allow countries to accumulate resources more quickly. Indeed, the biggest prizes lie in faster growth, not heightened efficiency; in accumulation and innovation, not allocation.” Source: Adapted from the Economist, July 20th 2006 CritismThe Terms of Trade The terms of trade measures the rate of exchange of one good or service for another when two countries trade with each other. For international trade to be mutually beneficial for each country, the terms of trade must lay within the opportunity cost ratios for both countries. We calculate the terms of trade as an index number using the following formula: Terms of Trade Index (ToT) = 100 x Average export price index / Average import price index If export prices are rising faster than import prices, the terms of trade index will rise. This means that fewer exports have to be given up in exchange for a given volume of imports. If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services. The terms of trade fluctuate in line with changes in export and import prices. Clearly the exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade. IB Economics notes Trade: An introduction
  8. 8. IB Economics notes Trade: An introduction