Comparative Advantage and Trade

Trade: Gains From Trade

Ricardo vs. Smith

Heckscher-Ohlin and the Linder Hypothesis

Problems with Specialization

Benefits of Trade to the United States

Developing World, Trade, and Globalization

Trade: Gains from Trade

The concept of comparative advantage in trade is an old and longstanding one. Simply put, the idea of comparative advantage is that a nation, by playing to its strengths, can experience greater gains from trade than from self-sufficiency. "By instead concentrating on the things you do the 'most best' and exchanging or trading any excess of those things with someone else for the things that person does the 'most best,' you can both be better off" ("Comparative advantage and the benefits of trade," 2012). Even if a nation can be theoretically self-sufficient, according to one of the first proponents of the theory David Ricardo, "To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time," thus according to the classical theory of comparative advantage the greatest gains will be derived from trade if Portugal exports wine and imports cloth (Cited in "Comparative advantage and the benefits of trade," 2012). Gains from trade results "when countries specialize in producing the goods they can produce at the lowest cost relative to other participants" ("Gains from trade," 2016).

In theory, the global economy would be vastly more inefficient if nations were forced to produce all the goods consumed within their borders or even produce goods they could otherwise purchase at lower cost abroad. However, despite the obvious theoretical greater efficiency on a macro level, a number of critics of the push to economic globalization have contested the notion that globalization has been of complete, uncomplicated benefit to all participants in the developed and especially the developing world.

Ricardo vs. Smith

The theory of comparative advantage was an expansion on the theory of absolute advantage, or Adam Smith's justification of free trade on the basis that a nation should produce what it is most efficient at producing; Ricardo's observation, however, is that "a country will profit by producing the product or commodity for which it enjoys a lower...opportunity cost, and then trading it for the ones other countries can produce at a lower relative internal opportunity cost" (Christopher & Daco 2012). Furthermore, even if a nation is most efficient at producing an item, it will still behoove that nation to focus on the goods for which it is most efficient, given that to produce other such items will still result in an opportunity cost of resources. To return to the Portuguese example, even though Portugal might be the most efficient of all nations at producing either cloth or wine, it still makes sense according to the law of comparative advantage to focus upon wine.

In the modern, global economy, "the combination of specialized, globalized production and, to a lesser extent, the adoption of 'lean' inventory practices (such as just-in-time and build-to-order) has helped many companies achieve significant financial success and has provided many countries with development opportunities" (Christopher & Daco 2012). In an ideal scenario, all nations involved in free and unfettered trade benefit. "Comparative advantage is not producing what you produce best but producing goods that you can produce cheaper, at the lowest opportunity cost, than all other participants...when they enter into trade with other countries, all participants experience increased net benefits" ("Gains from trade," 2016).

Heckscher-Ohlin and the Linder Hypothesis

The modern construct of the Ricardo model is that of the Heckscher-Ohlin model, which states that "countries export what can be most efficiently and plentifully produced...requiring factors of production that a country has in abundance and the importation of goods that the country cannot produce as effectively" ("Heckscher-Ohlin theorem," 2016). In other words, the United States, because of its climate, can grow and therefore export corn with relative efficiency versus, say, bananas. Nations should take the path of least resistance that garners them the greatest advantage. If the Heckscher-Ohlin model is valid, this means that global trade will be a boon to all nations. "Because a country does not have to rely solely on internal markets, it can take advantage of the more elastic demand" ("Heckscher-Ohlin," 2016). For example, even when demand for a particular good or service begins to decline within the nation, this can to some degree be guarded against by finding a new, captive market in another nation.

However, the Heckscher-Ohlin model is merely that -- a model, an ideal construct. In reality, there have been a number of problems which have arisen with the model. This is highlighted by the Linder hypothesis, or the observation that "countries with similar per capita income will consume similar quality products, and that this should lead to them trading with each other...countries will specialize in the production of certain high quality goods, and will trade these goods with countries that demand these goods" ("Linder hypothesis," 2016). In other words, while free trade may be beneficial, it is often primarily so for nations in the developed rather than the developing world. Consumers in the developing world do not have the incomes or lifestyles to necessarily benefit in an equal fashion from trade from the developed world and more often form a source of raw materials and labor.

Nations with high incomes have higher rates of consumption and also exhibit a greater demand for higher-quality products. "For example, while many countries produce automobiles, not all countries have healthy export markets for these products. Japan, Europe, and the United States actively trade automobiles" and benefit from such relationships but this is not universally true of all nations, which do not necessarily have the ability to afford such vehicles ("Linder hypothesis," 2016). However, arguably some nations have benefited and been able to grow their economies as a result of the new, global marketplace even if they are not traditional, developed economies. "Thailand is a key source of electronic component production; India hosts a cluster of call centers and outsourced information technology services. Many of these centers benefit from economies of scale and agglomeration, and are a key source of world profits for multinational corporations" (Christopher & Daco 2012). The burgeoning middle class in East Asia and Asia has largely been attributed to the expansion of intellectual capital in these nations as well as offering a source of lower-cost manufacturing. The comparative advantage of India is derived from the fact that it has a relatively highly-educated, English-speaking population that other, neighboring nations cannot produce with comparative ease and at comparative cost.

Problems with Specialization

Specialization is not without its perils, however. Even back in Ricardo's day, if two nations who were trade-dependent went to war, this could result in deprivation of the residents of those nations of necessary goods. The dependence of the developed world upon Middle Eastern oil has resulted in considerable friction when OPEC nations have banded together to successfully raise the price of oil. Furthermore, when the global market for any particular market is impinged upon, this can result in significant financial losses. "In Ricardo's example, a storm that would wipe out the clothing industry in England would leave both countries without new clothing, while a drop in the price of wine due to changing tastes or prohibition in England would devastate the Portuguese economy" (Christopher & Daco 2012). Even today, "natural disasters, political unrest, government instability, or exchange-rate volatility" as well as simple changes in consumer demand can have a seismic impact upon a nation that is overly dependent upon a particular product for its total revenue (Christopher & Daco 2012).

Benefits of Trade to the United States

Free trade has become a critical component of all developed world economies. The United States has grown increasingly dependent on trade with other nations to sustain itself. "In the 1960s, exports and imports represented less than 10% of U.S. gross domestic product" but today that percentage is as high as thirty percent (Schott 2016). Free trade gives United States consumers greater variety of products to choose from and access to cheaper goods. It enables producers to make use of input goods from abroad, including labor, to keep costs down "Trade benefits consumers in other ways -- many of the products that are produced in the United States are cheaper and better because they have imported components and raw materials, improving their quality and lowering their cost" (Schott 2016).

Of course, this does not mean that trade is advantageous to all Americans or indeed every worker with in the nation; "Trade deals can displace some workers from their current jobs," but on the other hand, "they also create many new jobs in areas where America has a competitive advantage such as business services and high-tech industries" (Schott 2016). Although free trade is often criticized as destroying American jobs, arguably unfettered exposure to the global economy ensures that America has maximum exposure to the ideas and resources of other nations, as well as to other sources of consumer demand. "Workers in manufacturing firms that export generally earn wages 12 to 18% higher than their counterparts in firms that only serve the domestic market" (Scott 2016). Once again reflecting the concept of comparative advantage, arguably focusing on technological innovation and a more educated workforce plays to the inherent strengths of the U.S. and its ability to generate and support innovative ideas and to educate its populace.

Opponents of the push to trade liberalization have argued that only "most privileged Americans have benefited from some cost-saving 'efficiency gains' due to trade," and the expanded access to consumer goods while "increased global integration can harm most working Americans" (Scott 2016). For Americans without college degrees whose labor has been replaced by lower-wage workers from abroad this is certainly true; on the other hand, arguably technological innovations can have a similar effect in terms of reducing the ability of low-wage, low-skilled workers to find employment. Regardless, it has been estimated "that the growth of trade with low-wage countries reduced the median wage for full-time workers without a college degree by about $1,800 per year in 2011" (Scott 2016).

Developing World, Trade, and Globalization

Despite the support for free trade as a concept, there is ample criticism that even nations that support it, such as the United States, and organization such as the WTO (World Trade Organization) do not really practice what they preach and that the current balance of trade is injurious to many lesser-developed nations. Developed world nations subsidize a number of commodities. For example, "$47bn in subsidies paid to rich-country producers in the past 10 years has created barriers for the 15 million cotton farmers across west Africa trying to trade their way out of poverty," given that their nations cannot afford to subsides them in a similar manner and "5 million of the world's poorest farming families have been forced out of business and into deeper poverty because of those subsidies" (Walker 2011). Many developed world nations also offer substantial agricultural subsidies to crops such as corn and sugar which can make it virtually impossible for the developing world to surmount (Walker 2011). Furthermore, making former colonies dependent upon their colonizers for food is questionable in an ethical fashion and many of the poorest nations find it difficult to sustain a comparative advantage in any good or service and thus have an inherently unequal footing in the current balance of trade.

There is evidence that the balance between the developing and developed world has been rectified somewhat in recent years. "In goods trade, the emerging world's share is 41% of exports and 38% of imports," although "if commodities and raw materials are taken out, exports become smaller than imports -- $4.2 trillion compared with $4.3 trillion" (Bershidsky 2014). Still, developing world markets in some areas are no better equipped to engage in what is called "knowledge-intensive flows' those in goods and services that require more research and development than labor," or the ability to export skilled labor such as technological workers or technology versus pure raw materials (Bershidsky 2014). The export of knowledge-intensive goods and services is viewed as a more critical measure of a nation's development than the trade balance alone by most economists. But "that relatively high share, however, is mostly a reflection of China's huge electronics exports" and arguably "cheap televisions and even mobile phones are no more 'knowledge-intensive' than toys or textiles, but they vastly improve the emerging world's statistics" (Bershidsky 2014).