Gains From Trade: Comparative Advantage and Globalization

Introduction: The Concept of Comparative Advantage

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 result "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 to produce goods they could otherwise purchase at lower cost abroad. However, despite the obvious theoretical efficiency gains at a macro level, a number of critics of economic globalization have contested the notion that globalization has been of complete, uncomplicated benefit to all participants — in the developed world and especially in the developing world.

Ricardo vs. Smith: Absolute and Comparative Advantage

The theory of comparative advantage was an expansion on the theory of absolute advantage — 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 the most efficient producer of a given item, it will still benefit that nation to focus on the goods for which its relative efficiency is greatest, since producing other goods still incurs an opportunity cost of resources. To return to the Portuguese example: even if Portugal were the most efficient nation in the world at producing both cloth and wine, the law of comparative advantage still prescribes focusing on 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 extension of the Ricardian model is 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 compared to, say, bananas. Nations should take the path of least resistance that garners them the greatest advantage. If the Heckscher-Ohlin model is valid, 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 a nation, this can to some degree be offset by finding a new, captive market in another nation.

However, the Heckscher-Ohlin model is merely that — a model, an ideal construct. In reality, a number of problems have arisen with it. This is highlighted by the Linder hypothesis, which observes 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 benefit equally from trade with the developed world, and they more often serve as a source of raw materials and labor.

Nations with high incomes have higher rates of consumption and 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). Nevertheless, some nations have been able to grow their economies as a result of the new global marketplace, even without being 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 and Southeast Asia has largely been attributed to the expansion of intellectual capital in those regions as well as to the availability of lower-cost manufacturing. India's comparative advantage derives from its relatively highly educated, English-speaking population — a resource that neighboring nations cannot replicate with comparable ease or at comparable cost.

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 American consumers a greater variety of products to choose from and access to cheaper goods. It also 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 to every worker within 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, unfettered exposure to the global economy ensures that America has maximum exposure to the ideas and resources of other nations, as well as to additional 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). Reflecting the concept of comparative advantage, focusing on technological innovation and a more educated workforce plays to the inherent strengths of the United States — its ability to generate and support innovative ideas and to educate its populace.

Opponents of 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. At the same time, technological innovation can have a similar effect in terms of reducing employment opportunities for low-wage, low-skilled workers. 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).

Conclusion: Regional Trade and the Balance of Benefits

More and more nations have been entering into regional trade agreements or creating trade blocs to facilitate trade and improve the benefits of comparative advantage. The NAFTA (North American Free Trade Agreement) between the United States, Mexico, and Canada is now considered to have been quite advantageous to all the involved nations — including, and perhaps especially, Mexico, which was widely regarded as the weakest of the three participants when the agreement was first constructed. "Mexico — in 1994, an insular, economic basket case — has in two decades emerged as a forward-looking country with expanding global reach, a handful of world-class corporations, and a ballooning middle class" (Beltrame, 2013). Although efforts to liberalize the economy had begun even before NAFTA was enacted, the breaking down of trade barriers was widely credited with revitalizing the Mexican economy. "Mexico is now estimated to be the world's 13th-largest economy with total output similar to Canada's, although on a per capita basis it still lags" (Beltrame, 2013).

For all partners, it is clear that "regional trade increased sharply over the treaty's first two decades, from roughly $290 billion in 1993 to more than $1.1 trillion in 2016," as did direct foreign investment (McBride & Sergie, 2016). It remains difficult to isolate the effects of the treaty from broader developments in the world economy. What is clear is that the United States has developed a more interconnected relationship with its neighbors to the north and south. "U.S. trade with its North American neighbors has more than tripled, growing more rapidly than U.S. trade with the rest of the world. Canada and Mexico are the two largest destinations for U.S. exports, accounting for more than a third of the total" (McBride & Sergie, 2016).

The NAFTA example illustrates that advantages from trade can accrue to nations that are less economically powerful than the United States. The concept of comparative advantage seldom operates as cleanly as it does in a textbook. But there is ample evidence that, despite the problems it sometimes generates, the benefits of trade overall outweigh its drawbacks, and that growth through the exchange of goods, services, and intellectual capital remains genuinely valuable.

References

Beltrame, J. (2014). NAFTA's biggest winner? Mexico. The Huffington Post. Retrieved from

Bershidsky, L. (2014). Globalization still favors the rich. Bloomberg. Retrieved from https://www.bloomberg.com/view/articles/2014-05-02/globalization-still-favors-the-rich

Christopher, C., & Daco, G. (2012). Ricardo's "comparative advantage" still holds true today. Supply Chain Quarterly. Retrieved from http://www.supplychainquarterly.com/columns/20121001-ricardos-comparative-advantage-still-holds-true-today/

Comparative advantage and the benefits of trade. (2012). The Encyclopedia of Economics and Liberty. Retrieved from http://www.econlib.org/library/Topics/College/comparativeadvantage.html

Gains from trade. (2016). Study.com. Retrieved from

Heckscher-Ohlin. (2016). Investopedia. Retrieved from http://www.investopedia.com/terms/h/heckscherohlin-model.asp

Linder hypothesis. (2016). Investopedia. Retrieved from http://www.investopedia.com/terms/l/linder-hypothesis.asp

McBride, J., & Sergie, M. (2016). NAFTA's economic impact. CFR. Retrieved from

Scott, R. (2016). They increase trade deficits, which have led to job loss. The New York Times. Retrieved from http://www.nytimes.com/roomfordebate/2016/03/17/are-trade-agreements-good-for-americans

Schott, J. (2016). Trade agreements benefit consumers and producers. The New York Times. Retrieved from http://www.nytimes.com/roomfordebate/2016/03/17/are-trade-agreements-good-for-americans

Walker, A. (2011). WTO fails developing countries. The Guardian. Retrieved from https://www.theguardian.com/global-development/poverty-matters/2011/nov/14/wto-fails-developing-countries