comparative advantage and international trade
Comparative advantage exists when a country has a margin of superiority in the production of a good or service i.e. where the opportunity cost of production is lower.
The basic theory of comparative advantage was developed by David Ricardo
theory of comparative advantage was further developed by Heckscher, Ohlin
and Samuelson who argued that countries have different factor
endowments of labour, land and capital inputs. Countries will specialise
in and export those products which use intensively the factors of production
which they are most endowed.
If each country specialises in those goods and services where they have an advantage, then total output and economic welfare can be increased (under certain assumptions). This is true even if one nation has an absolute advantage over another country.
Worked example of comparative advantage
Consider the data in the following table:
|Pre-Specialisation||CD Players||Personal Computers|
identify which country should specialise in a particular product we need to
analyse the internal opportunity cost for each country. For example,
were the UK to shift more resources into higher output of personal computers,
the opportunity cost of each extra PC is four CD players. For Japan the same
decision has an opportunity cost of two CD players. Therefore, Japan has a
comparative advantage in PCs.
Were Japan to reallocate resources to CD players, the opportunity cost of one extra CD player is 1/2 of a PC. For the UK the opportunity cost is 1/4 of the PC. Thus the UK has the comparative advantage in CD players.
Specialisation and potential gains from trade
|After Specialisation||CD Players||Personal Computers|
Output of both products has increased - representing a gain in economic welfare. Total output of CD players has increased by 2000 units and total output of personal computers has expanded by 500 units.
Allocating the gains from trade
For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of exchange of one product for another. To work this out, consider the internal opportunity cost ratios for each country.
Without trade, the UK has to give up four CD players for each PC produced.
A terms of trade (or rate of exchange) of 3 CD players for each PC produced would be an improvement for the UK In the case of Japan (specialising in producing personal computers) for each
|After trade (3 CD's for 1 PC)||CD Players||Personal Computers|
compare with the original production matrix
|Pre-Specialisation||CD Players||Personal Computers|
After trade has taken place, total output of goods available to consumers in both countries has grown. UK's consumption of CD players has increased by 200 and they have an extra 100 PCs. For Japan, they have an extra 200 CD players and 200 PCs.
Assumptions underlying the concept of comparative advantage
Perfect occupational mobility of factors of production
- resources used in one industry can be switched into another without any loss of efficiency
Constant returns to scale (i.e. doubling the inputs in each country leads to a doubling of total output)
No externalities arising from production and/or consumption
Transportation costs are ignored
If businesses exploit increasing returns to scale (i.e. economies of scale) when they specialise, the potential gains from trade are much greater. The idea that specialisation should lead to increasing returns is associated with economists such as Paul Romer and Paul Ormerod
What determines comparative advantage?
Comparative advantage is a dynamic concept. It can and does change over time. Some businesses find they have enjoyed a comparative advantage in one product for several years only to face increasing competition as rival producers from other countries enter their markets.
For a country, the following factors are important in determining the relative costs of production:
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). If an economy can improve the quality of its labour force and increase the stock of capital available it can expand the productive potential in industries in which it has an advantage.
Investment in research & development (important in industries where patents give some firms significant market advantage) - for more information on this have a look at this page
Movements in the exchange rate. An appreciation of the exchange rate can cause exports from a country to increase in price. This makes them less competitive in international markets.
Long-term rates of inflation compared to other countries. For example if average inflation in Country X is 4% whilst in Country B it is 8% over a number of years, the goods and services produced by Country X will become relatively more expensive over time. This worsens their competitiveness and causes a switch in comparative advantage.
Import controls such as tariffs and quotas that can be used to create an artificial comparative advantage for a country's domestic producers- although most countries agree to abide by international trade agreements.
Non-price competitiveness of producers (e.g. product design, reliability, quality of after-sales support)
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