Trade between two nations is based on absolute advantage. When one country (UK) is more efficient than another (France) in the production of one good (cloth) but is less efficient than the other country (France) in producing a second good (wine), then both countries can gain by specialising in the production of the good of its absolute advantage and exchanging part of its output with the other country for the good of its absolute disadvantage. We can show that absolute advantage is the ability of one country the UK to produce a good (cloth) using less resource than another country France and that France as an absolute advantage in wine using less resource than the UK.
It wasn’t until some 40 years later in a publication written in 1817 by British economist David Ricardo, ‘Principles of Political Economy and taxation’ that the problem faced with Adam Smith’s theory of Absolute Advantage was addressed and a true theory of trade explaining the patterns of, and gains from trade was introduced
with the, ‘law of comparative (relative) advantage’. David Ricardo solved the problem the theory of absolute advantage brought up, by developing the theory of comparative advantage. Absolute advantage looks at absolute productivity differences, comparative advantage looks at relative productivity differences Absolute advantage suggests that no trade would occur if one country has an absolute advantage over both products in a two country scenario. The differences between absolute and comparative advantage theories are faint. Absolute advantage looks at absolute productivity differences, comparative advantage looks at relative productivity differences. Take the UK and France again as examples, this time UK is better than France at producing both products cloth and wine, using only one factor of production, labour. UK produces 6 cloths for every 4 bottles of wine, and France produces 5 cloths for every 1 bottle of wine. Absolute advantage suggests that no trade should occur, because the UK is more productive than France in producing both goods. The theory of comparative advantage on the other hand, suggests that trade should still occur, as the UK is comparatively better than France in wine production, and France is comparatively better than the UK in the production of cloths therefore creating a basis for mutually beneficial trade, unless the absolute disadvantage that one country as with respect to other country is in the same proportion for both goods.
Ricardo’s principle of comparative advantage is based on several assumptions, There are only two countries and two goods, with free trade between the two participates with, perfect mobility of labour within each country but completely immobile between the two countries. There are constant costs of production and no transportation costs. No technological change and the labour theory of value.
The last assumption that the labour theory of value holds, states that the value of a good depends exclusively on the amount of labour that has gone into the production of a good. Specifically labour is not the only factor of production, and it is not used in the same fixed proportions in the production of all goods. i.e. more capital is needed per worker for the production of capital intensive products such as machines than for the production of goods such as clothes. Plus there can be changes in the inputs in producing the goods, by substituting between, labour and capital and other factor in the production process. Furthermore labour cannot be homogeneous (fixed) because it varies with training, productivity and incomes. Thus comparative advantage need not be dependant on the labour theory of value but instead can be better explained using the concept of opportunity cost. Ricardo explaining the law of comparative advantage in these terms leaves his method unacceptable.
However this theory fails to explain the causes of comparative advantage. It merely suggests that complete specialisation can take place. In other words, why do countries not choose to specialise in the production of one good.
The Heckscher and Ohlin (H-O) theory was developed by two Swedish economists Eli Heckscher and Bertil Ohlin in the early 20th century. It aims to explain the causes of comparative advantage. The H-O theory extends our trade model to explain the basis of comparative advantage and examines the effects of international trade on the earnings of factors of production. Classical economists did not conclude these two questions. Stating only,that the difference in relative commodity prices between two countries is evidence of their comparative advantage forming the basis for mutually beneficial trade. The Heckscher-Ohlin theory presents the issue that international and interregional differences in production costs occur because of the differences in the supply of production factors (Ball, McCulloch, 1999). Those goods that require a large amount of the abundant, thus less costly factor will have lower production costs, enabling them to be sold for less in international markets (Salvatore, 1995). Countries such as the US with relatively large amounts of land export land intensive products (eg, cattle and grain) but a country like China would export labour intensive products. There are exceptions to the Heckscher-Ohlin theory which are to do with the assumptions that Ohlin drew. One assumption was that the prices of the factor depended only on the factor endowment. This is not accepted as factor prices are not set in a perfect market. There are such factors to consider such as legislated minimum wages and benefits which force the cost of labour to rise to a point greater than the value of the product than many workers can produce (Ball, McCulloch, 1999). Many economists attempted to disprove the Heckscher-Ohlin theory. The most notable effort was by a man named Wassily Leontief. His paradox was self named (Leontief Paradox) and disputed the theory as a predictor of the direction of trade. This paradox failed to empirically validate the country based Heckschler-Ohlin theory (Mankiw, 1997).
The H-O theory extends our trade model to explain the basis of comparative advantage and examines the effects of international trade on the earnings of factors of production. Classical economists did not conclude these two questions. The H-O theory is also based on a number of assumptions, these being, that there are two countries, two goods and two factors of production. That both countries have the same technical ability involved in the production process. Each of the goods has the same factor intensity either being labour intensive or capital intensive. Factors are free to move domestically with no obstacles to free international trade (tariffs, transport costs). Consumer preferences are equal in both countries and the perfectly competitive market for both goods and factors.
Tests of the classical theories of trade with constant opportunity costs between countries can be explained by the law of comparative advantage.
Ricardo successfully demonstrated that there can be gains from trade between countries were relative costs of production in autarky differ. His model does not rely upon the labour theory of value, but is it fact a general requirement in Pareto efficiency in production; therefore any gains from trade are due to the increase in the availability of goods for consumption. Ricardo’s theory has an assumption of only one factor of production in labour; this proposes that the patterns of trade are determined by the relative labour productivities. This assumption however also leads to the models deficiency and fails to explain the causes of productivity of labour.
The supply and demand conditions differ between countries because production conditions and consumer tastes differ. The main theories emphasize differences in production conditions rather than tastes. Ricardo argued that trade is profitable because countries have different comparative advantages in producing different goods forming the basis for trade.
The Heckscher and Ohlin theory agrees with David Ricardo’s theory that comparative advantages in production are the basis for trade, but the H-O model explains comparative advantage in terms of differences in factor endowments. One conclusion from the H-O model is the contradictory nature that when countries export goods intensive in their use of their more plentiful factor,(capital) and import goods intensive in their use of the scarce factor (labour), these naturally equate relative factor prices and relative prices in differing countries. Under free trade and no transportation cost, factor price equalisation could occur. This is however not true, for example: factory workers in a least developed country do not earn the same income has a London factory worker. It therefore is not consistent with many real world trading patterns. The evidence is that the H-O model explains a large part of the world’s trade patterns in the real world, but leaves two important trade patterns such as intra-industry trade which consists of the importation or exportation of similar but differentiated goods i.e cars, and international trade in natural resources (oil, gold, and diamonds) because a country either possess these or does not. Further theories of trade seek to analyse these.
Words,1852
Ashley Sproston
Bibliography
Mankiw, G, 1997, Principals of Economics, The Dryden Press
Salvatore,D 1999, International Economics, Wiley Prentice Hal
Pugel, T 2007, International economics, New York, Mcgraw-Hill Irwin
Salvatore,D, 2004, International economics, John wiley & sons
Ball,McCulloch, 1999, International Strategic Partnering Handbook, McGraw-Hill
Brenton, P,Scott,H, Sinclair, P, 1997 International trade A European text, Oxford university press
