We must also consider the possibility of one country to produce all goods with less resources than another country. Under this circumstance both country’s can still trade if the relative efficiency between the two varies. This is particularly an advantage for less developed countries. If a developed country is more efficient in, for example producing silk and wheat. They produce eight metres of silk and four kilos of wheat as oppose to the less developed country producing one metre and two kilos. They both use the same amount of factor resources. However the less developed country has what is known as a comparative advantage in wheat with the developed country’s comparative advantage lying with silk. This is as wheat is cheaper in relation to silk in the less developed country. One metre of silk is sacrificed for two kilos of wheat compared to eight metres and four kilos in the developed country. The opportunity cost of producing wheat in the developed country is four times that of the less developed country. In relation, the opportunity cost of producing silk is four times higher in the less developed country.
Countries will export goods in which they have a comparative advantage on and import goods in which they have a comparative disadvantage. If we continue to use silk and wheat as examples we can also identify how the two goods are likely to reflect their opportunity costs. The less developed country produces two kilos of wheat for one metre of silk. It can therefore be said that the price of two kilos is roughly equivalent to one metre. Therefore the pre-trade exchange ratio for the less developed country would be two wheat for one silk and the developed country one wheat for two silk. As long as the exchange ratio is between 2:1 and 1:2 both countries will gain from exporting. The less developed country will gain from exporting wheat and importing silk and the opposite will be the case for the developed country. The relative price of wheat and silk after trade takes place will determine the actual exchange ratio. Prices are determined by total demand for and total supply of the good. Gains of the two countries may not be equal if the trade exchange ratio is nearer to one of the countries pre-trade ratios.
If a country increasingly specialises in one particular good, eventually it will cut into resources that would more adequately produce other goods. Therefore quantity produced of the other goods will be decreased. As a result, the country’s opportunity cost will increase. For example if a country specialises increasingly more in the production of tomatoes, it will have to cut into land that was used to grow potatoes. This land is less suited for tomato production and it also means land is taken away from and therefore a reduction in production of potatoes. The increasing opportunity cost is potato production levels. These growing costs of specialisation will lead to a reduction and eventual loss of the country’s comparative cost advantage. Further specialisation is therefore of no benefit.
It is the terms of trade that determine how much each country receives from their exports and how much they must pay for imports. In a base year the price index will be 100. It is the base year that all price changes, both up and down, are measured against. The base year of 100 would increase to 115 if the average price of exports relative to the average price of imports rose by 15 per cent from the first or base year. This 115 would then become the terms of trade as oppose to 100. The terms of trade change as demand and supply of imports and exports change. The exchange rate can also have an affect on the terms of trade.
The law of comparative advantage directly involves countries factor of resources and how these resources affect their comparative costs in an international market. However these are not the only factors that will affect countries comparative costs and which allow them to gain from international trade. Even if no initial comparative cost differences exist between the two countries they can still specialise due to economies of scale. As economies of scale are introduced so to are comparative cost differences. Countries eventually gain a comparative advantage.
The theory of comparative advantage does however make many assumptions. It assumes that there are no transport costs. In reality transport costs always exist and they will almost certainty reduce and sometimes even eliminate completely any comparative cost advantages. The theory also only features two economies producing two goods. This assumption is made to simplify its explanation, however when taken into theory in a broader sense there may be many complications. It is also taken for granted that traded goods are homogeneous or identical. But a Toyota car is different from a ford car. It can therefore be far more difficult to conclude that, for example, the Japanese have a comparative advantage in the production of cars. Factors of production are also assumed to be perfectly mobile. In order for a country to benefit from comparative advantage it must reduce those industries in which it is at a disadvantage and expand those in which it has an advantage. This inevitably leads to a fall in wages, price and then employment in the declining industry. Prices may be increased easily but are very difficult to bring down- ie the downward inflexibility of prices. This will form part of a general resistance to change from those in the declining industry. Such inflexibility may prevent an economy from benefiting fully from comparative advantage. There is no allowance for tariffs or quotas (trade barriers). Tariffs being taxes placed on imports either for the objective of raising revenue or protecting industries. These will be determined by the elasticity of demand for imports. If demand is elastic then the price increase imposed by the tariff will lead to a fall in demand for the import thus protecting domestic industries. Quotas are a quantity restriction on the amount of imports allowed into a country. They protect inefficient home producers. As a result people employed within certain declining industries may benefit, but consumers are left to pay higher prices for the goods. Comparative advantage also assumes there is perfect knowledge within markets. All buyers and sellers know where the cheapest goods can be found internationally.
In conclusion countries have different endowments of factors of production. These differences include population density, labour skills, capital employment, climate and raw materials. Country’s different factors remain somewhat unique as they are relatively immobile between countries. Land and climate are obviously immobile but restrictions, such as physical and social ones, restrict countries in the international market more than in their domestic market. Comparative costs of producing goods therefore vary.
Two countries which initially do not hold comparative cost differences can specialise in industries if economies of scale can be achieved as introduction of one will lead to introduction of the other. Therefore economies of scale is the only opposition to different endowment of factor resources fully explaining countries differences in comparative costs.
