This principally is where one country contains an advantage at producing a certain good more efficiently than another country i.e. can produce certain goods at a cheaper cost, but at the same time can be less efficient in producing another good in comparison to another country. (Piggott, Cook, 1999, p.50) uses the example “if we assume Belgium is more efficient at producing chocolates than the UK but the UK is more efficient in the production of cheese, then Belgium should produce chocolates and trade these with the UK in exchange for cheese; similarly the UK should produce and trade cheese for chocolates. Such an international specialisation and exchange will increase output of both chocolates and cheese, thereby allowing both countries to enjoy a high standard of living.” Here was a more conducive environment for which World Trade was to grow and benefit from country to country exchange and trade. However comparative advantage was not always possessed by every nation and also made this method of trading unfair in its existence and accounted for a small amount of world trade as a result. This caused people to rethink the theory from which came Ricardo’s Theory of Comparative Advantage.
The Theory of Comparative Advantage was to permanently change the way World Trade operated and create a fairer system for all to trade within. Comparative Advantage used the factor of superiority or quality of product as a method of gauging when a firm/country has or has not a comparative advantage. (Piggott, Cook, 1999, p51) used the following table to display how comparative advantage works: -
This table displays that Germany still obtains a degree of superiority in producing beer at a ratio of 8:2 which is better than its superiority in clothing which stands at a ratio of 16:12. Therefore Germany obtains a comparative advantage in Beer and comparative disadvantage in Clothing. France still has a comparative advantage in clothing even though Germany would appear to produce more, as they still have superiority in producing clothes when compared to beer as a ratio of 12:16 in clothing is better than the ratio of 2:8 in beer. This is where the law of comparative advantage comes from and (Piggott, Cook, 1999, p.52) states “each country should specialise in the product in which it has a comparative advantage and total world output of all goods will increase. All countries will gain.” However we must consider that the theory of comparative advantage is based mainly around assumptions, in particular technology. It also assumes that labour and capital are substititutional when in fact this is not always realistically possible. (Piggott, Cook, 1999, p.54) uses the example ”if highly skilled agricultural workers were transferred to high-technology computer industries, it is likely that efficiency would decline quite quickly as skills are not necessarily easily transferable as well as some other factors of production. Both Comparative Advantage and Absolute advantage do not take into consideration transaction costs, and in reality if the transaction costs of a good are too high then trade is unlikely to occur. Comparative Advantage also assumes full employment exists, which in reality does not exist. There is also no explanation of how different costs exist in relation to comparative costs. About 100 years later Heckscher-Ohlin came up with a potential solution to the problem of different costs etc.
Heckscher-Ohlin’s Theory assumes there are more than one factor of production such as land, labour and capital. It also takes into consideration that different goods need various shares of the different factors of production i.e. some goods are more labour, land or capital intensive. Also that different firms/countries contain varying amounts of the factors of production and as a result can create varying relevant factor prices. According to (Piggott, Cook, 1999, p.55) “This leads to the basic Heckscher-Ohlin conclusion – that countries should specialise in the goods which use intensively the factor of production which they have in abundance.” Such an example would be if a country which was particularly abundant in labour then they would specialise in producing labour intensive goods e.g. Turkey, India, Taiwan and Korea producing labour intensive goods such as textiles and the same would be applied in reference to capital intensive and land intensive goods. Though in reality some countries do not deal in the way predicted e.g. USA as discussed later in the Leontief Paradox. Yet again the Heckscher-Ohlin Model is based on assumptions. It does not allow for product differentiation other than whether it is labour or capital intensive and that production functions are the same in each country. It only considers 2 factors of production, 2 goods and 2 countries in its model. It also assumes each country to have same technology, which realistically is not the case. As well as this it depends upon constant returns to scale. It also assumes that the factors of production within a country are mobile and are not mobile cross borders, which is not the case especially today. Perfect competition is also assumed in the HO theory and there are again no transport costs to be considered as well as this is does not consider barriers to trade existing. Finally it assumes that no country will produce only one good but will produce both goods to a certain degree. When it came to applying the Heckscher Ohlin Theory to reality (Leontief, 1954) came up with a problem.
To illustrate this problem he created the Leontief Paradox. For the purpose of his study he used 1947 data from the USA and at that time the USA had a higher capita per head in comparison to its trading partners at the time. So the USA should export more of its capital intensive goods and import labour intensive goods but this proved not to be the case for the USA as it actually exported more labour intensive goods than it imported. This was totally opposite to what the Heckscher Ohlin model predicted. Though we should consider that the data used was in fact post war reconstruction statistics and where perhaps not the usual economic situation existed. New statistics were later used from 1951 but the paradox still remained although according to (Piggott, Cook, 1999, p.56) “Later work has suggested that ‘the paradox’ disappeared by the early 1970’s, although this does not dismiss the early problem. There is little reason to doubt that capital-abundant countries sometimes, temporarily, export labour intensive goods.” We must also remember that the HO model is a supply side theory and does not consider the demand side of things. As well as this (Vanek, 1963) says HO does not look or take into account natural resources of particular countries etc. Leontief on the other hand did not consider human capital within his labour idea (Piggott, Cook, 1999, p.56) claim Leontief thinks, “all labour has the same skill. It is argued therefore, that the USA was a skill abundant country, with a comparative advantage in skill-intensive, not in labour-intensive, commodities, so explaining the Leontief Paradox.” Therefore had Leontief considered labour differences then the problem would not have came about?
In relation to more modern thinkers and theory we shall look at Vernon’s Product Cycle Theory, which came about as a result of the Leontief Paradox. (Vernon, 1970) in particular addresses the relevant fact that some countries are more likely to have the ability to access high technology than others. As a result of this fact these countries have a tendency to have a comparative advantage in technologically advanced goods. He goes on to say that there are 3 stages to a product, namely: - new product – maturity/Innovation – standardised where mass production begins to occur. When at the new product stage the domestic market is fairly unsaturated, however when it reaches maturity stage it gradually becomes a more standardised product and this results in mass production occurring. This is when the product gets marketed internationally to similar markets and as there is an increase in the exports as a result then producers would begin taking into consideration the possibility of producing nearer or within that market, to save on costs etc. (Piggott, Cook, 1999, p.64) state “The conclusions reached by this theory are that different countries will export different products over time; similarly, different countries will export the same good as it moves through its life cycle.” A good example being that of colour TV Receivers as demonstrated in (Baker, 1990) originally began production in the USA in 1954, in 1967 imports of TVs stood at 6% and within 3 years these had increased to 19% of the market most of which came from Japan. The technology expanded to various countries like Korea and Taiwan who began overtaking Japan with imports and in 1977 Japanese imports had fallen 80 per cent. In relation to Vernon’s theory, it is not seen as being so relevant in the case of Multinational Enterprises who in fact cater for the global market whilst maintaining their base or headquarters in one particular country, as this goes against the basis of the theory. It is however still relevant for the inventive and innovative enterprises and as such still has much relevance today and of course relaxes the classic assumption of returning to scale.
Whilst there are still other theories to consider such as Linder, Dunning, Hennart, Kojima, Hymer etc. They all have basically worked towards the incremental process in creating Multinational companies and the understanding that World Trade can indeed be fairer than in the Mercantilists original theory. All of the theories help us to gain an understanding of the pattern of trade. All of the theories however seem to assume that Free trade is the normal and acceptable economy to them, when history has taught us, this is not in fact the case. You only have to consider the stability, which existed in the East German economy until the walls came down. So there is of course still the need for the incremental process to uncover new theories to combat such problems.
References
Baker, S, A. 1990. An introduction to International Economics. Harcourt Brace Jovanovich.
Hirst, P, Thompson, G, 1999. Globalisation in Question. 2nd Ed. Cambridge: Polity Press.
Piggott, J, Cook, M, 1999. International Business Economics. 2nd Ed. London: Addison Wesley Longman Ltd.
Vanek, J, 1963. The Natural Resource Content of Foreign Trade, 1870-1955. Cambridge, USA: The MIT Press.
Vernon, R, 1970. The Technology Factor in International Trade. USA: Columbia University Press.
