The Comparative and Absolute Advantage Theory

Introduction

Ideally no country in the world has complete advantage in production terms over another one. If it did so, it would be self-sufficient. This concept might have been popular in the past with respect to developing an internal economy that ideally caters to the needs of the local people. Hence, there would be no need to import goods and this policy would both suit the government and its people. This perception is both idealistic and unfounded in today’s economic situation. Within globalisation, all countries have some degree of dependency on one another and accept to trade in order to satisfy their domestic needs. Possibly, conditions where countries had absolute advantage existed earlier when industrialisation stepped in. The industrialised nation could produce much more effectively most goods than an undeveloped nation. At the same time, the trading partner could be a colony of the advanced nation which might consider it well to exploit resources from the poorer nation and consider it to be its market in terms of backward integration. Today, it is right to say that dependencies or colonised becomes are quite rare and that trade dependence is the existing mode underpinning international business.

There are theories that have been successfully adapted to trade whereby countries make exchanges in relation to what they produce better than others. Cuba is known for its high level of sugar production and is a market leader as such. Russia, an ally to Cuba, might be stronger in developing technology due to the earlier capabilities of the ex-USSR. If we imagine a trade opportunity between these two nations, it would be clear that Cuba would trade sugar for industrial or medical products from its ally, Russia. In a similar way, Russia cannot produce the sugar it needs for its consumption and needs to rely on Cuban sugar exports for its domestic consumption.

One of the major trade theories therefore rests on the foundation that one country can better produce certain products than another one with respect to another country. There are many factors that can illustrate such a theory known as the theory of comparative advantage. When Great Britain had colonies all over the world, it traded with them by selling electrical goods, industrial products and processed food in exchange of sugar and other tropical fruits or agricultural products.

Emerging economies within comparative advantage theory

Emerging economies are developing quite rapidly their opportunity to trade. Within globalisation such economies export quite well their production depending upon their degree of specialisation. Africa, Caribbean and Pacific countries forming part of the ACP sugar exporters sell sugar to the European Union. Their bargaining power was quite strong in the past as the importing countries provided a guaranteed price. African nations under the Lomé IV Convention of the past century benefited from guaranteed price from the sales of sugar. When European beet producers claimed their need to have beet sugar sold in the European Union, a protectionist attitude had the impact of lowering considerably the price of sugar exports by 36% making it much less economical for emerging markets to trade. Despite this compromising trade condition, such nations still sell sugar at comparative advantage but is this truly comparative today?

From another stand, emerging economies are providers of raw materials for input to production to advanced economies. Saudi Arabia and Arab countries forming part of the Organisation of Petrol Exporting Countries (OPEC) still trade oil with the rich countries. Ghana exports cocoa while Malaysia or Indonesia might specialise in the exports of palm oil and rubber.

There is also some evolution today despite the fact the general trade pattern remains the same. Some emerging economies are shifting to the services sector, some are diversifying their economy to create an industrial base, some others might specialise in niche areas like medical tourism, cosmetics, etc. All these to state that production shifts might to some extent counter comparative advantage. This has also been a tough test for China whose trade with the USA puts the giant emerging economy at comparative advantage with the superpower in the sense that there seems to be a trade war and protectionism more applied in such trade nowadays.

There is another useful concept where developing economies are fast developing their technological infrastructure. This allows such nations to benefit from technological transfer and produce goods that they were not earlier exposed to at an industrial level. Bangladesh, Turkey and Rwanda might have been quite good in apparel production but the fact that technology has been transferred to them recently make them become potential bases for production of clothing apparel with comparatively lower labour costs. Also, advanced economies are outsourcing production to emerging markets where they find it easier to produce and purchase.

However, emerging economies will remain dependent on mutual trade because innovations are developed in rich countries. Think of communication tools like smartphones along with mobile technology. This innovation comes from developed economies that, in turn, sell their products to emerging markets or produce such goods at low prices in emerging markets and eventually target them. There is also the possibility of franchising and licensing in emerging markets where the middle class and affluent people are eager to purchase western products that have an international or even global brand appeal. Names like Nike, Dolce and Gabanna or Tagheuer appeal highly to customers in emerging markets and makes them become targets for advanced economies that benefit in this circumstance from comparative production advantage both in terms of scale of production and technological expertise.

We will now examine certain situations illustrating the concept of comparative advantage:

  1. The United Kingdom produces industrial goods while it trades with other countries for some products like uranium, zinc, bauxite, and all the mineral resources which she cannot have or produce.
  2. Many tropical and sub-tropical products like rubber, rice, grapes may be produced in the United Kingdom but only at the expense of large heated greenhouses. Clearly, it is much cheaper for her to buy these things from the countries which can grow them out in open air at a little expense.
  3. Sometimes, two countries are capable of producing two products equally cheaply, but it has been found that if each country specialises in just one of the products, and makes enough to satisfy the wants of both countries, it will be producing in sufficient large numbers to reap the economies of scale in production. In this way, both countries will be able to raise their total production considerably and so raise the living standard in each country respectively.

Comparative advantage is when a country produces a good or service for a lower opportunity cost than other countries. Opportunity cost measures a trade-off. A nation with a comparative advantage makes the trade-off worth it. The benefits of buying their good or service outweigh the disadvantages. The country may not be the best at producing something. But the good or service has a low opportunity cost for other countries to import.

For example, technologically-advanced nations have comparative advantage in producing technologically-based products like machines. Their domestically-produced technology provides material at better cost and price when compared to countries without it. Advanced nations like Japan and the USA are competitive with other nations in developing new technology. Their technology is cheaper making their opportunity cost low.

Another example is Bangladesh’s textile industry. Rich nations purchase textiles because it is cheaper than producing in the West. Bangladeshi companies provide their service cheaply enough to make the transaction worth it.

In the past, comparative advantages occurred more in goods and rarely in services. The reason is that products are easier to sell. But telecommunication technology like the internet is making services easier to export. Those services include call centres, banking and entertainment.

Five basic reasons why trade may take place

There are five basic reasons why trade may take place. The purpose of each model is to establish a basis for trade and then to use that model to identify the expected effects of trade on prices, profits, incomes, and individual welfare.

Differences in technology

Advantageous trade can occur between countries if the countries differ in their technological abilities to produce goods and services. Technology refers to the techniques used to turn resources (labour, capital, land) into outputs (goods and services).

Differences in resource endowments

Advantageous trade can occur between countries if the countries differ in their endowments of resources. Resource endowments refer to the skills and abilities of a country’s workforce, the natural resources available within its borders (minerals, farmland, etc.), and the sophistication of its capital stock (machinery, infrastructure, communications systems).

Differences in demand

Advantageous trade can occur between countries if demands or preferences differ between countries. Individuals in different countries may have different preferences or demands for various products. For example, the Chinese are likely to demand more rice than Americans, even if consumers face the same price. Canadians may demand more beer, the Dutch more wooden shoes, and the Japanese more fish than Americans would, even if they all faced the same prices.

Existence of economies of scale in production

The existence of economies of scale in production is sufficient to generate advantageous trade between two countries. Economies of scale refer to a production process in which production costs fall as the scale of production rises. This feature of production is also known as ‘increasing returns to scale’.

Existence of Government policies

Government tax and subsidy programmes alter the prices charged for goods and services. These changes can be sufficient to generate advantages in production of certain products. In these circumstances, advantageous trade may arise solely due to differences in government policies across countries.

Illustrations

Comparative Advantage may be illustrated as follows:

Let us suppose that there are two countries: Country P and Country Q.

To keep our example simple, we will suppose that there are also two products involved: wheat and motorcars. There are six hundred workers in each country and before they began to specialise and trade with each other they allocated their labour force between wheat and cars as follows: 200 men growing wheat and 400 men making cars.

Their results were as follows:

It can be seen that Country Q is poorer than Country P in both fields of production. At this level, we say that it has comparative advantage on both factors of production. If Country Q would produce only 100 tonnes of wheat and produce 40 cars, then Country P would have absolute advantage over it.

In the above figure, Country Q which employs 200 men can produce only hundred tonnes of wheat compared with Country P’s 200 tonnes. The 200 men in Country P can produce 80 cars to the 20 cars by the same number of men in Country Q.

The people in Country Q may fear about engaging in trade with Country P. Their attitude will be as follows: If Country P’s production processes are more efficient than ours, then they will have nothing in particular to deal with Country Q.

If we examine the figures closer, we see that although Country P is superior to Country Q in both wheat and car production, her superiority is greater in car production than in wheat production. For example, it produced two and a half times as many cars than Country Q but less in terms of wheat production.

Absolute Advantage

Absolute advantage means being more productive or cost-efficient than another country whereas comparative advantage relates to how much productive or cost efficient one country is than another. In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce a greater quantity of a good, product, or service than competitors, using the same amount of resources.

The Concept of Specialisation

If specialisation has to take place, it seems it would be better for Country P to specialise in the making of motorcars where her superiority is greater, while Country Q specialises in the production of wheat where her inferiority is less marked.

Let us see what happens if Country P allocates all her six hundred workers to car production and Country Q allocates all her six hundred workers to wheat production.

Country P:
400 men produce 50 cars.
600 men produce: 50/400
600 =75 cars.
Country Q:
200 men produce 120 tonnes of wheat.
600 men produce: 120
3=360 tonnes of wheat.

If one compares these levels of production with the totals which we had before, that is, 300 tonnes of wheat and 100 cars compared with 360 tonnes of wheat and 180 cars, it is seen that the total production of both commodities is now greater by say, 5 cars and 40 tonnes of wheat.

The diagram below illustrates the production possibility curves of two economies X and Y.

Which country has comparative advantage or absolute advantage?

Answer

Country Y has comparative advantage in the production of machines because it produces one food unit to one machine unit whereas Country X produces 2 food units to 1 machine unit.

The table below shows the output per worker of three products in three countries.

If these countries agree to produce according to comparative advantage, the best combination of product specialisation that would result.

Answer

Convert to ratios:

According to the table, Country A is better at producing chicken (2.5), Country B is better at producing lamb (1.5) and Country C will have to produce beef.

Illustration of benefits of comparative advantage

The rise of Southern economies has given hope to millions of being lifted out of abject poverty. The emerging economies are creating their own niche in the development process, and occupying a notable place in the knowledge economy.

In the primary products, exports from emerging economies and their combined exports stood at 165 billion dollars in 2017, and consequently, their share in emerging economies exports rose from 30 percent to 45 percent. Brazil, India, and China performed significantly well, and registered a compound annual growth rate (CAGR) of 11 percent, 12 percent, and 9 percent respectively in primary goods exports.

In agro-product exports, South and South-East Asian Economies, including Malaysia, Indonesia, Philippines, India along with Russia, China, and Poland, were major exporters. These countries accounted 44 percent in 2017. Among these countries, Malaysia was an exceptional performer, followed by Indonesia.

In processed food exports, Brazil, Poland, Mexico, India, Indonesia, and the Philippines are key exporters among the emerging economies. Collectively, their exports amounted to 64.4 billion dollars in 2017; consequently, their share in emerging market exports increased from 15 percent to 28 percent in the same period. Among them, Brazil and Mexico were the major exporters.

A few criticisms of comparative cost advantage theory

Unrealistic assumption of labour cost

The main criticism of the comparative advantage principle is that it is based on the labour theory of value. In calculating production costs, it takes only labour costs and neglects non-labour costs involved in the production commodities. This is highly unrealistic because it is money costs and not labour costs that are the basis of national and international transactions of goods. Further, the labour cost theory is based on the assumption of homogeneous labour. This is again unrealistic because labour is heterogeneous-of different kinds and grades, some specific or specialised, and other non-specific or general [5].

No similar tastes

The assumptions of similar tastes are unrealistic because tastes differ with different income brackets in a country. Moreover, they also change with the growth of an economy and with the development of its trade relations with other countries.

State assumption of fixed proportions

The theory of comparative costs is based on the assumption that labour is used in the same fixed proportions in the production of all commodities. This is essentially a static analysis and hence unrealistic. As a matter of fact, labour is used in varying proportions in the production of commodities. For instance, less labour is used per unit of capital in the production of steel than in the production of textiles. Moreover, some substitution of labour for capital is always possible in production.

Unrealistic assumption of constant costs

The theory is based on another weak assumption that an increase of output due to international specialisation is followed by constant costs. The fact is that there are either increasing costs or diminishing costs. If the large scale of production reduces costs, the comparative advantage will be increased. On the other hand, if increased output is the result of increased cost of production, the comparative advantage will be reduced, and in some cases it may even disappear.

Ignores transport costs

The concept developed by Ricardo ignores transport costs in determining comparative advantage in trade. This is highly unrealistic because transport costs play an important role in determining the pattern of world trade. Like economics of scale, it is an independent factor of production. For instance, high transport costs may nullify the comparative advantage and the gain from international trade.

Factors not fully mobile internally

The principle assumes that factors of production are perfectly mobile internally and wholly immobile internationally. This is not realistic because even within a country factors do not move freely from one industry to another or from one region to another. The greater the degree of specialisation in an industry, the lower is the factor mobility from one industry to another. Thus, factor mobility influences costs and hence the pattern of international trade.

Two-country two-commodity model is unrealistic

The Ricardian model is related to trade between two countries on the basis of two commodities. This is again unrealistic because in actuality, international trade is among countries trading many commodities.

Unrealistic assumption of free trade

Another serious weakness of the principle is that it assumes perfect and free world trade. But in reality, world trade is not free. Every country applies restrictions on the free movement of goods to and from other countries. Thus, tariffs and other trade restrictions affect world imports and exports. Moreover, products are not homogeneous but differentiated. By neglecting these aspects, the Ricardian theory becomes unrealistic. Unrealistic assumptions of full employment

Like all classical theories, the theory of comparative advantage is based on the assumption of full employment. This assumption also makes the theory static.

Self-interest hinders its operation

The doctrine does not operate if a country having a comparative disadvantage does not wish to import a commodity from the other country due to strategic, military or development considerations. Self-interest stands in the operation of the theory of comparative costs.

Neglects the role of technology

The theory neglects the role of technological innovations in international trade. This is unrealistic because technological changes help in increasing the supply of goods not only for the domestic market but also for the international market. World trade has gained much from innovations and research and development.

Perspective

Heckscher-Ohlin Model and Krugman philosophies on comparative trade

The Heckscher-Ohlin model is an economic theory that proposes that countries export what they can most efficiently and plentifully produce. It evaluates trade and the equilibrium of trade between two countries that have varying specialities and natural resources. The model emphasises the export of goods requiring production factors that a country has in abundance. It also focuses on the import of goods that a nation cannot produce as efficiently. It takes the position that countries should ideally export materials and resources of which they have an excess, while proportionately importing those resources they need.

The Heckscher-Ohlin model explains mathematically how a country should operate and trade when resources are imbalanced throughout the world. It pinpoints a preferred balance between two countries, each with its resources.

The model incorporates other production factors such as labour. The costs of labour vary from one nation to another, so countries with cheap labour forces should focus primarily on producing labour-intensive goods, according to the model.

The model emphasizes the benefits of international trade and the global benefits to everyone when each country puts the most effort into exporting resources that are domestically naturally abundant. All countries benefit when they import the resources they naturally lack. Because a nation does not have to rely solely on internal markets, it can take advantage of elastic demand. The labour cost increases and marginal productivity declines as more countries and emerging markets develop. Trading internationally allows countries to adjust to capital-intensive goods production, which would not be possible if each country only sold goods internally.

In the late 1970s, Krugman noticed that the accepted model that economists used to explain patterns of international trade did not fit the data. The Hecksher-Ohlin model predicted that trade would be based on such factors as the ratio of capital to labour, with ‘capital-rich’ countries exporting capital-intensive goods and importing labour-intensive goods from ‘labour-rich’ countries. Nevertheless, Krugman noticed that most international trade takes place between countries with roughly the same ratio of capital to labour.

The watch industry in capital-intensive Switzerland, for example, exports watches to labour-intensive India, while Indian consumers also import watches from Switzerland through online traders like e-bay or Amazon. Krugman explained it with a simple, elegant and rigorous, model in which monopolistic competition was key. Under monopolistic competition, each firm’s product is differentiated from each other firm’s product. But monopolistically competitive firms compete with each other and competition drives economic profits to zero. In the monopolistically competitive equilibrium, each firm has unexploited economies of scale. For example, both Toyota and Mercedes could reduce average costs by producing a larger output in particular niches of the market. But they do not practice it because they could so only by reducing their price, and that would cost them profits.

Points to ponder

The Heckscher-Ohlin model is an economic theory that evaluates trade by emphasising the export of goods requiring production factors that a country has in abundance compared with the import of goods that a nation cannot produce as efficiently. Krugman noticed that most international trade takes place between countries with roughly the same ratio of capital to labour.

Case Study: A short perspective of comparative advantage

International trade, investment, migration and global economy, effects in the daily life, our global is a world of economic relationships; one cannot leave the world behind, in multinational cooperation and world financial markets. There is special problem in developing international economics, for the deep analysis of the international economies, theories need to support and balance the internal relations or global economy. The theories of International Economics might support the dispute of Europe and global economy are absolute advantage theory and comparative advantage theory. These theories could be beneficial to sustain the international trade and global surroundings.

Based on trade, any company could have competitive advantage; the country can get benefits after export its commodity or products, and if the country has inefficient ways of production, then country can import the products. Comparative advantage theory can support the economy and can lower or lessen the rate of disputes. If the company is producing higher number of products in lower price, then through comparative advantages, benefits and stability could be attained. However, if any country is producing less number of products in higher prices then import products on lessen prices, than country own production, will also give comparative advantages to the country. For example, if America is producing clothes at cheaper or lesser prices than in India, and India is producing crops (wheat) at cheaper or lower price than America, then comparative advantage can take place (Hantal, 2015).

In this way, relationship between both the countries could be better, and dispute rate around the world, on different issues could be resolved, it will also result in increased domestic opportunities and production, as the country needs to get compensation in future, from fewer input maximum output could be generated. Through comparative advantage, transportation cost could also be saved. If one country is less productive, then export can be helpful, world trade has laws and regulations to prolong this theory, natural environment could be sustained. As regarding to the health issues, to remove disputes, as country get many disadvantages of disputes trading is essential, economy of the country can also develop strong relationships with other country, and can help them and get help when needed.

Questions

How might comparative advantage theory help in lowering disputes in international business? How might transportation costs be covered through comparative advantage? Do emerging economies benefit from comparative trade, how and to what extent?