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Deconstructing Theory Of Comparative Advantage

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Question:

Discuss about the Deconstructing Theory of Comparative Advantage.
 
 

Answer:

Introduction:

The Gross Domestic Product of a country is the sum of the values of the goods and services produced within the geographical boundaries of a country, within a particular period of time, usually one economic year. The GDP of a country and the growth in the same is an indicator of the economic growth of the country. However, though the increase in the GDP of a country indicates that the productivity of the country is increasing and the country is experiencing economic growth, the welfare of the residents of the country cannot be robustly measured with the help of this economic indicator (Burda and Wyplosz 2013). The reasons are as follows:

  • The distribution of income of a country cannot be seen from the increase in the GDP of the country. Even if there is high inequality in income distribution of the country but the productivity of the country is high, then also the GDP of the country will be high though the welfare of a major share of people residing in the country will be low.
  • The GDP of a country does not take into account the development indicators like education, health, sanitation and others.
  • The GDP of a country only takes into account the value of the final goods and services that are accounted for within the country. But there are many goods and services which are produced in a country and are not accounted for. GDP cannot account for these goods and the positive and negative externalities (Fleurbaey and Blanchet 2013).

Having a high GDP does not essentially mean that the country is also doing well in terms of the overall economic development and welfare aspects, which can be seen from the following table:

Country

GDP Ranking (2016)

HDI Ranking (2016)

China

2

90

Norway

30

1

As can be seen from the above table, China excels visibly in terms of the GDP growth as it stands second in the world GDP ranking in 2016. However, when seen in terms of the Human Development Index, which measures the overall welfare of the residents of the country in terms of education, income and life expectancy, the country ranks visibly low at 90. Norway on the other hand, ranks 30th in terms of GDP but excels in the welfare grounds by topping the chart in the global scenario (Bray et al. 2012).

One of the major criteria which the firms take into account while taking decisions regarding investment expenditures is the rate of interest which is prevailing in the economy under the domain of which it operating at that particular point of time. This is the interest rate in the country determines the amount of borrowing and also the amount of saving. When the interest rates are high, households as well as firms borrow less as the cost of borrowing is high. Conversely, a lower interest rate prevailing in a country boosts up borrowing which in turn increases the investment expenditures of the firms (Mankiw 2014). This can be shown with the help of the following diagram and taking references of the two countries, the United States of America and the Japan:

As can be seen from the above figure, a higher rate of interest rate increases savings and discourages borrowings, thereby decreasing the investment expenditure as is currently seen to be happening in the USA as the Federal Reserve is increasing their interest rate. On the other hand a lower interest rate increases the extent of investment expenditures as the commercial firms as well as the households gain confidence to borrow money from the banks. This is the case, which is consistently prevailing in Japan over the last few years. The interest rates are maintained at almost a negative level in the country, which facilitates investments tremendously which n its turn can be considered to be one of the driving force and primary factor behind the country’s impressive growth (Aron et al. 2012).

 

Implications of interest rate on the growth of GDP:

When the interest rate of a country prevails at a low level, it facilitates borrowing and investment expenditures in the country as discussed above. Investment being one of the significant components of the aggregate demand in any country, the rise in the investment expenditures increases the aggregate demand in the country, which in its turn contributes in increasing the overall productivity in the country in that particular period of time. This in its turn facilitates the economic growth of the country and the GDP of the country experiences positive growth (Mankiw 2014).

Thus, it can be asserted that in a general framework, lower interest rates facilitates borrowing and investment expenditure in a country, which in turn increases the aggregate demand and the GDP of the country is expected to rise.

The comparative advantage theory of international trade came after the limitations of the classical trade theory of absolute advantage in trade were revealed. According to the comparative advantage theory, a country tries to specialize in the production of that commodity or service and also tries to export the same in which it experiences a comparative advantage in production, over the other country with which it is trading. In simpler words, a country generally exports that commodity, which it can produce abundantly, and more cost effectively, depending upon the nature of resources it has and imports that commodity which it cannot produce efficiently and has a comparative disadvantage than the other countries with which it is trading (Gopinath, Helpman and Rogoff 2014).

The theory of comparative advantage is considerably relevant in the real world trade scenario as the countries do export the goods and services which they can produce more efficiently than others do and imports those commodities or services whose domestic cost of production is high.

When considered from a broader and generalized perspective, free trade is expected to benefit all the countries in the world as free trade allows the consumers of a country to get products at a cheaper price and the firms of the country to export their products and earn revenue. However, though it has many positive implications on the economic growth of the countries, there are several negative implications of the same, especially in the less developed or developing countries. In these countries, the existence of free trade often poses threat to the growth of the small domestic industries as their bigger global counterparts gain the market by providing better quality commodities at a cheaper price, which prevents the domestic firms to attain economies of scale. Again restricting free trade by imposing tariffs also hamper the firms as they cannot import new innovations, technologies and improved machineries from abroad to boost up their production (Schumacher 2013).

 

References

Aron, J., Duca, J.V., Muellbauer, J., Murata, K. and Murphy, A., 2012. Credit, housing collateral, and consumption: Evidence from Japan, the UK, and the US. Review of Income and Wealth, 58(3), pp.397-423.

Bray, F., Jemal, A., Grey, N., Ferlay, J. and Forman, D., 2012. Global cancer transitions according to the Human Development Index (2008–2030): a population-based study. The lancet oncology, 13(8), pp.790-801.

Burda, M. and Wyplosz, C., 2013. Macroeconomics: a European text. Oxford university press.

Fleurbaey, M. and Blanchet, D., 2013. Beyond GDP: Measuring welfare and assessing sustainability. Oxford University Press.

Gopinath, G., Helpman, E. and Rogoff, K. eds., 2014. Handbook of international economics (Vol. 4). Elsevier.

Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.

Schumacher, R., 2013. Deconstructing the theory of comparative advantage. World Social and Economic Review, 2013(2, 2013), p.83.

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