Assessing The Potency Of The Theory Of Comparative Advantage In Explaining Production, Distribution And Allocation Of Scare Resources In The Global Economy

On successful completion of this module you will be able to demonstrate how to:

1. Examine and critically assess how scarce resources get produced, consumed and allocated and how various stakeholders in the global economy make optimal decisions.

2. Examine and critically assess the economic, market and political forces shaping the business environment.

3. Employ Comparative Advantage and related trade models in analysing a country’s role  in the world economy and the related effects on social, business and economic pathways.

Trade Theories in the Global Economy

With ever rising dependence between the economies, world market is now more complex in nature that makes it hard to develop ideal solution to assess the situation properly (Baumol and Blinder 2014). Though there were ideas in past that opening up economy deteriorates, however, researches over time has showcased that it not only aid to promote growth to the participating economy, moreover provides sustainability (Blonigen and Wilson 2018).  Once the trading between nations started to take place since the time of colonisation, researches started to find out the theories that can aid the economies to have better revenue generation through trading (Begg and Ward 2013).  Over the year there have been various researches regarding the trade theories, however most of them have failed to provide any solid solution to the question. During 1817, David Ricardo came with his theory of comparative advantage that provided a basis of understanding to enhance trade and how it can help a nation to increase its income through utilising the resources available to them (Ruffin 2017). This essay is aimed to critically assess the magnitude to which the theory of comparative advantage developed by David Ricardo is potent to explain how scare resources are produced, consumed and allocated in the global economy. While using the various theories and figures, this essay will provide analysis of the Ricardian model of comparative advantage considering the real life scenario.

Over the year there has been various researches that tried to trace how scare resources are produced, consumed and allocated in the global economy, however most of the researches failed to provide any solution (Daniels, Radebaugh and Sullivan 2016). During 1776, Adam Smith came with absolute advantage theory of trade that answered to this question to a great extent (Ginzberg 2017). According to the absolute advantage theory, if a country can produce one good with more efficiency compared to its trade partners, then it has absolute advantage in production of that good (Levchenko and Zhang 2016). With better efficiency in production, country with absolute advantage in production of the said good will export the same (Grant 2013). However, the absolute advantage model failed to describe how trade will occur in case a country has absolute advantage in production of both the goods and the other trade participating nation does have less efficiency compared to its trade partner (Laursen 2015). Thus, next to absolute advantage theory of Adam Smith, during 1817, David Ricardo came with his theory of comparative advantage that argues though between the two participating nations one may not have similar ability to produce goods and services, however, both of them can indulge into mutually beneficial trading as argued by David Ricardo (Habermas 2015). According to the researches of Watson (2015), it has been found that despite of being having absolute advantage in production of a commodity; it not necessarily promotes the fact that it will have comparative advantage. Owing to the fact that comparative advantage takes into account factor like opportunity cost, thus accepts the value of what the producing nation has to give up to produce something else (Cohen 2016). According to the Ready et al. (2017), despite a trade participating country has absolute advantage in production of many goods, it will possess comparative advantage in lesser amount in order to produce another thing, and lots of other things need to be given up.

Absolute Advantage Theory

According to the theory of David Ricardo, if there are two nations and they are trading two commodities, even if one nation between the participating countries have less efficiency in production of both the commodities, there is still ground to have mutually beneficial trade (Nunn and Trefler 2014). Depending upon the differences in commodity prices between the participating nations, Ricardian model of comparative advantage has been developed. Theory of comparative advantage argues that the trade participating nation that has lower relative price in production of a good has comparative advantage in production of the said good (Perman and Scouller 1999). Similarly good that has high relative price of production has comparative disadvantage in production (Fridell and Ervine 2015). In practical terms, theory of the comparative advantage provides the idea that between the two trade participating nations, one will export that commodity in which it has comparative advantage and the same country will import in which it has comparative disadvantage. Next to this, during 1919 another idea that describe how scare resources are produced, consumed and allocated in the global economy came into existence known as the Heckscher – Ohlin model (Feenstra 2015).

Heckscher – Ohlin Factor Endowment model is the extended version of the comparative advantage theory, that assess the comparative advantage through stating that different commodity requires different factor proportion to get produced and different economies have different amount of these factor endowment capability. Thus, trade participating countries will produce and export those goods only that utilise the resources, which are endowed to them (Tietenberg and Lewis 2016). Depending upon the factor abundance theory a nation will import only that commodity in which production requires those factors of production which are scares in the nations and expensive to avail. Thus, Heckscher – Ohlin model argues nations, export import capability will not only consider the opportunity cost to determine the trade flow, besides this, it is important to consider the factor endowment intensity (Grossman, Helpman and Kircher 2017).  Considering this, trading country that has abundance in capital will produce and export capital intensive goods and it will import labour intensive goods and services. On the other hand, those have abundance in labour, will produce and export labour abundance goods and import labour intensive goods

Comparative advantage is one of the best suited models to describe the production, distribution and allocation of scare resources (Lannaccone 2016). Using the data showcased in figure 1, phenomenon under analysis in this essay can be explained easily. From the figure 1, it can be seen that country B has absolute advantage in production of both the cars and trucks because it can produce either 35m cars or 21m trucks while utilising the available resources completely; whereas country A has absolute disadvantage in production of cars and trucks from the perspective of country B because it can produce only 6m trucks or 30m cars while utilising all the available resources. However, according to the comparative advantage, it can be seen that country B has 3.5-time efficiency in production of trucks with full endowment of available resources.

Comparative Advantage Theory

On the other hand, it can be seen that country B has only 1.17-time efficiency in production of cars compared to country A. Opportunity cost of producing cars for country A is (30/6 = 5:1) and opportunity cost of procuring truck is (6/30 = 1:5). On the other hand, opportunity cost of producing trucks by country B is (21/35 = 7:5) and opportunity cost of producing car is (35/21 = 5:3). Considering this, it can be seen that cost of producing cars is higher in the case of country B compared to country A; thus, country A will produce Cars and country B will produce trucks owing to lower opportunity cost (Sloman and Garratt 2016).    

Utilising the Trade Data since 1947 of US, Leontief attempted to test the efficiency of the Heckshcer-Ohlin model in real scenario (Guo 2015). According to the extended model of the comparative advantage it was assumed that being a capital abundant country, US will export capital intensive goods and import labour intensive goods. However, in reality it was found from the US Trade Data that US export more labour intensive goods and imports capital intensive goods (Feenstra 2015). This phenomenon is known as the Leontief paradox and it lead the researches again to the basic Ricardian model of comparative advantage. According to the, Leontief, as the determinant of the comparative advantage, terms of technology can be utilised because with change in technology, economies are ought to face larger impact compared to the factor endowment intensity.

Vernon during 1966 and Frenken during 2006 introduced a model that explain various stages of international trading and provides business executives to assess essential information regarding the product lifecycle on global scale (Krugman 2017). According to their research, it has been found that most of the product goes through product life cycle as showcased in figure 2. Initially the product is introduced by the developed nation and the nation starts to export the same (Mankiw, Taylor and Ashwin 2016). During next growth is achieved, where profit also tends to rise. Post the growth stage it reaches to maturity and profit also reaches to its peak (Baron 2012). Next to this, which were importing the commodity from the developed nation, gain economies technological advancement over the production, which leads commodity market to fall for the developed nation (Tolentino 2017). Through intra-industry trade, once the exporter become importer of the same due to fall in price in foreign market. As practical instance, it can be seen that 3D printers were initially adopted by the developed nations and as it is one of the most unique development at that time, consumers started to absorb it more quickly (Bilir 2014). This explains, how technological product are produced fast and get allocated quickly before being consumed by the end user rather than focusing on the comparative advantage of producing the same by the trade partners (Griffiths and Wall 2011).

Heckscher – Ohlin Factor Endowment model

However, according to the John and Gillies there was limitation in the case of Vernon’s theory (Wetherley and Otter 2014). Government regulations can restrict the international trade and reduce the production, allocation and consumption of the goods. For instance, it can be seen in the case of Russian oil situation, where the country has stopped exporting oil to the Europe due to sanctions imposed by the European countries and USA (Richter and Holz 2015). Besides this, it has also been argued that minimum wage law in developed nation restricts them to produce goods and services at lower price compared to the developing nations (Sloman and Garratt 2013). Thus, in this situation, commodities initially need to be imported from the developing nations to the developed nations and it contradicts the Vernon’s Life Cycle model (Lall 2016).

According to the classical trade theories, comparative advantage is present in the case of factor endowments like labour, land and resources (Besanko et al. 2013). However, these are not the only factors that influence the production, and make an economy endowed. Factors like human capital, technological advancement, knowledge base, governmental aid and even national culture can influence the trade cycle (Nakata and Antalis 2015). According to the figure 3, it can be seen that porter has expressed the trade incentives from his diamond model. Porter argued that, if there is high demand in the domestic market, then it will lead to better technological development (Griffiths and Wall 2011). In addition to this, with new products being introduced in the market, it will influence the global market. With rise in demand from the foreign market, domestic manufacturing industry can get influenced largely (Bates 2014).

With the help of the governmental aid and related support, there is high chance to enhance the trade from domestic market to foreign market, even though exporting country does not have comparative advantage in production (McAleese 2004). This contradicts the basic idea of the comparative idea and within the present trading scenario makes it invalid.

Conclusion:

21^st century is a complex world, where more and more nations are indulging them into trading. With rise in openness in the market, new trade theories have evolved, which describes the trend of trade between nations. Among those, comparative advantage is one of the best theories that provided basis for assessing the benefits of trade and explain how scare resources are produced, distributed and consumed. However, considering the recent trade scenario it can be stated that comparative advantage fails to describe how scare resources are produced, allocated and consumed completely. Owing to the outdated consideration for determining the efficiency in production commodities, comparative advantage model of David Ricardo is not as efficient as one would have presumed prior to performing this research under the present situation of global economy, where technological advancement is more important than the factor endowment. Recent researches has found that intra industry-trade theory is one of the most applicable theory that determine the production, allocation and consumption practice of scare resources better than the opportunity cost theory. Besides this, Krugman’s finding explain the intra-industry trade more efficiently while portraying how scare resources are produced, allocated and consumed.

Analysis of the Ricardian Model

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