The Theory Of Comparative Advantage And Resource Allocation In Economics

Examine and critically assess how scarce resources get produced, consumed and allocated and how various stakeholders in the global economy make optimal decisions.
Examine and critically assess the economic, market and political forces shaping the business environment.
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.

What is Economics and the Problem of Scarcity

Essay 1: The theory of comparative advantage; allocation, production and consumption of scarce resources

Economics is the study of scarce resource. Resources are scarce in the sense that these resources fell short of unlimited wants of people. Hence, there always remain a trade-off between different wants in the economy. To produce more of something, it is necessary to sacrifice some other goods.  The objective of economics is to allocate scarce resources optimally to cater need of the people as much as possible (Burstein and Vogel 2017). The idea of trade originated from the need of optimizing resource use. When country specializes in a particular commodity then resources are used more efficiently than when resources are divided between different commodities. Countries specialize and exchange goods to meet their demand in the cheapest way. Different trade models have developed to determine the line of specialization for countries. The pioneering trade model in this context is that developed by Adam Smith and is known as the theory of absolute advantage. However, the theory has failed to explain trade in all possible circumstance. The theory of comparative advantage then developed by David Ricardo to explain the line of specialization (Huggins and Izushi 2015). In addition to these two primary model of trade, economists had introduced different trade models to explain evaluation of trade between two more nations.

Before discussing how comparative advantage and other related trade model explain allocation, production and consumption of scarce resources it is necessary to understand the problem of scarcity in the economy.

Prof. Lionel Robin was first who introduced the problem of scarcity in the definition of economics in 1930. The definition of scarcity implies the supply constraint in relation to demand. The problem arises from the fact that people have unlimited wants and only limited means to satisfy the wants (Helpman and Razin 2014).  The four primary factor of production include land, labor, capital and organizer. All these factors should be used optimally to maximize level of production. The scarcity problem is the central of many economic problems. The first associated problem is problem of choice that every economy faces every day. The choice problem involves the concept of opportunity cost. The opportunity cost is defined as the cost of sacrificing income obtained from the next best alternative use (Laursen 2015). In every decision in the daily life, people face a choice problem. Labor in the economy faces the problem between labor-leisure choices. More work effort leads to higher income but at the expense of a reduced leisure time. The opportunity cost and choice problem in more relevant for a country in times of resource allocation between different production choices. This can be understood better with the concept of production possibility curve indicating production boundary of a nation.

Production Possibility Curve and the Choice Problem

Figure 1: Production Possibility Curve

(Source: Blaskova, and Skultety  2015)

The production possibility curve is built in a two goods framework that assumes using all the resources; the nation can produce two goods. As shown from the figure above, increasing production of any one good involve a decreasing production of the other good.

From the resource allocation and choice problem leads to three central question of the economy- what to produce, how to produce and for whom to produce. Trade relation by defining specialization and exchange helps to answers these questions with respective consequences on the economy and society (Burstein and Vogel 2017).

Absolute advantage and evaluation of comparative advantage: Absolute advantage refers to the ability of a nation to produce a good at a relatively lower unit cost production compared to other nation. Having absolute advantage in a good implies country can produce the specific good with a fewer resources and hence, incur a lower cost (Levchenko and Zhang 2016). A hypothetical example is given be to understand the theory of absolute advantage. The table below shows the output per worker in a year for the two US and Brazil.

As shown from the table, US can produce 5 cars and 1 bi-cycle in a year by using one labor. Brazil in contrast produces 2cars and 8 bicycles with the same input. Therefore, US has an absolute advantage in cars while Brazil has an absolute advantage in Bicycles.

In reality, however countries often enjoy absolute advantage in both goods because of abundant stock of resources and efficient technology. Under such circumstance, the way out is given by the comparative advantage theory (Caselli et al. 2015). The theory states that when one nation has an absolute cost advantage in both goods then specialization should be defined based on the opportunity cost or production. Because of resource constraint, production of every good involves opportunity cost. Specialization should be done on goods in which country faces a relatively lower opportunity cost. The comparative advantage theory explains that a country should export a good in which is enjoys a comparative advantage (Nunn and Trefler 2014). The good with a relatively higher opportunity cost should be imported from other nation. The specialization by nations lead to increase in total production. When world output increases then consumption increases as well.

The notion of comparative advantage can be understood using the following example. The table below shows unit cost of producing wine and cloth in Portugal and England expressed in terms of unit of labor requirement.

Absolute Advantage and Evaluation of Comparative Advantage

As depicted from the table, Portugal requires 80 units of labor to produce 1 unit of wine and 90 units of labor to produce 1 unit of cloth. England in contrast requires 120 units of labor for producing 1 unit of wine and 100 labor units for 1 unit of cloth. Therefore, Portugal has an absolute advantage in both Wine (80<90) and Cloth (90<100). Following absolute advantage theory, no trade relation is explained between England and Portugal. However, trade is possible by looking at the opportunity cost of production and the theory of comparative advantage.

However, in terms of opportunity cost England has a lower relative cost in cloth (0.9 < 1.12) and Portugal has a lower opportunity cost in Wine (0.9< 1.12). Henceforth, Portugal should specialize in wine while England should specialize in cloth.

Specialization and gains from trade: Because of differences in opportunity cost of production, both the countries gain from specializing in goods having a comparative advantage. In the autarky, Portugal needs to use 90 units of labor to produce one unit of cloth. However, after involving in trade with England it can exchange 1 units of wine for 1 units of cloth. For producing wine, it requires 80 units of labor. Therefore, Portugal from trade gains 10 unit of labor that can be used for producing more Wines. Similarly, England gain 20 units of labor for exchanging cloths for wine and hence, can produce more clothes with the additional labor.

The theory of comparative advantage though sound well as compared to absolute advantage but the theory has some severe drawbacks preventing it to explain trade dynamics in very aspects. One principle component of exchange is the involved transportation cost depend on physical distance between regions (Ferto and Jambor 2015). The transportation cost often offset the benefits derived from the comparative cost advantage. There are socio-political aspects as well that are not explained by the theory of comparative advantage. Countries when producing only one good over a long period of time then monotonicity arises leading to a decline in productivity (Caselli et al. 2015). This in the long-run results in diseconomies of scale. Countries are often overloaded with only one type of good. Moreover, Ricardo in evaluation of the theory considers only one factor of production namely labor. However, in reality several factor of production is used that are not considered by Ricardo.

Based on Ricardo’s trade model another trade model is developed by Heckscher and Ohlin explaining the pattern of specialization and trade depending on the factor endowment in the region. Unlike Ricardo’s model, trade with Heckscher Ohlin model does not require different technology of production rather it assumes identical production technology (Burstein and Vogel 2017). The H-O model though eliminates technical variance but involve additional factor of production; endowment of capital. The model thus endogenously explains inter-country differences of labor productivity that is assumed exogenous in the Ricardian model. The model identifies countries as labor abundant and capital abundant based on their factor endowment. According to this theory a labor abundant country should specialize in labor intensive commodity while a capital abundant nation should specialize in capital intensive goods. Despite defining comparative advantage in line with country’s relative factor abundance in reality nation often faces difficulty in specializing goods with their abundant factors. A real world example of this phenomenon is United States (Helpman and Razin 2014). The nation is rich in capita and therefore, as per Heckscher Ohlin model should specializes in capital-intensive good. However, in reality the US is known for exporting more labor-intensive good and importing capital-intensive goods. This is in direct contrast to the trade theory proposed by Heckscher and Ohlin. Professor Wassily W. Leontief was first found in 1953 and was came to be known as Leontief Paradox (Taylor and Copeland 2014). Leontief later explains the Paradox by reasoning that it might be possible that laborers in US are more efficient than foreign laborers.

Specialization and Gains from Trade

Intra-industry trade is another important aspect in the discussion of international trade. The intra industry trade occurs when commodities and services are exchanged between nations belonging to the same industry (Ferto and Jambor 2015) This implies in the process of intra industry trade nation exchange similar kind of goods. The real world examples of intra-industry trade include exchange of automobiles, beverages and foodstuffs, minerals and computers. Europe for example in 2002 exported automobiles worth 2.6 million. During this year automobile import for from Europe worth 2.2 million (Hine and Greenaway 2016).

Raymond Vernon explains the inconsistency in the Heckscher-Ohlin model by the theory of Product Life Cycle.  The theory states that in the early stages of production all the parts and associated labor is first related to the area where the factors are invented. After adaption and acceptance of the product in the world market, it gradually shifts away from the origin of invention (Stark 2015). The product often becomes an imported item of the origin country. A common application of this theory is found in trade pattern of United States. This is associated with the invention, growth and production of personal computers. At the first stage, both production and consumption occur in US, there is no trade or export (Armstrong et al. 2015).  Once the product reached to the mature stage techniques of mass production are adapted along with the expansion of foreign demand. Then, US exports the product to other nations. In the intermediate production stage, production shifts to the developing nations and gradually the nations achieve the stage where products are exported to developed countries (Hauschild and Huijbregts 2015).

Figure 2: Product life cycle theory

(Source: Hauschild and Huijbregts 2015)

Another model explaining the country’s competitive position in the international market is the model developed by Michael Porter and is known as Porter Diamond model. The mode is named so following the fact that all the important factors of international business competition look like points of a diamond (Huggins and Izushi 2015).

Figure 3: Porter’s diamond model

(Source: Anton 2015)

The Porter’s diamond model is used by nations to convert the national advantage into the international advantage. The model explains that home based advantage of a nation helps to create an advantage at the global scale (Harzing and Giroud 2014). The determinants of such advantages are factor condition, success of the related and supporting industries, demand condition in home country and firms’ strategy, structure and presence of rivalry.

The essay summarizes the mechanism of allocation of scarce resources globally using the essence of different trade models. Each model has its own advantages and drawbacks. The theory of absolute advantage is the first pioneering theory of international trade. The model unable to explain trade between nation when one nation has absolute cost advantage over all the products. This issue is addressed by David Ricardo with the theory of comparative advantage. Other important trade model making significant contribution in explaining trade patterns include Heckscher-Ohlin model of factor endowment, intra-industry trade model, the theory of product life cycle and Porter’s Diamond model of national advantage

Reference list

Anton, R., 2015. An Integrated Strategy Framework (ISF) for Combining Porter's 5-Forces, Diamond, PESTEL, and SWOT Analysis.

Armstrong, G., Kotler, P., Harker, M. and Brennan, R., 2015. Marketing: an introduction. Pearson Education.

Blaskova, M. and Skultety, F., 2015. US intra-industry trade in air transport services: measurement and results. Transport Problems, 10.

Burstein, A. and Vogel, J., 2017. International trade, technology, and the skill premium. Journal of Political Economy, 125(5), pp.1356-1412.

Caselli, F., Koren, M., Lisicky, M. and Tenreyro, S., 2015. Diversification through trade (No. w21498). National Bureau of Economic Research.

Ferto, I. and Jambor, A., 2015. Drivers of vertical intra?industry trade: the case of the Hungarian agri?food sector. Agricultural Economics, 46(1), pp.113-123.

Harzing, A.W. and Giroud, A., 2014. The competitive advantage of nations: An application to academia. Journal of Informetrics, 8(1), pp.29-42.

Hauschild, M.Z. and Huijbregts, M.A., 2015. Introducing life cycle impact assessment. In Life Cycle Impact Assessment(pp. 1-16). Springer, Dordrecht.

Helpman, E. and Razin, A., 2014. A theory of international trade under uncertainty. Academic Press.

Hine, R.C. and Greenaway, D., 2016. Intra-Industry Trade: An Analysis of Country-and Industry-Specific. Intra-Industry Trade and Adjustment: The European Experience, p.70.

Huggins, R. and Izushi, H., 2015. The Competitive Advantage of Nations: origins and journey. Competitiveness Review, 25(5), pp.458-470.

Laursen, K., 2015. Revealed comparative advantage and the alternatives as measures of international specialization. Eurasian Business Review, 5(1), pp.99-115.

Levchenko, A.A. and Zhang, J., 2016. The evolution of comparative advantage: Measurement and welfare implications. Journal of Monetary Economics, 78, pp.96-111.

Nunn, N. and Trefler, D., 2014. Domestic institutions as a source of comparative advantage. In Handbook of international economics (Vol. 4, pp. 263-315). Elsevier.

Stark, J., 2015. Product lifecycle management. In Product Lifecycle Management (Volume 1) (pp. 1-29). Springer, Cham.

Taylor, M.S. and Copeland, B.R., 2014. International Trade and the Environment: A Framework for Analysis (No. 2014-71).