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

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.

Examine and critically assess the extent to which the theory of comparative advantage can explain how scarce resources are produced, consumed and allocated in the global economy.

Scarcity and resource allocation

The allocation of resources is one central problem of economies. The origin of the problem lies in the fact that people in the economy have unlimited wants. However, to satisfy these wants only limited resources are available. From this arises the issue of scarcity. The scarce resources need to be used optimally to meet desire of people as much as possible. Trade is an efficient way of allocating resources globally (Costinot et al. 2015). The direction of trade among nations is determined following different models of trade. Each nation has its own trade pattern. The first model of trade was initiated by Adam Smith and is known as theory of absolute advantage. The theory of absolute advantage was followed by Ricardo’s model of comparative advantage. With passes of time, countries across the globe adapt different trade pattern and each is explained with a different trade theory. The essay focuses on resource allocation with the help of different contemporary trade theories.

Scarcity and resource allocation: The scarcity in economies indicates the most vital aspect of any economy- limited means and unlimited ends. The ‘means’ here defines available resources while ‘ends’ implies desires of people. The unlimited wants of the people cannot be satisfied with limited resource (Stiglitz 2017). Hence, come the question of optimal allocation of resources. The scarcity problem leads to the choice problem where people has to make choices among the available alternatives. The optimal resource allocation points to three most important questions of any economy-what to produce, how to produce and for whom to produce.  These three questions in turn points to choices of commodity, efficient production technique and distribution of the produced goods.

The stock of resources and available technologies vary across nations. Therefore, countries have specialization skills over different goods. The global welfare is maximized when countries specializing in different goods exchange goods. This line of specialization can be determined based on absolute cost advantage, relative cost advantage, relative factor abundance and others ((Feenstra 2015). Each of this aspect is taken care of separate trade theories.

Absolute and comparative advantage: Adam Smith developed the theory of absolute advantage. The theory states that when a country is able to produce one good at a lower cost as compared other nations then the country is said to have an absolute advantage over the good. When a country has absolute advantage in a good then it can make the good by employing a relatively smaller amount of resource (Costinot et al. 2015). Countries thus when specialize following principles of absolute advantage and trade with each other; resources are used optimally raising world welfare.

Absolute and comparative advantage

The problem arises when one country has absolute advantages over others on all product. The Smith’s theory then fails to explain any trade pattern between countries. When absolute cost difference cannot determine the trade direction then the alternative approach is to compute the opportunity cost. David Ricardo first develops trade theory in terms of opportunity cost. The trade model developed by Ricardo is known as theory of comparative advantage. The comparative advantage of a nation is the ability to produce a good a lower opportunity cost than other nation. Involving in trade following principles of comparative advantage is mutually beneficial for both the trade partners. Both the participating nations are benefitted from comparative advantage and world output as a whole increase (Feenstra 2015). Countries when specializes in goods that has a lower opportunity cost then the resource waste is minimized. Following an efficient resource allocation and higher world output, more goods are available for consumption satisfying more wants and thus stimulate world’s welfare.

The concept of comparative advantage and the involved opportunity cost will become clearer with the help of the following example.

The table below shows the required labor hours for producing wheat and cotton in two nations namely China and US.

Labor hours

(for producing 1 unit )

Wheat

Cotton

China

10

5

US

8

2

For producing 1 unit of wheat and cotton the required labor hours for China are 10 and 2 respectively. While US requires a relatively less labor hour for producing both wheat and cotton. For wheat, the required labor hour is 8 while for cotton it is 2. This implies US has absolute advantage over China for both Wheat and Cotton. No trade relation therefore can be defined from the theory of absolute advantage. Trade however is possible by taking into consideration the associated opportunity cost.

Opportunity cost

(for producing 1 unit )

Wheat

Cotton

China

10/5 = 2

5/10 = 0.5

US

8/2 = 4

2/8 = 0.25

For China, the opportunity cost of wheat is only 2 units of cotton while for US the involved opportunity cost for wheat is 4 units of cotton. Following a lower opportunity cost China should specialize in Wheat. For cotton however US has a lower opportunity cost (0.25 < 0.5) and hence should specialize in cotton.

From specialization, China gains 5 hours of labor that it requires to produce cotton. US gains 6 units of labor hours. Both the countries when specializes as per their comparative advantage then the additional labor hours can be used to produce additional output leading to an increase in total world output.

The theory proposed by Smith and Ricardo though initially explained trade pattern quite well but as trade evolves between nations countries new factors came in front that the two pioneering model had not considered ((Ethier and Hillman 2017). The first is the presence of transportation cost. In reality, exchange of goods among nations requires significant transportation cost because of physical distance between the trade partners. Both the model considered factor cost of only one input that is labor. In real world, capital also plays an important role in production (Grossman, Helpman and Kircher 2017). However, none of the models considered any factors other than labor.

Heckscher-Ohlin theory

Heckscher-Ohlin theory: Based on the Ricardian comparative advantage Heckscher and Ohlin developed a trade model in terms of factor endowment of nations. According to the theory, goods are classified as labor-intensive and capital-intensive. Therefore, nations having abundant labor should specialize and export labor intensive goods. While countries rich in capital should specialize in capital intensive goods (Guillo and Perez?Sebastian 2015). The specialization as explained by this theorem is due to the relation between factor abundance and factor prices. The country faces a cheaper price for its relatively abundant factor and a higher price for scarce factor of production. Thereby, difference in factor endowment leads to a difference in comparative advantage (Ethier and Hillman 2017).

An empirical test performed on US economy during 1947, revealed inconsistency with Heckscher-Ohlin model. In 1947, US had seemed to be endowed with more capital. The theory therefore predicts export orientation towards capital-intensive good. However, in reality it was found that imports of US were 30% more capital intensive as compared to US export (Paraskevopoulou, Tsaliki and Tsoulfidis 2016). This contradictory finding is known as Leontief Paradox.

Porter Diamonds trade theory: This theory was developed by Micheal Porter to determine advantage of a nation. The theory stress that in determining comparative advantage in the international market, the prevailing condition in the home market plays an important role (Riasi 2015). The different factor affecting nation advantage is presented resembling the shape of a diamond and hence, the model is known as Porter’s diamond model.

In the model factors refer to the necessary inputs for production of goods and services. The factors include natural resources and labor as well as advanced factor such as infrastructure and community. Countries lacking natural resources tend to develop advanced methods of production for attaining national advantage. One example is South Korea. Demand condition in the model is indicated by size of the domestic market. High demand in the domestic market encourages producers to improve quality of the product and helps to attract foreign demand (Rothaermel 2015). The growth of related industries generates external economies of scale and gives firms a cost advantage. Finally, strategies, structure and rivalry influence success of an organization by influencing its operation.

Intra-industry trade: The term intra-industry trade implies trade of products within the same industry.  This term is applied to international trade when countries export and import same products (Lee 2017). A real world example of intra industry trade is exchange of vehicles in Japan. Japan in 2002, imported vehicles worth 0.3 million. As against this, Japan exports vehicles worth of 4.7 million. Neither Ricardian model of comparative advantage nor Heckscher-Ohlin model of trade can explain rationale for such intra-industry trade pattern (Peterson and Thies 2015). Finger in 1975 attempted to explain intra-industry trade with heterogeneous factor endowment exists in the same industry. This argument was redundant as intra-industry trade seemed to occur even after disaggregation of industries to the final level. Flavey  & Kierzkowski (1987) gave a potential explanation by stating that identical goods are not always produced by employing identical technologies. Goods produced with a capital-intensive technique tend to be superior to labor intensive that produced with labor-intensive one. The quality differences often cause intra-industry trade. This argument was dismissed on the ground that it did not address the aspect of trade for goods that need similar kind of factor endowment (Balassa and Bauwens 2014).

Porter Diamond’s trade theory

Finally, there comes the New Trade Theory asserts by Paul Krugman. Krugman explains specialization not in terms of regional differences in factor endowment in terms of increasing return to scale. This is supported by neo-classical trade theory. The theory suggests that countries by producing a limited variety of commodities enjoy the benefits of increasing return to scale (Ciuriak et al. 2015). The presence of economies of scale provides the nation a significant cost advantage. Because of international trade, production of limited variety of goods does nor limit the available variety of consumption.

The discussion above shows how different trade theories explain allocation of scarce resource globally. The very first theory of international trade is the theory of absolute advantage constructed by Adam Smith. However, the theory fails where one nation has a better cost condition than other does in all goods. Trade then is explained by difference in opportunity cost. This theory is known as Ricardo’s theory of comparative advantage. However, both the absolute and comparative cost advantage theory considers cost of only one input namely labor. Heckscher Ohlin defined specialization based on the factor endowment. Heckscher Ohlin theory faced difficulty when some trade pattern of some nation revealed an inconsistent pattern to the theory. Another type of trade pattern observed in today’s world is the intra industry trade corresponds to import and export of same product. The porter’s diamond trade model and New Trade Theory proposed by Krugman always explains some specific form of trade across nations.

Reference list

Balassa, B. and Bauwens, L., 2014. Changing trade patterns in manufactured goods: An econometric investigation (Vol. 176). Elsevier.

Ciuriak, D., Lapham, B., Wolfe, R., Collins?Williams, T. and Curtis, J., 2015. Firms in International Trade: Trade Policy Implications of the New New Trade Theory. Global Policy, 6(2), pp.130-140.

Costinot, A., Donaldson, D., Vogel, J. and Werning, I., 2015. Comparative advantage and optimal trade policy. The Quarterly Journal of Economics, 130(2), pp.659-702.

Ethier, W.J. and Hillman, A.L., 2017. The Politics of International Trade.

Fainshmidt, S., Smith, A. and Judge, W.Q., 2016. National Competitiveness and Porter's Diamond Model: The Role of MNE Penetration and Governance Quality. Global Strategy Journal, 6(2), pp.81-104.

Feenstra, R.C., 2015. Advanced international trade: theory and evidence. Princeton university press.

Grossman, G.M., Helpman, E. and Kircher, P., 2017. Matching, Sorting, and the Distributional Effects of International Trade. Journal of political economy, 125(1), pp.224-264.

Guillo, M.D. and Perez?Sebastian, F., 2015. Convergence in a Dynamic Heckscher–Ohlin Model with Land. Review of Development Economics, 19(3), pp.725-734.

Lee, H.S., 2017. Inter-Industry Labor Mobility and Lobbying for Trade Protection. The International Trade Journal, pp.1-22.

Paraskevopoulou, C., Tsaliki, P. and Tsoulfidis, L., 2016. Revisiting Leontief’s paradox. International Review of Applied Economics, 30(6), pp.693-713.

Peterson, T.M. and Thies, C.G., 2015. Intra-industry trade and policy outcomes. The Oxford Handbook of the Political Economy of International Trade, p.177.

Riasi, A., 2015. Competitive advantages of shadow banking industry: An analysis using Porter diamond model. Business Management and Strategy, 6(2), pp.15-27.

Rothaermel, F.T., 2015. Strategic management. McGraw-Hill Education.

Stiglitz, J.E., 2017. The overselling of globalization. Business Economics, 52(3), pp.129-137.

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