Understanding Comparative Advantage

The concept “comparative advantage” occurs when a country or industry produces a product among many to consume and trade with other countries or industries due to lower opportunity costs. Opportunity cost implies the amount of benefits that a person, business or country misses out for selecting one alternative by sacrificing other (Laursen, 2015). Hence, opportunity cost calculates trade-off that takes place between two economic entities or nations. This theory, developed by Ricardo, has replaced the concept of absolute advantage theory. This theory provides an industry or country the ability to sell products at a lower price compare to its competitors through enjoying stronger sales margins. Based on this theory, each participating units enjoy benefits, for instance, international trade helps a participating country to enjoy higher standard of living through developing its economic condition by producing and trading products with comparatively lower costs. Some chief sources that can influence a country to enjoy comparative advantage are availability of different types of natural resources, demographics, division of labour, returns to scale, rates of capital investment, exchange rate fluctuation and investment opportunity for research and development. Moreover, technology, new production strategy and economies of scale can also help an industry to experience comparative advantage within a country (Levchenko & Zhang, 2016). According to some economists, an industry or country cannot exploit its comparative advantage completely due to imperfect mobility of factors within the economy, transport cost, protectionism and imperfect information among consumers and producers. However, instead of these barriers, most of the countries across the world, practice international trade.

Hence, from the above discussion it can be seen that comparative advantage takes a significant position among countries or industries to conduct trade. For this, the report intends to discuss about reasons for discussing about comparative advantage along with some facts and figures that how two countries or industries trade with each other based on this trade theory.

Comparative advantage is referred as an economic law through which David Ricardo represents that comparative advantage can help an economy while it experiences absolute advantage in every aspect of production. The chief fright for an economic entity to enter into a free trade is that it cannot produce some products in which it has absolute advantage and consequently this entity needs to import these products instead of producing and export these internally (French, 2017). Comparative advantage motivates a country or industry to specialise in particular products for manufacturing and exporting and importing other products. As stated before, this dynamic concept depends on some sources that can influence a county or industry to enjoy comparative advantage and consequently, these can be stated as main reasons for practicing this trade theory.

Reasons for Practicing Comparative Advantage

Firstly, the quality and quantity related to available natural resources can be differed county wise. For instance, some countries as China and India have huge population while the amount of capital accumulation in these countries is comparatively low (Martin & Mejean, 2014). As a result, these countries have comparative advantage to produce any labour abandoned products compare to other countries. Moreover, some countries like Australia have vast and productive farmland along with oil and gas mines. Hence, the country gets comparative advantage to cultivate and export agricultural products along with oil and gas. In this context, geography and climate also play significant role to create different comparative advantage among different countries. For instance, Brazil has comparative advantage to produce coffee beans due to its weather and this in turn helps the country to export coffee beans by large amount across the world (Rosiana, Nurmalina, Winandi & Rifin, 2017). Secondly, demographics also play significantly influence comparative advantage of a country. An ageing population and outward migration can adversely affect total workforce of a country and this further reduce the total productivity within the country (Ngai & Petrongolo, 2017). On the contrary, inward migration, and educational improvement can help an economy to increase its labour force with skilled labour, which further can help the economy to produce more products with higher quality. Thirdly, a country can experience increasing returns to scale for producing any particular output due to specialisation. Moreover, division of labour can also influence an industry or country to enjoy comparative advantage. As a result, this specialisation in long-term can reduce the cost of production (Frey & Osborne, 2017). Fourthly, huge amount of capital investment can develop infrastructural facilities of a country. Higher infrastructural facility reduces cost of trade by making supply comparatively cheap. Fifthly, investment in research and development also helps a nation to experience comparative advantage (Fu et al., 2018). Thus, these are some chief reasons based on which a country can trade with others based on its comparative advantage where opportunity costs to produce some products are comparatively low.

Comparative advantage can be observed among different industries within a country as well. This difference occurs due to different production strategies, increasing demand for particular product and economies of scale (Sejkora & Sankot, 2017). In a country, a firm can experience comparative advantage to produce particular commodity because either the firm gets efficient production techniques to product the product more efficiently with comparatively lower cost or it innovates new product that has huge demand in both international and domestic market. Moreover, increasing demand and output can influence an industry to exploit economies of scale. In this situation, the industry can earn higher profits and consequently can reinvest it in production process for developing product, marketing and distributing it in a wide network. Skilled labours also influence a company to get comparative advantage (Wang & Mao, 2017). For instance, an industry with large amount of skilled labour can produce higher amount of products with greater quality compare to others, where the number of skilled labour is low. In these situations, some industries experience comparative advantage to produce particular products with its limited resources and labour force within a country while some other industries can experience comparative advantage to produce other products (Nyambane & Bett, 2018). As a result, a trade-off among these industries happens to fulfil their requirements.

Industries’ Comparative Advantages within a Country

Bilateral relation between China and the United Kingdom:

 Industries within a country also experience comparative advantage due to different production technologies, economies of scale and division of labour. For instance, the textile industry of the U.K developed significantly though during 1970s the country started to import raw materials for its textile industry from overseas (Kelliher, 2017). Since 1990, maximum materials related to this industry have been imported from the European Economic Area (EEA), Association of Southeast Asian Nations (ASEAN) and countries of North America. However, the U.K has started to import raw materials from China significantly (Xu, 2017). Thus, it can be said that China has enjoyed comparative advantage to export raw materials in other countries due to production techniques, textile prices, tax system and political trade barriers. In this context, the trade relation between China and the U.K can be discussed.

In 2016, the HM revenue and Customs statistics of the U.K has represented a bilateral trade relation between the China and the U.K worth $ 18.95 billion, while the U.K has imported $ 14.49 billion from China and the amount has represented  9.65 of the country’s total import. Of all imports from China to U.K, the raw material related to textile industry has taken third position accounting for 13.4% of total (Botchie, Sarpong & Bi, 2017). In this context, labour-intensive production technique of China has played significant role and consequently has enjoyed comparative advantages in the international market. As a result, the country has accounted for 23.4% of total imports of the U.K.

 

Figure 1: Imports of textile raw materials of the U.K across the world

Source: (Xu, 2017)

According to above figure it can be said that imports of U.K from China has increased significantly since 1990. In the beginning of 1990s, China could not export raw materials to the U.K by large extend due to quota restrictions of the Europe.  However, after 2000, trade policy with China relaxed due to textile trade policy (Huang, Salike & Zhong, 2017). The Chinese enterprises that export textile in other countries have experienced comparative advantages due to lower production costs and higher in international market. However, to satisfy needs of developed countries for their textile industries, the country has also imposed strict restrictions for regulating the production process of raw materials to meet the international standard. As a result, some Chinese companies have experienced disadvantage to fulfil this international standard.

 

Figure 2: Total export value of China

Trade Relationship between China and United Kingdom

Source: (Xu, 2017)

Due to the huge pressure in international market, China has stopped to pay customers duties from domestic side on 17 textile materials. As a result, exports of this county in international marker have increased continuously. The above diagram has represented this phenomenon since 1992.

 

Figure 3: Total import value of the U.K from China

Source: (Xu, 2017)

Figure 6 has represented the trend of U.K’s textile imports from China since 1990. According to this figure, the amount of import has started to increase drastically after 1999. Hence, from this, it can be said that in international market, China has possessed incomparable comparative advantages after the EU. China’s export of textile raw materials has started to develop drastically after it has become the member of the World Trade Organisation in 2000.

In addition to this, other countries like the U.S.A and China can also be taken under consideration to discuss comparative advantage. China also experiences comparative advantage to manufacture and exports products all over the world and especially in the U.S.A due to its cheap labour costs. To produce consumer goods, Chinese workers demand comparatively lower wages than that of any U.S.A workers and for this, China experience lower opportunity costs to produce these commodities. On the contrary, the U.S.A experiences comparative advantage in capital-intensive production techniques. Due to technological improvement, skilled workforce and huge capital, the country produces sophisticated products or possesses lower opportunity costs to invest in both national and international market in the form of foreign direct investment (FDI) (Shapiro, Vecino & Li,2018). China also receives huge amount of FDI from the U.S.A. As a result, both countries benefit each other through trading with each other based on their specialised product. During the initial stage of new technological development, the U.S experienced comparative advantage to produce new products, supported by this technological innovation. However, rest of the world, especially countries with less-skilled labour, have adopted these technologies when they have understood these technological processes. As the technology and production process have become well understood by other nations, the production strategy has been migrated from the U.S.A to less expensive countries. In addition to this, strict legal support also helps the country to enjoy comparative advantage. The success of the U.S regarding the green technology sector experiences development as the country provides regulatory, economic and legal support for implementing these new technologies. Thus, the U.S.A experiences comparative advantage due to its geographical position, such as, large ocean adjoined coasts, mass, fertility land and fresh water reserves. These further have developed diverse population along with authorised legal system. America has comparatively less expensive political security, natural resources and a healthy market of research and development, which further help the country to lead the world with its industries like defence, aerospace and banking.

Analysis of Comparative Advantage in International Trade

At present, China is going to be the largest economy all over the world through performing better compare to the U.S.A by producing and exporting large amounts of products. This in turn has helped China to capture maximum share in international market. However, the U.S.A is still considered as one of the strongest economy across the world. In 2014, the country produced almost $17.5 trillion products that were estimated as 20% of the world’s total production, which was, $107.5 trillion. It is seen that most of the developing countries’ national income has become equal with that of a state of the U.S.A (Arezki, Fetzer & Pisch, 2017). As a result, citizens of the U.S.A experiences higher standard of living.

 

Figure 4: United States imports from China (2008-2017)

Source: (Tradingeconomics.com., 2018)

The above diagram has represented the trend of product imports of the U.S.A from China since 2008. According to this figure, it can be said that U.S.A has increased its imports from China over the year. In January 2017, imports of the U.S has increased to US $ 41376.30 million while at the end of 2016, the average amount of imported product was US $ 39382.80 million.

Figure 5: Exports of the U.S to China (2008-2017)

Source: (Tradingeconomics.com., 2018)

According to above figure, it can be said that average trend of export of the U.S.A has increased over the year as well. However, in 2016 this trend has decreased while in 2013 this has reached at higher level. In January 2017, China has imported US $ 10072.90 million from December 2016, while the amount was US $ 11626 million.

Hence, from these two diagrams, it can be said that both countries enjoy comparative advantage to trade with each other to experience lower costs of production and this trade further has helped both countries to develop its economic condition and standard of living.

Australia experiences comparative advantage to produce cattle and export beef across the world. The country has the highest capabilities regarding agriculture research and development in the areas of genetic modification and breeding. Moreover, Australia has developed agricultural science along with agronomy capabilities that helps the country to manage its production system. Australia has its R&D activities related to advance bio-fuels that chiefly focus on feedstock. In this context, the Australian Bureau of Agricultural and Resource Economics and Sciences and the Commonwealth Scientific and Industrial research Organisation take important role. Huge production of feedstock has helped the country to breed cattle by large number. As a result, beef industry in Australia contributes significant portion to the country’s national income. During 2016-17, the country’s total value of producing cattle and beef including exports of live cattle was AUD 12.7billion. In addition to this, beef production contributes 20% of the farm’s total production in Australia (Dong, Waldron, Brown & Zhang, 2018). The beef production in Australia includes cow-calf system based on pasture, a grow-out period on pasture and pasture finishing. The country has a vast range of agro-climatic zones covering from northern tropical to southern Mediterranean consisting with equal range of temperature genotypes along with temperature systems. As of 2016, Australia is considered as one most efficient cattle producer and the third largest beef exporter across the world. On the contrary, other countries like Korea, Japan and China do not experience any advantage to produce beef and for this, they import the product from Australia.

 

Figure 7: Beef industry in the Australia

Source: (Greenwood, Gardner & Ferguson, 2018)

Thus, from the above figure, it can be seen that Australia has taken third position after India and Brazil to export beef in other countries and taken seventh position to produce beef. In 2016, the country has exported almost 68% of total beef to 77 countries.

Conclusion:

Hence, according to above discussion, it can be concluded that the practice of comparative advantage within countries and industries can be observed significantly. Comparative advantage helps a country or an industry to produce any commodity with lower costs while other countries or industries can experience higher opportunity costs to produce the commodity. To understand the importance of comparative advantage, the report has analysed the reason for selecting the concept of comparative advantage to trade with other countries. In this context, quality and quantity can considered that vary from country to country or from region to region. Demographic condition also plays significant role for which different countries face different comparative advantage. For instance, if aged population capture maximum share of total work force then this can weak the total work force of a country and this in turn can affect total productivity of the country adversely. On the contrary, country with young population can produce comparatively more products. In addition to this, the number of skilled labour within the country also plays significant role. In addition to this, increasing returns to scale due to efficient environment and production strategy along with huge amount of capital investment can influence a country or an industry to enjoy comparative advantage for particular products. Some other factors like economies of scale, production technology and labour specialisation can influence the industry to enjoy this advantage over other industries. To understand the concept more precisely, the report has described trade relations of China with the United Kingdom and the U.S.A while China has experienced comparative advantage to produce raw materials for textile industries and other consumer products with the help of its large number of unskilled workers. To explain comparative advantage experienced by an industry, the report has considered beef industry of Australia. Due to positive climatic condition and large area for agriculture, the country gets comparative advantage to produce livestock that further helps beef industry to develop further.

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