Introduction to Economics and its Objectives

Economics, as a subject, deals with several key aspects of concern, among which the primary one is that of optimally meeting the demands and needs of all the people in an economy, with the help of the scarce resources present in the economy. The resources of production, being broadly classified into four types- labor, land, capital and entrepreneurship, are limited and are therefore required to be utilized efficiently in order to maximize the production of goods and services from the same (Baumol and Blinder 2015). However, not all countries have abundance in all the resources of production and thus, different countries produce different types of commodities and services based on the resources present with them, which in turn gives rise to the concept of inter-country trade.

Over the years, various economic theories and concepts have come to existence in the aspect of international trade and trade relations. One of the most widely used and comprehensive trade theories present in the contemporary global scenario is the comparative advantage theory. Keeping this into account, the essay tries to discuss the comparative advantage theory, its implications and usefulness in the real scenarios of contemporary global trade activities (Laursen 2015). The primary objective of the essay is to explain the effectiveness of such theories in explaining the production, consumption and allocation of scarce resources of production, in the light of real trade scenarios in the global framework. 

The theory of Comparative Advantage in international trade came into existence as a successor of the Absolute Advantage Theory, proposed by Adam Smith. This theory, first highlighted the aspect of country specific specialization in production stating that a country should emphasize in producing goods and services which can be more efficiently produced with the help of the resources that are abundantly present in the country itself and should trade the same in exchange of those commodities in the production of which the country do not enjoy such productive advantages (Costino and Donaldson 2012).

However, in many real scenarios of trade set ups between two particular countries, it was observed that one of the countries enjoy absolute advantage in production of all the goods and services over the other country. This, in the absolute advantage framework, nullified the scope of any trade relation among the two concerned countries. This, being the primary drawback of absolute advantage theory, gave way to the Comparative Advantage Theory as was suggested by David Ricardo (Hausmann et al. 2014). The Comparative Advantage Theory proposed by David Ricardo, incorporates the economic notion of opportunity cost in the production process, while assessing the comparative advantages of different countries in the production of different commodities and services. The opportunity cost of production of one additional unit of a commodity is measured in terms of the values of other commodities which have to be sacrificed for the production of the former (Rios, McConnell and Brue 2013).

Comparative Advantage Theory and its Principles

The above theoretical framework of the Comparative Advantage Theory, incorporating the opportunity cost mechanism can be explained with the help of the following hypothetical example, considering two countries, each producing ice cream and chocolates with their resources:

Commodities	Country 1	Country 2
Ice creams	30	35
Chocolates	6	21

The hypothetical table, given above, shows the maximum number of ice creams and chocolates each of the two countries can produce by fully utilizing their productive resources. From the above numbers, it can be seen that Country 1, with maximum utilization of its resources, can produce either 30 ice creams or 6 chocolates, whereas Country 2, can produce either 35 ice creams or 21 chocolates. This in turn, implies that Country 2 enjoys absolute advantage of production in ice creams as well as chocolates, over that of Country 1, thereby making trade an invalid option in the light of Absolute Advantage Theory (Schumacher 2012). This in turn, in the Absolute Advantage Theoretical framework implies that all the commodities should be produced by Country 2 only. However, this is not a feasible solution in real case scenarios as the resources cannot remain non-utilized in country 1.

The Comparative Advantage Theory provides a more realistic solution with the help of the opportunity cost mechanism, which is shown with the help of the following table:

Opportunity Cost	Country 1	Country 2
Ice Creams	0.2	0.6
Chocolates	5	1.67

From the above table, it can be observed that the opportunity cost of production of ice creams in Country 2 (0.6) is higher than the same in Country 1 (0.2). Again the opportunity cost of production of chocolates is higher in Country 1 (5) than that of the same in Country 2 (1.67). This makes it more feasible for Country 1 to produce ice creams only and Country 2 to produce chocolates only and trade between one another. In doing so, the global production of both chocolates as well as ice creams is expected to be higher than the same in the autarkic condition (Bernard et al. 2012).

The Comparative Advantage Theory, though sounds more realistic than its preceding theory, however, has several drawbacks, especially in the aspect of explaining the dynamics in international trade in real case scenarios. The comparative advantage theory, while analyze the trade opportunities between different countries, does not take into account several other exogenous factors which may affect the dynamics, which primarily includes components like the cost of transport of the goods and services produced between the potential trading partner countries (Noussair, Plott and Riezman 2013). 

Comparative Advantage Theory vs Absolute Advantage Theory

Often this cost if transport may be so high that they can entirely rule out any comparative advantage in production of goods and services of the countries. Other affecting factors also include components like international exchange rate dynamics, socio-political aspects affecting the transport of commodities and others. The theory also overlooks the problems of diseconomies of scale which might occur in a country due to over specialization and excess supply issues. Another drawback of Ricardo’s theory is that it assumes that all the commodities are produced using same resource, which Ricardo takes to be labor to be specific (Costinot and Rodríguez-Clare 2014).

However, in reality, goods and services are produced with the help of combinations of different amounts of various factors of production, which is considered in one of the succeeding trade theories, popularly known as the Hecksher-Ohlin’s Theory of Factor Endowment. According to this theory, different commodities and services require different amounts of productive resources, depending upon their nature and these factors of production are also present in different proportions in different countries. Keeping these resource endowments in consideration the countries need to produce and export different commodities and services, such that both the domestic production as well as the global efficiency is maximized (Bond, Iwasa and Nishimura 2012).

This theory of production and trade seems to be more close to reality than the Ricardian Theory. However, there still remain several aspects in the Hecksher-Ohlin Theory, which are found to be less relevant in the real world trade scenarios. There may remain several hurdles which are faced by the countries in general in utilizing their abundant resources effectively, which can be elaborated with the help of examples of such occurrences in the contemporary global trade framework.

Example: The USA is considered to be one of the primary countries with highest per head capital over the years. This high abundance of capital resources makes it apparently obvious for the country to produce and export those commodities and services whose production are capital intensive in nature and import those commodities and services which require more labor than capital, as per the theoretical assertions of the Hecksher-Ohlin Framework. However, in reality USA is seen to be producing and exporting more of labor intensive commodities than that of the capital intensive goods, which directly contradicts the theoretical framework.

The above example of discrepancies between the theoretical assertions and observed phenomena, particularly in the economy of the USA is named as the Leontief Paradox, which in turn makes the Hecksher-Ohlin Theory practically infeasible in explaining the actual mechanisms in producing, consuming and allocating the scarce resources (Mariolis and Tsoulfidis 2016). The anomaly in the expected and proposed outcomes in the international trade dynamics can be explained by the presence of several regulatory or natural bindings in the economies in general. One such example of regulatory hurdles is the presence of minimum wage laws in many of the countries, especially the developed ones. The presence of high minimum wage  makes the cost of labor high in these countries, even when labor are abundantly present in such economies. Minimum wages, implemented with the objective of increasing the welfare of the society as a whole, leads to a tradeoff between equity and efficiency aspects, thereby hampering efficient allocation of resources in the production of goods and services (Meer and West 2015). 

Opportunity Cost Mechanism in Comparative Advantage Theory

Another aspect of the actual international trade scenario, which has become increasingly relevant in the contemporary periods, is the aspect of intra-industry trade, which cannot be considerably, explained by none of the above comparative advantage theories in this aspect. The phenomenon of intra-industry trade refers to the similar commodities or services exchange among different countries, the commodities exchanged belonging to the same industry.

Example: Europe is seen to export millions of automobiles to different countries. However, Europe also imports automobiles in huge numbers from other countries, which indicates towards the presence of intra-industry trade, which is overlooked by the conventional trade theories. There have been substantial works in the aspect of explaining this phenomenon of intra-industry trade. While some of the economists proposes the presence of commodities of different factor endowments in single industry, due to subtle variations in the nature of the goods produced, several others points out that not all commodities, even in the same industry, are produced under similar technical conditions.

One of the prevailing trade theories, which try to explain this phenomenon to some extent, keeping into consideration the aspects of comparative advantages in production of commodities and economies of scale is the Product Life Cycle Theory of Vernon, which can be explained with the help of the following diagram, depicting the different stages of trade cycle of most of the commodities produced in an economy and the corresponding sales volume of the same:

 

Figure 1: Stages in the Product Life Cycle Theory

(Source: Wright.edu, 2018)

As is evident from the above figure, in the initial stage of introduction of the product in the market of a country, the product relevant to the productive advantages and factor intensities of the economy is introduced in the market. In the growth stage, the product sees increased demand, which increases the cost efficiency of the firms, thereby leading to economies of scale in production. However, the demand for most of the products becomes saturated after some time, with the maturity stage being reached (Bilir 2014). This denotes stagnation in the demand for the same product, with the same being present with all the customers and the customers waiting for new and improved products. The final stage sees a decline in the demand for the same, thereby decreasing the profit in the industry. The customers start preferring higher end products, thereby leading to intra-industry trade in the concerned economy. 

Drawbacks and Limitations of Comparative Advantage Theory

Another theory, proposed by Paul Krugman, known as the New Trade Theory, which emphasizes on the fact that the countries tend to produce commodities according to the increasing returns, though the consumption habits of the residents do not depend on the same. However, the theory does not take into account the aspects hampering free flow of commodities and intra industry trade among the different nations, which primarily includes the trade restrictions and socio-political tensions among the nations, which makes imports and exports difficult (Ossa 2012).

All the previously discussed trade theories emphasize on the natural comparative advantages which the countries enjoy due to the inherent presence of advantageous factors of production, failing to highlight the fact that the countries can create several factor advantages for themselves, which are highlighted by the Porter’s Diamond Strategy. These include skilled labor, human capital, increased efficiency of government infrastructure and technological innovations (Riasi 2015). According to the theory, there are several interrelated factors which lead to national comparative advantages for the economy, which are diagrammatically represented as follows:

 

Figure 2: Porter’s Diamond Strategy

(Source: Claessens, 2018)

This theory, focusing on the factors like the demand conditions, backward and forward industry linkages, the scopes of expansion of new industries, the factor conditions and the structure of rivalry and strategic options of the firms, provides a more comprehensive outlook in the aspects of the international trade dynamics and in the aspects of allocation of scarce resources in the production of different commodities and services.

Conclusion

From the above discussion, it is evident that with the consistently increasing complexities in the global trade and commerce and with more determining factors getting involved in both the demand as well as the supply side, the trade theories like that of Comparative Advantage Theory or Hecksher-Ohlin Theory, provide only partial explanations to the usage and allocation of scarce resources in different production activities across different countries. More inclusive frameworks are developing, like that of Porter’s Model or Trade Cycle Model, which aims to discuss these issues in a multidimensional framework, incorporating wider ranges of causal factors and determinants of the production behavior of the countries in the international scenario. 

References

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