BUMKT6942-International Trade Theory Assignment Help
Abstract
This essay examines three early trade theories Mercantilism, Absolute Advantage and Comparative Advantage to understand the underlying philosophies. The theories are discussed from the point of view of their objectives, historical context, inherent assumptions and limitations in the present context. Some comparisons amongst these three theories is also included in the deliberations.
Introduction
The reasons for any nation to trade internationally are numerous and diverse. Each nation has its own idiosyncrasies and compulsions to trade or not to trade with other countries. The benefit obtained is primarily economic, but there may be political and social concerns as well. What enables them to a position where they can sell their goods depends on the advantages which they possess in producing and selling the goods. The advantages could germinate from better natural resources, better technology, specialization etc. All these advantages ultimately need to create a relative advantage for the country to import or export. This modern understanding was preceded by theories which explained or described the trade practices of the nations. Early trade theories included Mercantilism, Absolute Advantage and Comparative Advantage.
Mercantilism is a theory where the main objective of trade is to increase the nation’s wealth by encouraging exports and restraining imports (LaHaye 2008). The theory, which is still practiced in its modern variants, was widely prevalent in the 16th to late 18th centuries. At that time, it was thought that by increasing exports and limiting imports a nation could increase its gold and silver reserves (LaHaye 2008). Increased bullion reserves was the main motive (paper money was not in practice) and was associated with being a wealthier nation. In a way, it was a political form of economy where colonial powers were in a position to control the trade. The favorable balance of trade, and consequent increase in bullion reserves was thought to enrich domestic economy by enhancing production and domestic employment. Here, government and merchantile class were together in their pursuit for increased exports (LaHaye 2008). Government regulated the trade, and used its political influence abroad, especially in the colonies controlled by them, to influence the trade dynamics. Tariffs and other measures were practiced to achieve the end. Subsidies were there to support exports and imports were discouraged through trade barriers / prohibition (LaHaye 2008). Import of raw material was supported compared with import of finished goods. Likewise, export of finished products was mooted compared with export of raw materials (Hornick 1684). This was because it was thought that selling a more value added (finished) product would result in more benefit for the exporting nation. Colonizers may have exercised their influence to ensure that the colonies exported raw materials to the dominant nations. The political system of the times (monarchies) also could have helped the countries to practice this system as democratic voices could not disturb imperialistic endeavors. Exports were the main focus of the supporters of Mercantilism, and hence production was more important than domestic consumption. In those times, these ideas may have been relevant and even beneficial for increasing power of nations. The nexus between private sector and the government surely may have helped the exporters.
Even in current times, international trade does have political motives. Though outright support may be difficult in the current environment, tools like exchange rate management etc. have been practiced by countries like China (Rodrik 2013). But world trade bodies attempt to prevent restrictive trade practices to encourage free trade. However, it is common knowledge that even modern nationalism does recognize the importance of economic power in becoming a politically stronger and more influential nation.
Absolute advantage is a school of thought which refers to the ability of an entity (e.g. country, firm etc.) to produce a good or service at a lower unit cost than other entities (Landsberg 2013). This reduced cost leads to obvious advantages including enhanced profits. For example, if Country X takes 5 labor hours to produce a product A and Country Y takes 10 hours to produce the same product, then X has an absolute advantage over Y for the product A. Thus country X can export the product to country Y as there is an absolute cost advantage. This theory, often attributed to Adam Smith, leads to an understanding that countries with lower production cost (using lesser resources per unit of the product) will be better positioned to export the product to other countries. Adam Smith’s theoretical discussions focused on labor as an input for comparing the production costs (Smith 1776).
As per Schumacher (2012), the argument was taken further to understand that division of labor leads to quantitative and qualitative improvements in the methods of production. That is, to achieve and maintain this state of absolute advantage, there is specialization through division of labor and there is an increased focus on development of technology. This leads to further trade and the nation’s wealth increases as economic growth is promoted. The growth is, however, limited by the size of the market, and nations hunt for other markets to further sharpen their absolute advantages. However, when this comparison is extended to a number of products produced by both the countries, it is theoretically possible that the country X possesses an absolute advantage in producing all the products being compared. Thus there is a possibility that the ensuing trade may not be equally beneficial for both the countries. Furthermore, it is possible that if transport cost are also taken as a factor, even other countries can have absolute advantage in producing the same product with reference to different markets (WTO 2010. As per the theory, it is the ensuing trade which leads to specialization / division of labor and not the other way round. Taking this division of labor to the global level, specializations due to division of labor and technological advancements will be established over time where countries produce what they are at an absolutely advantage to produce. This is the main perceived advantage of the absolute advantage where the overall production increases and is done at the lowest cost. Compared to mercantilism, the absolute advantage believes in free trade and the focus on consumption is relatively more. Even absolute advantage may be a consequence of policy support, but the emphasis on consumers is more.
Comparative advantage refers to the ability of an entity to produce goods / services at a lower relative cost as compared with other entities (Landsberg 2013). Here relative cost is measured by taking into account the opportunity cost of not producing other alternative products where the entity can deploy its resources. This theory, attributed to David Ricardo, implies that it is not the absolute cost which matters, but it is the relative cost (opportunity cost) which is important. In a simple model where two products of two countries are compared it is possible that one country has an absolute advantage in both the products. However, if opportunity cost of other products is also considered, then each country will have a comparative advantage for one product. It is not possible for a country to possess a comparative advantage for both the products. It is basically trying to understand the cost of production of the other product which is given up to produce the first product. The product where the country has a lower opportunity cost is what it should produce. For example, consider two individuals P & Q, and two jobs repairs and painting. Presuming that P can repair 4 rooms and paint 8 rooms per week and Q can repair 3 rooms and paint 4 rooms per week. If examined from the point of view of absolute advantage, P is more efficient in both the jobs. So ideally, P should be doing both the jobs and Q should be taking his help in getting both the jobs done. However, P cannot do both the jobs at the same time because the time he spends on repair is always at the cost of the time he could have spent on painting. Thus there is an opportunity cost of both the tasks depending upon what he does not do. The opportunity cost of repair for P is 8/4 = 2 rooms of painting. For Q the opportunity cost of repair is 4/3 = 1.33 rooms of painting. Thus Q’s opportunity cost for repair is less and he should be repairing and P should be painting. When this analysis is taken further, it appears that the overall production is higher and more efficient for both the products in such a situation (Mankiw 2000).
This makes a little more sense as it leaves room for an incentive for all countries to produce that product where they have a comparative advantage. Again, the focus is primarily on cost advantages, albeit relative. Furthermore, as stated by Ricci & Trionfetti (2011), ‘Ceteris paribus, the ex-ante probability of exporting is larger in the industry of comparative advantage’. Further as per WTO (2010), existing trade theory of natural resources reflects that comparative advantage also holds when the specific (practical) features are taken into account. Thus, the theory does hold good even today.
Limitations of early theories
None of the theories mentioned above are totally irrelevant and several principles apply to modern trade dynamics. However, the theories do suffer from limitations which can be traced, at least partially, to the era in which they originated. Some major aspects are highlighted below.
Mercantilism had its origins in the political aspirations of imperialistic countries where the governments and the merchants supported each other to create political clout and deter military ambitions of enemies (LaHaye 2008). However, the assumption that increase in bullion reserves leads to increase in wealth of nations was questioned by Smith (1776). While this could have been true to an extent in those times as paper money was not used, presently concentration of bullion in a few countries would have an effect of reducing the prices of these commodities relative to other products in those countries. Secondly, in current times, due to free trade principles being propagated by world trade bodies etc., it is not possible to practice unbridled protectionism to support local traders in exports. Thirdly, it is not clear whether it is possible or even desirable to continuously maintain a trade surplus. Present models of exchange rate dynamics indicate that there may be automatic appreciation of the currency if the exports were to increase continuously. Fourthly, nowadays countries have options of procuring goods / services from other countries, and cannot be forced by a few nations to buy or sell any product. Lastly, when seen in light of comparative advantage theory, it appears that it may not be desirable to avoid imports for all the products and in all situations. Doing so would deprive the countrymen of access to efficiencies prevalent in other economies. Furthermore, as presented by Fabrice & Alejandro (2012), export focus also may harm the local markets as in case of China.
Further, free trade reduces complacency in the domestic producers which may develop in mercantilism due to excessive dependence on government support. This forces innovation and development of better methods of production. Protectionism also has costs and spoils the investment climate.
Absolute advantage & Comparative advantage are examined together to understand their limitations. As discussed by Schumacher (2012), the comparative advantage approach is more static relative to the absolute advantage model where the ensuing specialization is dynamic, and is a persistent consequence of trade. Further, the absolute advantages may not be present or discovered before start of trade between two nations, and only after subsequent specialization the countries drive home the absolute advantage. The trade leads to economic development. The comparative advantage has an inherent assumption that countries differ before they start trade, and the trade is a result of the differences. Dynamism is not an attribute of the comparative advantage theory. In absolute advantage, the differences are more endogenous whereas they are more exogenous in comparative advantage. This is because comparative advantage, is a comparative of the opportunity cost which is relevant when the comparisons are exogenous.
However, free trade flow based on product cost (whether absolute or relative), may not always be beneficial as protectionism is known to help infant industries. All restrictions are not imposed on trade to gain competitive or economic advantages. This is because nations may not compete like companies, and have other considerations also e.g. Pharmaceutical companies which spend billions on R&D, are protected by the patent regime for initial part of their product life cycle. This leads to higher costs but provides impetus to innovation. Lastly, it is also well known that if productivity is increased, wages also rise suitably. Thus increased productivity cannot be leveraged purely based on labor costs.
The inherent characteristic of Absolute advantage appears to be flawed when compared with the advantages which emerge if relative cost model is considered. Absolute advantage ignores interplays between opportunities, and also does not factor the possibility of higher & more efficient production even if one does not have absolute advantage in any thing. Further, as stated by Gupta (n.d.) absolute advantage is neither necessary nor sufficient in determining how trade will pan out across nations.
Comparative advantage theory, though relatively more accurate, considers labor as the key factor in determining the cost of production. It does not factor cost of transportation, government interventions /supports, economies of scale and disruptive technologies which may bring in additional efficiencies (e.g. lowering opportunity cost of other products). This sudden change in relative costs may change the dynamics, and dependance on imports for products where one does not have comparative advantage, may prove to be risky and costly. So instead of playing based on comparative advantage alone, nations may be safer where trade patters are more diversified. This may imply more inefficiency in the system in the short term, but risk costs should also be determining factor in the equation.
Conclusion
Overall, some aspects of these theories still remain relevant but many have become obsolete with the passage of time and change in the quality, structure, size and dynamics of the world economy. For example, quality and individual preferences are also important in buying a product. Further, competitive advantage theories imply that nations / companies can compete based on segmentation and differentiation also (Porter 1980). Most importantly, comparing two countries purely on cost basis, without considering the exchange rate dynamics, may not be practically correct. Environmental concerns / norms, labor norms etc. have to be accepted despite the fact that they add cost to the system. Further, easier access to low cost capital across the world does make comparative advantage more dynamic.
None of the simplistic or outdated assumptions in the three early trade theories discussed can be considered totally correct or relevant. Trade is driven by joint influence of various factors like natural resources, capital goods, strength of the economy (more subsidies / incentives )etc. rather than pure cost play. One must give due credit to the early trade theories as the data available at that time was not that accurate or detailed. Information technology has equipped us with better analytical skills and the flow of information is less inhibited than what it was in those times. These theories or descriptions of trade phenomena help and perhaps lay the foundations of modern economic theories.
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References
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HYPERLINK “http://www.wto.org/english/res_e/booksp_e/anrep_e/wtr10-
