The law of comparative advantage has, for a long time, been used as the basis of international trade. The law is one of the main potential explanations for income growth rates and higher incomes of open economies. International trade currently accounts for about 25% of the worlds GDP, thanks to the liberalization of trade and the increase in foreign direct investment. Countries and companies trade with each other because of the gains or benefits that accrue from the exchange of goods and services to the trading countries. According to the law of comparative advantage, countries should produce the goods in which they have the comparative advantage. Products are grouped into two according to the Heckscher-Ohlin theory: capital intensive products, and labor intensive products. A country rich in labor is most likely to produce the labor intensive products, whereas the other rich in capital tends to produce the capital intensive products. These two countries would then trade in these products and enjoy the benefits of the international trade. This paper highlights the law of Comparative Advantage and its impacts on international trade. This analysis explains why comparative advantage forms the basis of international trade.
This theory was first introduced in 1817 by David Ricardo. According to the theory, there is comparative advantage when a country has “margin of superiority” in production of goods and services. Margin of superiority means that the marginal cost of production is lower. According to the theory, specialization is a precondition for enjoying the gains from trade. International trade results from the relative difference in the productivity between countries. The larger the differences in the sources of comparative advantage across the countries, the greater the gains from the trade.
The main contribution of the theory is not the absolute differences but rather the relative differences in countries’ abilities to produce certain products (goods and services) which facilitate international trade (Deardorff, 2011). Therefore, a country with greater efficiency in producing a given product as compared to another country, may find it profitable to import that product and export other products in which its efficiency in production is even greater. Besides, countries can concentrate in the production of what they are relatively more efficient at and exchange these products for those efficiently produced in other countries (trading in line with the comparative advantage).
Sources of Comparative Advantage
Based on the original hypothesis, Ricardo argued that comparative advantage results from differences in relative labor productivities. Thus, a country has competitive advantage in products which can be produced at lower opportunity costs relative to another country. Ricardo‘s example involved England and Portugal. England had the comparative advantage in the production of cloth due to lower opportunity cost of focusing on cloth production than focusing on wine production. This was so although England might have been more efficient in the production of wine in absolute terms (by using less units of labor per unit of wine). The Hecksher-Ohlin theory was based on Ricardo‘s general formulation and explained why there might be differences in the opportunity cost of production across countries. Comparative advantage, according to this theory, depends on the differences in the relative factor endowments such as land, labor, and capital, and the production processes of various products which use these factors in various proportions. Recent OECD studies have looked at the implications of the law of comparative advantage in trade patterns and endowments (Stone et al., 2011).
One of the sources of competitive advantage is the differences in the relative factor endowments as proposed by Hecksher-Ohlin model of international trade. Various empirical studies reveal that countries tend to export the products which are produced by relatively intensive use of factor of production, in which the countries are relatively well endowed. Based on this premise, a capital-abundant country tends to export capital-intensive products and at the same time import the labor-intensive products (Debaere, 2003; Romalis, 2004; Chor, 2010; and Stone et al., 2011). The country therefore specializes in the production of what it is relatively more efficient at, in this case the capital-intensive products, and exchanges it with other products which other countries produce relatively more effectively. This calls for the export and import trade, thus forms the basis of international trade.
Human capital is another source of comparative advantage. According to various economic studies, accumulation of human capital is the engine of growth (Lucas, 1988). This is based on the differences in human capital productivity relative to the differences in physical capital productivity. Thus, human capital accumulation enhances economic growth. A country with higher accumulation of human capital can relatively and more efficiently produce the goods and services whose production is labor-intensive. The country can then exchange these goods and services with other goods and services which it lacks relative efficiency in producing, from the countries with the advantage. This forms the basis of international trade.
Another source of comparative advantage is the dependence on the external credit and the availability of the credit. A pre-condition for economic development is the financial development. If a country has more developed financial markets, the industrial sectors that are largely in need of external finance tend to develop faster. Financial development directly translates into comparative advantage in the industries which use more external finance (Beck, 2003; and Manova, 2008). A country with more developed financial markets (a financially developed country) specializes in the industrial sectors that largely need external finance. The products from these sectors can then be exported to other countries which are relatively less financially developed, and the country imports other goods and services for whose production it lacks comparative advantage. This export and imports brings forth the international trade.
Energy intensity and supply also contributes greatly towards comparative advantage. In order to produce goods and services, there must be energy inputs, which however, are scarce and are imported in most cases. The energy costs vary considerably across countries and industries. The costs are greater in sectors producing processed energy products such as coal and petroleum product industries, and also in heavy industries such as Minerals, metal, rubber, plastic, and chemical industries. These sectors are mostly vulnerable to hikes in energy prices and the external supply pressures due to their reliance on the energy inputs, especially the energy-importing countries. The difference in energy dependence across sectors and countries is thus an important source of comparative advantage.
Generally, business climate have direct impact on economic growth of trade. Resurgent literatures have attempted to measure the impacts of several of doing businesses indicators on the aggregate performance of trade. Business climate influences structure and specialization of trade. In essence, institutional quality is sources of comparative advantage and analysis of differences in institutional quality through a framework of incomplete contracts. This presentation thus proposes that to proxy the industry-level dependence on institutional quality with a measure of input concentration as a proxy for product complexity and found that institutional aspects can significantly influence flow of trade. It is also identified that influence of institutional quality as pertains to diverse sectors by considering levels of job tasks complexity associated with the production of different goods and services, specifically, good industries with good infrastructures forms complementary source of competitive advantage. The impact of contract enforcement specifically on exports in terms of industry difference in relation species as proxied to shares of customized inputs required therefore, enforcement of good conduct is crucial for the export performance of relationship specific sectors of the economy, i.e. it has considerable impact on trade patterns. In essence, the enforcement of contract illustrates on more of the global pattern of trade than the given County’s of combined skilled labor and human capital and skilled labor combined. This paper therefore follows this literature and measures extent of comparative advantage which propagates from interactions of regulatory quality which are measured by county level indictors of regulatory quality, control of corruption and rule of law.
Available literature proposes that the difference across countries in labor marker characteristics is a determinant of how firms adjust to idealistic shocks. It is also hoe they interact with idiosyncratic shocks. Also, is difficult to find out how they specifically interact to sector with differences as concerns demand volatility in generating new source of competitive advantage. In particular, counties with more flexible labor have the tendency of specializing in sectors characterized with higher volatility demand. This presentation therefore follows hypothesis and constitutes interactions indicators selected of the regulation of labor market regulation measured at exporter level but with indication of demand volatility of the sector. Employment laws govern the individual employment contract. Collective or industrial relations laws regulate the bargaining, adoption, and enforcement of collective agreements, the organization of trade unions, and the industrial action by workers and employers. Such regulations may cause rigidity and prevents s markets from adjusting to economic shocks simply through raising costs of hiring workers by the firms as well due to the cost of employment levels adjustment. For instance, laws aiming at raising cost of employment, specially, those concerned with protection of employment make firms hire employees with a lot of curiosity and minimize flow out of unemployment.
This is the final source of comparative advantage. It basically concerns with tariff protection which translate to the impact it has in the intermediate inputs imports. Available literature postulates that trade in intermediate inputs represents overall flow of trade in services and goods and are most common in the developed economies.
It is also significant that in comparison to final good and trade, the imports of intermediaries are highly sensitive to trade costs. More so, industries do differ pertaining to ration of values of intermediaries imported inputs to the value of production electronic equipment and petroleum products recording the highest shares, for instance. Therefore, general level of protection of tariff constitutes comparative advantage with lesser protected economies possessing an advantage in those sectors with high shares of imported intermediate inputs. Thus, the estimated coefficients on tariff interaction terms should not be interpreted as measuring the impact of trade protection on trade in general but rather as measuring the extent to which high tariffs on imported intermediate inputs affect sectoral trade patterns.
On the whole, the discussed results signify that comparative advantage is still a critical determinant of trade. For instance, the ratios of labour to capital are equally important is illustrating the industry trade patterns just as the geographical distance. Importantly, credit availability and primary supply of energy, quality of regulatory and rigidity of the labour market is realized to be core influencers of patterns of trade, though with different degree.
Comparative advantage theory stresses relative productivity difference between countries as reasons for international trade, thereby for benefits from trade. Quite often, the greater differences in comparative advantage in underlying sources across the countries, the higher the trade gains. Generally, currently as well as in the near future, comparative advantage is more for South-South and North-North trade. From the presentation, it is clear that comparative advantage is still the determinant of trade and that it has changes institutions and policies overtime. For instance, higher explanatory powers of human capital and physical capital underscore significance of policies pace as well as quality of human and physical capital accumulation.
Correspondingly, credit availability is noticed to able to boost exports highly in sectors bestowed with reliance in external funding. An increase in primary energy supply-to-GDP ratio is noticed to be to boost exports in relatively energy-intensive sectors. Overall, government should not actively influence trade patterns but their actions may be counterproductive in case they appear inconsistent with country’s resource base as well policies in place. Thus, when seeking to maintain or develop competitiveness in a certain area—for instance capital-intensive sectors—this is best achieved through drawing on best practices and developing effective broad policies that facilitate capital accumulation. This implies that comparative advantage and driven specialization is not at all a constraint to an economic development but acts as catalyst.
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