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Comparative Advantage David Ricardo took Adam Smith's theory one step further by exploring what might happen when one country has an absolute advantage in the production of all goods.4 Smith's theory of absolute advantage suggests that such a country might derive no benefits from international trade. In his 1817 book Principles of Political Economy, Ricardo showed that this was not the case. According to Ricardo's theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.5 While this may seem counterintuitive, the logic can be explained with a simple example. Assume that Ghana is more efficient in the production of
both cocoa and rice; that Ghana has an absolute advantage in the production
of both products. In Ghana, it takes 10 resources to produce one ton of
cocoa and 13 1/3 resources to produce one
The Theory of Comparative Advantage ton of rice. Thus, given its 200 units of resources, Ghana can produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or any combination in between on its PPF (the line GG' in Figure 4.2). In South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice. Thus, South Korea can produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or any combination on its PPF (the line KK' in Figure 4.2). Again assume that without trade, each country uses half of its resources to produce rice and half to produce cocoa. Thus, without trade, Ghana will produce 10 tons of cocoa and 7.5 tons of rice (point A in Figure 4.2), while South Korea will produce 2.5 tons of cocoa and 5 tons of rice (point B in Figure 4.2). In light of Ghana's absolute advantage in the production of both goods, why should it trade with South Korea? Although Ghana has an absolute advantage in the production of both cocoa and rice, it has a comparative advantage only in the production of cocoa: Ghana can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice. Without trade, the combined production of cocoa will be 12.5 tons (10 tons in Ghana and 2.5 in South Korea), and the combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade, each country must consume what it produces. By engaging in trade, the two countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods. The Gains from Trade Imagine that Ghana exploits its comparative advantage in the production of cocoa to increase its output from 10 tons to 15 tons. This uses up 150 units of resources, leaving the remaining 50 units of resources to use in producing 3.75 tons of rice (point C in Figure 4.2). Meanwhile, South Korea specializes in the production of rice, producing 10 tons. The combined output of both cocoa and rice has now increased. Before specialization, the combined output was 12.5 tons of cocoa and 12.5 tons of rice. Now it is 15 tons of cocoa and 13.75 tons of rice (3.75 tons in Ghana and 10 tons in South Korea). Table 4.2 summarizes the source of the increase in production. Not only is output higher, but also both countries can now benefit from trade. If Ghana and South Korea swap cocoa and rice on a one-to-one basis, with both countries choosing to exchange four tons of their export for four tons of the import, both Table 4.2 Comparative Advantage and the Gains from Trade
countries are able to consume more cocoa and rice than they could before specialization and trade (see Table 4.2). Thus, if Ghana exchanges 4 tons of cocoa with South Korea for 4 tons of rice, it is still left with 11 tons of rice, which is 1 ton more than it had before trade. Moreover, the 4 tons of rice it gets from South Korea in exchange for its 4 tons of cocoa, when added to the 3.75 tons it now produces domestically, gives it a total of 7.75 tons of rice, which is .25 of a ton more than it had before trade. Similarly, after swapping four tons of rice with Ghana, South Korea still ends up with six tons of rice, which is more than it had before trade. In addition, the 4 tons of cocoa it receives in exchange is 1.5 tons more than it produced before trade. Thus, consumption of cocoa and rice can increase in both countries as a result of specialization and trade. Generalizing from this example, the basic message of the theory of comparative advantage is that potential world production is greater with unrestricted free trade than it is with restricted trade. Ricardo's theory suggests that consumers in all nations can consume more if there are no trade restrictions. This occurs even in countries that lack an absolute advantage in the production of any good. To an even greater degree than the theory of absolute advantage, the theory of comparative advantage suggests that trade is a positive-sum game in which all gain. As such, this theory provides a strong rationale for encouraging free trade. Ricardo's theory is so powerful that it remains a major intellectual weapon for those who argue for free trade. Qualifications and Assumptions The conclusion that free trade is universally beneficial is a rather bold one to draw from such a simple model. Our simple model includes many unrealistic assumptions:
Simple Extensions of the Ricardian Model Let us explore the effect of relaxing two of the assumptions identified above in the simple comparative advantage model. Below we relax the assumption of constant returns to specialization and the static assumption that trade does not change a country's stock of resources or the efficiency with which it utilizes those resources. Diminishing Returns The simple comparative advantage model developed in the
preceding subsection assumes constant returns to specialization. By constant
returns to specialization, we mean that the units
of resources required to produce a good (cocoa or rice) are assumed to
remain constant no matter where one is on a country's production possibility
frontier (PPF). Thus, we assumed that it always took Ghana 10 units of
resources to produce one ton of cocoa. However, it is more realistic to
assume diminishing returns to specialization. Diminishing
returns to specialization occur when more units
of resources are required to produce each additional unit. Whereas 10
units of resources Ghana's PPF under Diminishing Returns
may be sufficient to increase Ghana's output of cocoa from 12 tons to 13 tons, 11 units of resources may be needed to increase output from 13 to 14 tons, 12 units to increase output from 14 tons to 15 tons, and so on. Diminishing returns imply a convex PPF for Ghana (see Figure 4.3), rather than the straight line depicted in Figure 4.2. There are two reasons why it is more realistic to assume diminishing returns. First, not all resources are of the same quality. As a country tries to increase output of a certain good, it is increasingly likely to draw on more marginal resources whose productivity is not as great as those initially employed. The end result is that it requires more resources to produce an equal increase in output. For example, some land is more productive (fertile) than other land. As Ghana tries to expand its output of cocoa, it might have to utilize increasingly marginal land that is less fertile than the land it originally used. As yields per acre decline, Ghana must use more land to produce one ton of cocoa. A second reason for diminishing returns is that different goods use resources in different proportions. For example, imagine that growing cocoa uses more land and less labor than growing rice, and that Ghana tries to transfer resources from rice production to cocoa production. The rice industry will release proportionately too much labor and too little land for efficient cocoa production. To absorb the additional resources of labor and land, the cocoa industry will have to shift toward more labor-intensive production methods. The effect is that the efficiency with which the cocoa industry uses labor will decline; and returns will diminish. The significance of diminishing returns is that it is not feasible for a country to specialize to the degree suggested by the simple Ricardian model outlined earlier. Diminishing returns to specialization suggest that the gains from specialization are likely to be exhausted before specialization is complete. In reality, most countries do not specialize, but produce a range of goods. However, the theory predicts that it is worthwhile to specialize until that point where the resulting gains from trade are outweighed by diminishing returns. Thus, the basic conclusion that unrestricted free trade is beneficial still holds, although due to diminishing returns, the gains may not be as great as suggested in the constant returns case. Dynamic Effects and Economic Growth Our simple comparative advantage model assumed that trade
does not change a country's stock of resources or the efficiency with
which it utilizes those resources. This static assumption makes no allowances
for the dynamic changes that might result from The Influence of Free Trade on the PPF trade. If we relax this assumption, it becomes apparent that opening an economy to trade is likely to generate dynamic gains.9 These dynamic gains are of two sorts. First, free trade might increase a country's stock of resources as increased supplies of labor and capital from abroad become available for use within the country. This is occurring right now in Eastern Europe, where many Western businesses are investing large amounts of capital in the former Communist bloc countries. Second, free trade might also increase the efficiency with which a country uses its resources. For example, economies of large-scale production might become available as trade expands the size of the total market available to domestic firms. Trade might make better technology from abroad available to domestic firms. In turn, better technology can increase labor productivity or the productivity of land. (The so-called green revolution had this effect on agricultural outputs in developing countries.) Also, opening an economy to foreign competition might stimulate domestic producers to look for ways to increase the efficiency of their operations. Again, this phenomenon is occurring currently in the once-protected markets of Eastern Europe, where many former state monopolies must increase the efficiency of their operations to survive in the competitive world market. Dynamic gains in both the stock of a country's resources and the efficiency with which resources are utilized will cause a country's PPF to shift outward. This is illustrated in Figure 4.4, where the shift from PPF1 to PPF2 results from the dynamic gains that arise from free trade. Because of this outward shift, the country in Figure 4.4 can produce more of both goods than it did before free trade. The theory suggests that opening an economy to free trade not only results in static gains of the type discussed earlier, but also results in dynamic gains that stimulate economic growth. If this is so, the case for free trade becomes stronger, and the World Bank has assembled evidence that suggests a free trade stance does have these kind of beneficial effects on economic growth.10 |
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