International Economics

International Economics

Explain the relationship between a nation’s factor endowment and its comparative advantage in international trade:

Comparative advantage theory:

David Ricardo coined the comparative advantage theory of trade. He considered two countries, two products and two factors of production. In his theory he stated that even if one country had absolute advantage in the production of the two goods they would still gain by trading, absolute advantage according to Adam Smith refers to the cost advantage country posses in the production of goods.

Ricardo compared two goods which is wine and cloth which were produced in Portugal and England, in his study he discovered that Portugal had absolute advantage on the production of both cloth and wine but the two countries would still gain from trading where Portugal will olny produce that product which it is more efficient in production and which it has more comparative advantage while England would produce the other good. According to this theory the two countries will gain from trade if each country specialises in the production of that good which it has a higher comparative advantage.

The table below shows comparative advantage of two countries:

country

International Economics

GOOD 1

GOOD 2

A

80

90

B

120

100

We assume that the given numerical figures are the costs of labour in the production of good 1 and good 2 in both countries, from the above table it is clear that country A has absolute advantage in the production of both goods but according to the comparative advantage theory the two countries will still gain by trading

International Economics

Comparative advantage:

Country A

Good 1 = 80/120 X 100 = 67%

Good 2 = 90/100 X 100 = 90%

Country B

Good 1 = 120/80X 100 = 150%

Good 2 = 100/90 X 100 = 111%

From the analysis of the comparative advantage it is clear that despite country A having absolute advantage in the production of both goods it even more efficient in the production of good 1, for country B it is less disadvantaged in the production of good 2. for this reason country A will produce good 1 and country B will produce good 2 and they will gain from trading.

International Economics

The gains from trade:

Both countries will gain from trading, if we assume that the exchange rate of good 1 and good 2 is 1:1 then we can summarise the gains as follows:

Country A produces good 1 and therefore gains 90 – 80 = 10 units of labour, country B will produce good B and gain 120 -100 = 20 units of labour.

Therefore trade will offer a country an opportunity to specialise and therefore countries will reallocate factors of production to those goods in which it has comparative advantage in and therefore gain in the process.

Assumptions of the comparative advantage theory:

International Economics

Factor endowment theory:

Hecksher ohlin trade theory states that trade occurred due to factor endowment, factor endowment according to him meant that a country was either endowed with capital or labour, he stated that those countries that were rich in capital produced capital intensive goods while those that were rich in labour produced labour intensive goods. Capital intensive goods are those goods that require more units of capital per unit of production, while the labour intensive goods are those goods that require more units of labour per unit of production.

Factor endowment therefore refers to the amount of resources has, however this theory was based on the assumptions that there were no transport costs, perfect competition in the commodity and factor market, only two goods are produced where one good is labour intensive while the other is capital intensive and the final assumption is that the production function differ between commodities but is same in both countries.

The comparative advantage theory and the Hecksher ohlin theory therefore is based on the assumption that we consider 2 countries and two commodities, they also assume that there are no transport costs and explain why countries will trade, according to David Ricardo countries will trade in order to gain from trade while according to the hecksher ohlin theory countries will trade due to factor endowment.

If we consider factor prices in two countries where country one is capital endowed and country two is labour endowed then we expect that the capital endowed country the cost of one unit of capital is lower than in country two and in the same case for the labour abundant country two the cost of one unit of labour is less than in country one which is capital endowed. If we tke a hypothetical example where country one has 100 units of capital and 60 units of labour and country two has 50 units of capital and 100 units of labour then the production possibility frontier for the two countries will be as follows:

Given the above scenario then we expect that country one which is capita endowed we expect

International Economics

the price of one unit of capital to be lower than in country two, on the other hand we expect that in country two which is labour endowed the cost of one unit of labour is lower than in country one.

For this reason therefore country one will produce capital intensive goods due to the abundance and low cost of capital while country two will produce labour intensive goods due to abundance of labour and the low cost per unit of labour. For this reason the countries will trade and gain from trade due to the cost differences of factors of production, country one will export capital intensive goods and import labour intensive goods.

However the Hercksher ohlibn theory faces some problems where there exist demand reversals and factor reversals, when demand reversals occur then this theory does not hold, it refers to the situation where the preference pattern in a country where a capital intensive country will demand capital intensive goods while in the labour endowed country consumers may demand labour intensive goods. Factor reversals refer to a situation where a good which is labour intensive will become a capital intensive good at a certain level of production and there is no correspondence between factor prices and factor intensities and goods produced can no longer be classified as labour intensive or capital intensive, therefore When factor reversals occur this theory will not hold.

Assumptions of this theory:

–  There exist no trade impediment and         transport costs and therefore this states that the

prices of goods in both        countries are the same

–  There is perfect competition in both         the factor and commodity market and therefore the

allocation process is        made in an optima way

–  Productions functions of the two       goods are in such a way that they portray factor

intensities where good A      is labour intensive and good B is capital intensive.

–  The production function differ between      countries but are the same in both countries,

International Economics

this means that there exist        no factor reversals.

Discussion:

From the above discussion of the two theories regarding factor endowment and comparative advantage countries will trade and gain from trade, the two theories state that there should be free trade between countries, a country that is rich in capital according to the factor endowment theory will produce capital intensive goods, while the labour endowed country will produce the labour intensive goods, in the countries which are endowed in capital then the unit cost of capital used in production is lower than the labour endowed country, for this reason therefore the country will try to capture this advantage by producing capital intensive method.

The capital endowed country therefore has a comparative advantage in the production of capital intensive goods while the labour endowed country will have comparative country in the production of labour intensive goods. For this reason therefore each country will specialise in that good which they have comparative advantage in, according to the comparative advantage theory by Ricardo the countries will gain by trading.

The factor endowment theory is based on the assumption that the price of factors of production and the commodity price are determined by the market, the competitive market determines the factor price and for this reason if the supply of capital is high then the price will be low in those capital endowed countries, on the other hand in the labour endowed country we expect the supply of labour to be high and for this reason the price of one unit of labour used in production is low.

International Economics

Given the factor prices in the two countries we can therefore determine which goods will be produced and traded in the countries, the countries have their own unique comparative advantage and therefore they will specialise and gain from trading. The labour endowed country will produce the labour intensive goods while the capita intensive good will produce the capital intensive goods and trade with the other country importing the goods it does not produce.

To show different factor endowment we can give an example whereby we have a labour intensive good example an agricultural product and also capital intensive product which is the production of computers, a developing country which abundant labour will produce agricultural products because of the low cost of labour compared to capital cost and trade it with the capital endowed country and import computers and export agricultural products.

The capital intensive product which is computers will be produced in the capital endowed country at a very low cost and it will export the product and import the labour intensive product which the agricultural product. The capital cost in the labour abundant country is much higher in than in the capital abundant country while the labour cost is much higher in the capital abundant country and therefore the two countries will gain from trading which will lead to specialisation.

In conclusion we can state that the capital endowed country will have comparative advantage in the production of capital intensive goods while the labour endowed country will have comparative advantage in the production of labour intensive goods and for this reason the two countries will specialise and gain from trade.

References:

Brian Snow (1997) Macroeconomics: introduction to macroeconomics, Routledge publishers, London

International Economics

Philip Hardwick Et Al (2004) Introduction to Modern Economics, Pearson Education Press, London

Heller R. (1973) International Trade: Theory and Empirical Evidence, Prentice Hall publishers, New York

Joseph E (2005) Fair Trade for All: How Trade Can Promote Development, Oxford University Press, Oxford