Under what conditions are states likely to engage in trade? Critically asses the theory of comparative advantage, its assumptions, the role of the World Trade Organisation (WTO) and rival explanations for state behaviour in questions of trade.
International trade must first be defined in order to explore the conditions under which it will occur. For our purposes international trade can be defined as the act of buying, selling, or exchanging commodities between countries. The Ricardian theory of international trade provided the first clear general analysis of the conditions under which such trade would both take place between nations and be beneficial to them. The theory of comparative advantage (Ricardo 1817) has subsequently been criticised on a number of levels, in particular for the restrictive nature of the assumptions and corresponding lack of general application (Mushanyuri 2013). Neoclassical trade theory developed the Ricardian theory further, replacing some of the restrictive assumptions with those that were more acceptable and realistic (Widodo 2009).
The reliance of the original analysis on the existence of pure free trade has been empirically challenged. The World Trade Organisation (WTO), which emerged from its predecessor, GATT, has as one of its roles the increasing promotion of open trade between nations. Whilst this could be seen as facilitating the beneficial outcomes of the neoclassical theory, both the GATT and WTO have been criticised. This criticism has focused on their role and execution of their role. Despite strong theoretical evidence in relation to the economic benefits to nations of engaging in international trade there are still different behaviours at a national level towards trade activity. This essay will explore these behaviours and consider their explanation.
The world would be a poorer place without international trade. Products that consumers take for granted and services they take advantage of would either not exist or would be produced very inefficiently if there was no trade between states. The first part of this essay explores the conditions under which states are likely to engage in such trade in order to take advantage of the potential inherent advantages.
The conditions under which trade will take place rely on differing opportunity cost ratios in producing the goods or services within which each state has a comparative advantage. An illustrative analysis using two countries and two products will help. The original theory (Ricardo 1817) used wine and cloth with Portugal and England but we can use country X and Y making Palm Oil and Ground Flour.
Total Annual Potential Output of Palm Oil and Ground Flour for Country X and Country Y
Engaging all of its resources, country X can make 60 million litres of palm oil or 12 million kilograms of ground flour, whilst country Y can make 80 million litres of palm oil cars or 24 million kilograms of ground flour.
Country Y has an absolute advantage in the production of both products, but its comparative advantage is in ground flour production because it is relatively more efficient at producing this. country Y is two times better at making ground flour and only 1.33 times better at producing palm oil.
Under these conditions country Y uses fewer scarce resources in the production of ground flour and hence the opportunity cost of production is lower. Y is therefore more efficient in producing ground flour and should focus on this commodity whilst country X focuses on producing palm oil.
In economic terms the efficiency gain from international specialisation and trade under these conditions would be an increase in world output of four units (assuming equal rates of marginal transformation).
30x + 40y PO + 6x + 12y GF = 88 world units with no trade
80x PO + 12y GF = 92 units with full specialisation and trade
The sufficient conditions under which exchange would be beneficial is that it takes place at an exchange rate between the two countries’ domestic opportunity cost ratios.
The outcomes of the concept of comparative advantage rely on a set of very strict assumptions, some of which have been relaxed in more recent models of international trade. The Heckscher-Ohlin model, for example, advanced the Ricardian theory to conclude that the conditions under which comparative advantage applies will be ‘in the production of commodities into which enter considerable amounts of factors that are abundant and cheap’ (Ohlin 1933, p. 20).
We will now turn to the assumptions of the model, which form the basis of our critical assessment. First, the model assumes that factors of production do not move between nations. This is a cornerstone of the theory because if labour and capital were internationally mobile then factor endowments and comparative opportunity costs would be similarly variable. Whilst Ricardo and neoclassical economists defended this assumption, it is difficult to justify in the modern age. ‘The assumption that labour and capital are not mobile internationally lacks a logical and theoretical justification and has no empirical support. It is not an appropriate simplification of reality’. (Schumacher 2013, p 89).
Secondly, the model relies on the balance of the trade between nations, meaning that the value of imports equals the value of exports and that trade can be seen in some sense, to be a straight barter, devaluing the role of exchange rates and money. There is neither empirical evidence nor theoretical backing for such an assumption, which is damaging, as its removal means that comparative advantage alone cannot explain international trade flows (Dillard 1988, p.306).
Thirdly, the model does not allow for dynamic change either as the result of exogenous factors or through specialisation and trade itself. Endowments are likely to change over time. It is very likely that industrial nations will undergo technological development and therefore to assume a static nature for the model is somewhat problematic. It is especially difficult to consider ‘capital’ as a static endowment and as pointed out by Milberg (2001, p 414), in reality these ‘endowments’ are not natural and change as a consequence of trade.
Fourthly, the notion of opportunity cost is central to the model’s outcomes and central to the impact of opportunity cost is the idea of the full employment of labour and capital. This is because with underutilised resources, outputs could be increased without corresponding reductions elsewhere. Criticism of this assumption is clearly difficult to deny. In practice, unemployment exists across nations – the ‘world is characterized by unemployment’ (Felipe and Vernengo 2002)
Finally, the theory relies on exchange taking place as a means to mutual benefit rather than due to profit motives. This is clearly difficult to rationalise in the current economic climate. Market economies driven by profit, survival and growth do not operate along lines of mutual harmony. The fact that nations compete for political influence, military power and bargaining power, which are all influenced by their economic success, (Dunn 1994) contradicts this assumption on which the theory relies.
It is clear that the world of Smith, Ricardo, Marshall and the neoclassicists has moved on and their previously reasonable assumptions may appear less viable today. However, the challenge of contemporary defenders of such theories has been to adapt the models of comparative advantage to explain their relevance today. The World Trade Organisation (WTO) is one institution that could facilitate their efforts.
The WTO has as a core function: the opening of and promotion of trade between nations and the regulation of that trade. It develops very precise rules of trade and acts as a tribunal if there is a dispute. It also monitors trade and mentors its members. This essay will now develop a critical assessment of the role of the WTO.
Al Islam (2007) talks or radicals (abolish the WTO), reformers and conformers differ only in their degree of opposition to the WTO. Certainly, there is much opposition to the role and its execution as played out by the WTO, in particular, its non-legitimate governance due to under representation of poorer nations and over representation of commerce in relation to civil society. The WTO is also criticised for being too powerful in that it can compel states to change laws and for its poor performance in the realm of dispute resolution with weaker nations having little voice in the decision making processes (Lumina 2008).
The WTO lacks either drive or urgency in matters of trade agreements, negotiations or the consideration of the impact of free trade on workers’ rights. Questions of social justice are rarely discussed in WTO forums and when they are, the discussion does not refer to any recognised social justice framework. It is also argued that the WTO supresses less developed nations by restricting their diversification and it lacks consideration of the market failures associated with environmental degradation and reduced cultural diversity (Harrison 2007).
Despite the wealth of literature in favour of trade (liberalisation) there are still different approaches that can be taken.
Unilateral protectionism and a disengagement with the international trade system is one approach. Melgar et al. (2013) attempt to explain this approach in their study. They conclude that the consequence of trade liberalisation is not as beneficial as the theory predicts. Large post-liberalisation increases in inflation and/or unemployment increase the protectionist attitude and show a lack of trust in free trade. They argue that instability in markets and the fear of adjustment costs outweigh the positive effect that free trade could bring through a more efficient reallocation of resources (Melgar et al. 2013).
An opposing view is offered by the government of Tanzania (Ministry of Industry and Trade 2003) which in their pro-trade approach to liberalisation see the merger of domestic and international markets as a positive development. The productivity and efficiency gains from access to international markets is significantly helping export-led growth and development in Tanzania. The overall strategy includes reform of institutional structures and a change of cultural norms to accelerate the process of re-orienting the economy towards the open market, targeting export-led growth.
A final opposing explanation of behaviour in relation to trade issues is that which champions the customs union approach. Andriamananjara (2011) presents the case where the benefits of the access to larger markets afforded by CU membership outweigh the loss of autonomy. This explains why a country may be willing to surrender such freedom; it is driven by goals that go beyond trade and include perceived longer term benefits and security afforded by monetary and economic mergers and political integration.
Based on explanations given, it is clear that there is no conclusive evidence regarding the benefits of international trade. Ricardian and neo classical models of comparative advantage have been developed to include a dynamism which goes some way to addressing some of the criticisms (Smit 2010). The WTO continues to be criticised on many levels with some calling for its abolition on the basis that it is not serving its purpose. The most favoured nation principal in particular continues to come under scrutiny from a microeconomic theoretical perspective (Redding 2006). Benefits from specialisation and trade clearly depend on the number of nations taking part. Objections to the issues around specialisation and trade could be effectively reduced if there were a universally accepted regulatory body and state participation large enough for domestic efficiency savings to be more widely enjoyed.
Andriamananjara, S (2011), ‘Customs unions’, in J-P Chauffour & J-C Maur (eds), Preferential trade agreement policies for development: a handbook, World Bank, Washington, DC, pp. 111-20
Dillard, D (1988), The Barter Illusion in Classical and Neoclassical Economics, Eastern Economic Journal, 14 (4), pp. 299-318.
Dunn, M H (1994), Do Nations Compete Economically?, Intereconomics, 29 (6), pp. 303-308
Felipe, J and M Vernengo (2002), Demystifying the Principles of Comparative Advantage: Implications for Developing Countries, International Journal of Political Economy, 32 (4), pp. 49-75.
Harrison, J (2007),The Human Rights Impact of the World Trade Organisation. London: Bloomsberry
Lumina, C (2008), Free trade or just trade? The World Trade Organisation, human rights and development (Part 1), AJOL, Volume 12 No.2.
Melgar, N et al (2013), Explaining Protectionism Support: The Role of Economic Factors, ISRN Economics, Volume 2013, Article ID 954071
Milberg, W (2004), The Changing Structure of Trade Linked to Global Production Systems: What Are the Policy Implications? International Labour Review, 143 (1-2), pp. 45-90.
Ministry of Industry and Trade Dar Es Salaam, (Feb 2003), Trade Policy for a Competitive Economy and Export Led Growth, The United Republic of Tanzania National Trade Policy
Mushanyuri B. E. (2013), An Assessment of Comparative Advantage of Mauritius European Journal of Sustainable Development, 2, 3, 35-42.
Ohlin, B., (1933), Interregional and International Trade, Harvard University Press, Cambridge, MA.
Redding, S.J. (2006), Empirical Approaches to International Trade, London School of Economics and CEPR.
Ricardo, D. (1817), On the Principles of Political Economy and Taxation, London, John Murray,
Al-Islam, S. Alqadhafi, (2007), “Reforming the WTO: Toward More Democratic Governance and Decision-Making”, Gaddaffi Foundation for Development.
Schumacher, R. (2013), Deconstructing the Theory of Comparative Advantage, World Economic Review No. 2.
Smit, A. J. (2010), The competitive advantage of nations: is Porter’s Diamond Framework a new theory that explains the international competitiveness of countries? AJOL, Volume 14 No.1.
Widodo, T, (2009), “Comparative Advantage: theory, empirical measures and case studies”. Review of Economic and Business Studies. Issue 4, 57-82.