Classical Theories Describing Trade Between Different Nations Economics Essay
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Published: Mon, 5 Dec 2016
The following essay encompasses a review based on two of the popular “Classical Theories” describing the fundamental basis for trade between different nations. The foremost part comprises of a treatise about the ways in which Ricardo’s law of comparative advantage is superior to Smith’s theory of absolute advantage. The middle part is a discussion over the gains from trade arising as a result of comparative advantage. The final part talks about ways in which a less efficient country can export anything to a second nation that is more efficient in production of all commodities.
In what way was Ricardo’s law of comparative advantage superior to Smith’s theory of absolute advantage?
It is imperative to understand Ricardo’s law and Smith’s theory in order to be able to highlight superiority of former over the later.
Smith’s theory of absolute advantage declares that ” A country benefits by producing only those products in which it has absolute advantage, or can produce using fewer resources than another country.” (Cavusgil, Knight, & Riesenberger, 2008 )
Adam Smith was of the view point that since one nation’s import is the export of another nation so it was not viable for all countries to become wealthy concurrently by following mercantilist view. He asserted that if all countries were to focus only on products in which they have absolute advantage, they could export them to other countries and in return import those products in which they do not have absolute advantage in producing. He believed that this free trade will benefit all countries simultaneously.
Ricardo’s law of comparative advantage states that ” It can be beneficial for two countries to trade without barriers as long as one is more efficient at producing goods or services needed by the other. What matters is not the absolute cost of production, but rather the relative efficiency with which a country can produce the product.” ( Cavusgil, et.al.2008)
David Ricardo argued that international trade will benefit countries even if one nation has an absolute advantage in production of all commodoties. He believed that if a country could produce a product more efficiently than a country which was self sufficient in producing the same product but with less efficiency then it is better to import that commodity from the country producing it more efficiently.
“Though Smith successfully established the case for free trade, he did not develop the concept of comparative advantage. Because absolute advantage is determined by a simple comparison of labor productivities, it is possible for a nation to have absolute advantage in nothing.” (www.encyclopedia.com)
The above excerpt quite answers the way in which Ricardo’s law has an advantage over the Smith’s theory. The key point of the selection is quite evident: What if a nation has absolute advantage in nothing? Does it stop importing products from other nations because it has nothing to export?
This is where David Recardo’s law of comparative advantage is superior to Smith’s theory. It is more comprehensive in terms of associating specialization with opportunity cost. Unlike Smith’s theory which is completely based on absolute advantage, Ricardo’s law of comparative advantage generates hope for nations that are technically on the back foot by entailing that they can involve in international trade even if their labor output in all commodities is less than that of a developed country.
In today’s scenario, an example could be of Pakistan exporting cotton products to United States and importing military guns, tanks and missiles. (http://internationaltrade.suite101.com/)
United States can produce cotton products too but relatively less efficiently than Pakistan. On the contrary, United States has a relative advantage in making military products. According to Ricardo’s law of comparative advantage, United States is benefitting from Pakistan’s efficiency in making cotton products whereas Pakistan is benefitting from United States’s efficiency in making military products.
The above example justifieses the win-win situation as was proposed by Ricardo.
If United States was to choose to grow cotton on its land and make its own cotton products, it could possibly have done that, less efficiently though. This signifies that if Smith’s theory was implemented, Pakistan would have nothing left to trade with the United States.
How do gains from trade arise with comparative advantage?
Based on Ricardo’s law of comparative advantage, gains from trade arise in terms of increased world output for any commodities that any two countries import and export from each other. No one country wastes extra time and money producing the same product less efficiently which another country can produce more efficiently.
Let us assume that Country “A” produces a commodity more efficiently and therefore has a relative/comparative advantage over Country “B” for that commodity which might be able to produce that same commodity but less efficiently. Suppose Country “A” exports its commodity to Country “B” in exchange for importing something which it cannot produce as efficiently. Both Countries “A” and “B” utilized comparative advantage to get what they wanted. Both countries gained from each others area of expertise. This assumption outlines outcome of Ricardo’s law of comparative advantage.
Another example could be of trade between Saudi Arabia and Australia. Both nations utilize their natural advantages to gain from trade. Saudi Arabia has ample Oil which it exports to Australia. In return it imports Bauxite (finest quality of coal) from Australia. In this way, both nations are benefitting by exchanging what they have in excess with what they do not have or which may be there but more difficult to extract. Australia might be having reservoirs of Oil available deep within its Oceanic boundaries but the cost of extracting them would be too high.
Labor costs are much higher in developed countries such as United States. These countries mostly hire government owned or government supported firms providing cheap skillful labor in developing countries such as China to get their task accomplished. What did they each gain from trade arising with comparative advantage?
Developed countries gain: Cheap labor hence more profit.
Developing countries gain: Employment.
So it becomes a win-win situation. United States gets its product manufactured at a much lower cost than it would have back in United States. China gets employment.
How can a nation that is less efficient than another nation in the production of all commodities export anything to the second nation?
Ricardo’s law of comparative advantage demonstrates that a nation that is less efficient than another nation in the production of all commodities can still export to the second nation. That is because “… what matters is not the absolute cost of production, but rather the ratio between how easily the two countries can produce the products.” (Cavusgil, et.al.2008)
Ways in which Ricardo’s law plays its role in helping a less efficient nation export commodities to a more efficient nation have been discussed in the previous part of question.
A less efficient nation can also export to the more efficient nation by implementing and incorporating competitive advantage in its international trade policies. A nation can attain competetive advantage by coming up with innovative advancements, by targeting industries for development, providing low-cost investment, reducing taxes, and by investing in emerging technologies to take up the future. Policies should be encouraging for local and foreign investments such as tax free business in Dubai. Industrial clusters should be promoted which often act as a nation’s export platform.
Michael Porter’s famous Diamond Model outlines the way a country can increase its competetiveness:
( Cavusgil, Knight, & Riesenberger, 2008, pp-104)
As is evident from the above essay, Ricardo’s law is superior from Smith’s theory because it justifies that trade is still possible between two countries even if a country does dont have absolute advantage in anything. The above arguments also prove that comparative advantage is advantageous to both the trading nations as a result of utilizing relative advantage in import and export. Besides Ricardo’s law of comparative advantage, competetive advantage supported by Michael Porter’s Diamond Model can help a less efficient nation develop industrial clusters so as to be able to export to a more efficient nation.
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