CFA, Finance

Comparative Advantage

Comparative Advantage

Introduction:
In a world that’s more connected than ever before, surely a country producing everything by itself is not the most efficient way forward. How then does a country decide what to produce domestically and what to import? Resources are limited, and there’s an opportunity cost involved in the production of anything and everything. Is the Specialization of production a viable concept for countries to follow? This time, we’ll take a look at the theory of Comparative Advantage and how it holds up in a world with increasing Globalization, connectivity, trade liberalization, and technological innovation.

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The Theory:
David Ricardo (1772-1823) is best known for his work “On the Principles of Political Economy and Taxation (1817)”. While Adam Smith and other free traders emphasized on the concept of “Absolute Advantage” wherein every nation specializes in whatever they’re most efficient in the production of, Ricardo demonstrated that “comparative advantage” influences free trade.
Comparative advantage is based on the concept of “Opportunity Cost”. Opportunity Cost measures a trade-off, therefore a country with a lower opportunity cost in producing something can benefit by producing solely that commodity and trading the other commodity with a partner that enjoys lower opportunity cost in producing the other good. Both parties would then benefit from such a trade.

CA

For example, Portugal in the table above has an absolute advantage in producing both Cloth and Wine compared to England. But within Portugal, the production of cloth requires more resources than the production of Wine. Using Ricardo’s comparative advantage theory, Portugal could focus on wine production, export the surplus, and import Cloth from England. It would be suitable for England as well because, within England, they are more efficient in the production of Cloth compared to Wine.
Revealed Comparative Advantage:
Revealed comparative advantage (RCA) is based on the Ricardian trade theory. Although productivity differences are difficult to observe, an RCA metric can be readily calculated using trade data to “reveal” such differences. While the metric can be used to provide a general indication and first approximation of a country’s competitive export strengths, it should be noted that applied national measures that affect competitiveness such as tariffs, non-tariff measures, subsidies, and others are not taken into account in the RCA metric.

CA1

Where
• P is the set of all products (with i∈P),
• XAi is the country A’s exports of product i,
• Xwi is the worlds’ exports of product i,
• Σj∈PXAj is the country A’s total exports (of all products j in P), and
• Σj∈PXwj is the world’s total exports (of all products j in P).
(visit: https://unctadstat.unctad.org/EN/RcaRadar.html for RCA charts for different countries)

Example from Real Life:
Prices drive the system. For example, Ireland has a comparative advantage in the production of cheese and butter due to climate and a large amount of land suitable for dairy cows. China has a comparative advantage in electronics because of its abundance of labor. With the removal of the milk quota and the opening of trade between China and Ireland, Irish dairy farmers will experience higher milk prices and will expand dairy production. Milk products from Ireland will be sold to thousands of retail outlets in China. Irish consumers will see inexpensive electronic products from China and will more electronics than would otherwise have been the case. The beauty of the system is that dairy is in surplus in Ireland and trade allows it to move to an area where milk products are expensive and in scarce supply. The opposite is true for electronics. Trade allows producers on both sides to specialize in the production of goods that use intensively factors that are in relative abundance (grassland in Ireland and labor in China). Producers in the exporting country see better prices and consumers in the importing country see lower prices. The net gains are more than enough to compensate Irish electronic factory workers and Chinese dairy workers. But these displaced workers may not be happy with the compensation they receive.

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Criticisms of the Theory:
1. Since Transportation, Shipping, and other external costs like trade, air, and sea pollution, are not taken into consideration, the benefits may be lower than what’s actually calculated.
2. Complete specialization creates structural unemployment, which means that workers can’t transfer from one sector to another.
3. Relative Prices and Exchange rates not considered.
4. Theory assumes that markets are Perfectly Competitive – perfectly mobility without any diminishing returns.
5. Comparative Advantage is not a static concept and will change over time as the economy faces non-renewable resources which can slowly run out, increasing costs of production, and reducing gains from trade. For example, Vietnam has become a global player. seeing its global market share increase from just 1% in 1985 to 20% in 2014, making it the world’s second-largest producer. Most countries also strive for food security, trying to keep a minimum balance even if they should specialize in non-food products.

Conclusion:
International world trade is a complex thing to quantify and theorize with countries exporting and importing many different goods and services from many other different countries. Comparative advantage nevertheless provides a good logical reason why countries specialize. Modern approaches to explain trade patterns and flows tend to use theories like Gravity Theory, wherein the sizes of bilateral trade flow between any two countries can be approximated by employing the ‘gravity equation’, which is derived from Newton’s theory of gravitation. While planets are attracted to each other in proportion to their sizes and proximity, so too are countries. Despite its significant criticisms, the underlying principle of comparative advantage can still be said to give some ‘shape’ to the pattern of world trade, even if it is becoming less relevant in a globalized world and in the face of modern theories.

 

Author:  Aman Aggarwal

About the Author: Aman is an Economics and Finance graduate with a budding interest in Strategic Management and Investment. An avid reader of all things Behavioral and Data Science –I strongly believe in solving problems with creative solutions backed up by quantitative rigor.

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