Carefully explain the trade theories of David Ricardo and Heckscher-Ohlin and critically discuss the validity of these theories. By using any country of your choice as an example, discuss whether the concept of comparative advantage can explain actual trade patterns in real-life.
Solution
Contemporary Economy
Most of the contemporary economies are based on liberal-economic notions and principles, which also have a political side to them. The liberal economic model encourages trade, emphasis on small-government, and promotes those policies that attract Foreign Direct Investment. The study, of contemporary economies, makes it clear that the structure of these economies and their functioning is based on the concepts and principles of neo-classical economics (Martin, 2015). For instance, modern economies consider non-intervention (lassies-fare economy), free-market, and trade essential to achieve primary economic objectives. These primary objectives are sustainable economic growth and full employment (ignoring the natural rate of unemployment). Therefore, we can understand that for modern economies use, trade, non-intervention, free-market and private sector investment (foreign and local) as tools to realise major economic objectives.
Since the mid-90s, economies are putting additional focus on Trade and Foreign Direct Investment. Trade has always remained a controversial subject, because of the results, which it produces. These results are mixed and it is hard to figure out how trade affects the size and quality of the economy. However, in the global economic system, trade has great economic and strategic significance and relevance.
We also learn that global financial institutions also encourage free trade and strongly discourage protectionist policies, which are adopted by some countries. For understanding the importance of trade, one should look at the size of world trade. Statistics reveal that size of trade has increased incredibly in last thirty years. However, statistics also reveal that only a few countries have truly benefitted from trade. Some studies also suggest that trade benefits a country, only under certain economic conditions. In some cases, it may hurt the economic interests of an economy/country.
Trade
As per the most common understanding, trade is the transfer of goods and services. If only a single party is selling/transferring goods and services, then it is a one-sided trade or exchange. Modern economies not only transfer goods and services (exports) but also receives goods and services (imports). The earliest form of trade was barter, in which goods and services were exchanged for other goods and services, as there was no other medium of exchange. However, in the modern economy, currency is used to buy and sell products in international markets, which directly affects the economy in some ways (balance of payments, foreign debt, exchange rate etc.). Therefore, in modern times, trade affects the modern economy in numerous ways, and that is why it is such a sensitive and important subject.
It is evident that trade is an instrument of the contemporary liberal economy, which it uses to achieve specific economic objectives. It suggests that the concept of trade, in the modern economy, is backed by various theories, which propose that trade is beneficial is an end in itself and not just a mean. Trade theory, which was promoted by classical economists, was grounded in the concept of Absolute Advantage. However, the trade theory proposed, by neo-classical economists, was based on Comparative Advantage. With time, trade theory based on Absolute Advantage vanished; however, trade theory, about the concept of Comparative Advantage, not only remained applicable but also improved.
Trade Theories and Comparative Advantage
There are various trade theories, which classical and neo-classical economists promoted. One of the oldest and major theories, about trade, was the Theory of Absolute Advantage. As per this theory, by Adam Smith, trade is based on Absolute Advantage, which is an ability to produce a greater quantity of goods and services than the other party while using the same amount of resources. The theory remained popular and relevant until David Ricardo put forth his theory of Comparative Advantage, which was more contemporary, comprehensive and expand international trade better.
Comparative Advantage
As per the general understanding, of Comparative Advantage, under free trade conditions, a consumer will produce more of that good (and consume less of that good) for which a producer has a comparative advantage. The theory can also be understood with the help of the economic concept of Opportunity Cost. A producer will produce that good, which has low opportunity-cost or low autarky price. It implies that the marginal cost of producing a product should be low in comparison to the production of other product or service. In Comparative advantage theory, monetary or resource costs are not considered, but rather opportunity cost is considered (across the countries) (Senga et al., 2017).
David Ricardo intended to explain international trade, rather than dictate it through his theory. Also, he was discussing the possibilities of trade, even when a country is more efficient in producing all kinds of goods and services, in comparison to other countries. Furthermore, Ricardo suggested that trade increases consumption, without affecting prices (drastically). However, for free trade, there must be differences in labour productivity of engaging countries, in producing particular product or service. On these bases, Ricardo claims that it is comparative advantage, rather than an absolute advantage, which is responsible for international trade.
Heckscher and Bertil Ohlin mathematically explained this theory through the Heckscher – Ohlin model. The model predicts the pattern of trade and to an extent the size of the trade through factor endowment theory (how much resources and about what nature a country has consumed (Heckscher & Ohlin, 1991). In a nutshell, the model proposes that a country’s exports are produced by cheap and abundant resource, whereas those resources, which are scarce in that country, produce the imports.
The flaws in the theory are very visible, which is why it is not entirely applicable. For instance, it assumes that changing industries, for a labourer, is easy. Also, it assumes that an economy produces only two producers. In fact, the economy is far more complex than this. Furthermore, it assumes that by doubling the number of workers, production will also double. The theory also ignores taste, the universality of technology and the flight / landing of capital (Siddique, 2016).
Selected Country-United Kingdom (UK)
A country, which we have been selected for this academic exercise, is the United Kingdom. Regarding GDP (2016), the United Kingdom’s economy is the fifth largest economy in the world, just behind Germany. As per purchasing power parity criterion, it is the ninth largest economy in the world, just behind Indonesia.
When it comes to trade, United Kingdom is the 10th largest exporter of goods and services in the world. In the year 2016, United Kingdom Exported goods and services that worth $404 billion and imported goods, which worth $625 billion. Therefore, the trade deficit was about $220 billion (Gordon, 2016).
When we study the imports and exports of the country, we learn many interesting things. For instance, we learn that top exports of the country are Packaged Medicaments ($21.6 billion), Cars ($40.6 billion), Gas Turbines ($19.3 billion) and Aircraft parts that worth ($15 billion). The imports, of the United Kingdom in the year 2016 are Cars ($45.6 billion), Gold ($57.9 billion), Packaged Medicaments ($18.8 billion), Vehicle Parts ($15.6 billion), and Gas Turbines ($17.4 billion) (Atlas Media, 2016). There are products, such as Scotch, which allow United Kingdom trade deficit (Scotch Whisky Association, 2016).
The selected country, United Kingdom, has a labour force, which is highly productive. It also contributes to the comparative advantage, as it reduces the opportunity cost. Also, the productivity is growing, which is evident from statistics (Office for National Statistics, 2017).
Size of Trade of UK (graphs and commentary)
We have already established that size of trade has increased over the years. It is also true in the United Kingdom, which size of trade has evidently increased since 1980. In the year 1980, the size of exports has been just above $55 billion, and imports were slightly less fat than imports. However, as the time progressed, the size of trade increased, and in the year 2014, it was slightly above $1000 billion. In this year, imports were higher than exports, which caused the budget deficit. The graphs below reveal to us the size and direction, which will facilitate us in understanding how comparative advantage has affected trade (Office For National Statistics Digital, 2015).
It must be acknowledged that trade policy, of both developed and developing countries, is based on the Ricardian theory of comparative advantage. However, when we systematically study international trade, we do not find strong support in favour of comparative advantage. In this section of the academic exercise, we will examine whether comparative advantage affects United Kingdom’s trade and economy. If it does, how it affects it?
Import and Export UK Graph has been taken from (Office for National Statistics Digital, 2015)
When studying the graph, we learn that in the 90s, the size of the trade grew very steadily. However, after the year 2000, the size of trade increased dramatically. Various factors played their role in the swelling of the size of the trade. For instance, the European Union became more effective and promoted tariff-free trade, which was positively correlated with the size of the trade and to extend the nature of trade. Also, global trade agreements, such as WTO also directly affected United Kingdom’s trade (World Trade Organization, 2017).
Trade Surplus and Trade Deficit UK Graph has been taken from (Office For National Statistics Digital, 2015)
The chart regarding trade deficit and a trade surplus reveals that since 1980, mostly the United Kingdom has faced a trade deficit rather than the trade surplus. In the year 2014, the trade deficit was $35 billion, which was more than the size of exports in the year 1982. The trade deficit increased dramatically in the crisis year (2007 when The Great Recession started).
Role of Comparative Advantage in UK’s Trade
Economists believe that trade surplus represents a comparative advantage, whereas the trade deficit represents a comparative disadvantage. In fact, in the Heckscher–Ohlin model too, it has been suggested that imports are products and services that are produced by using resources that are scarce for importing country. However, from the list of imports and exports, we learn that the United Kingdom exports many such products, which it also imports. For instance, in the year 2016, it exported cars that had the monetary value of $40.6 billion, while in the same year, United Kingdom imported cars of around $45.6 billion worth. Similarly, United Kingdom exported Packaged Medicaments worth $21.6 billion, whereas it imported Packaged Medicaments worth $18.8 billion. This Ricardian dichotomy is not only true for these Packaged Medicaments and cars, but it is also true for turbine fan and gold.
This Ricardian dichotomy can be explained or understood in two different ways. It is possible that the products that are being exported and imported simultaneously are not identical, but rather similar (taste/quality). For instance, parts of the particular brand being produced in particular country the United Kingdom are exporting, whereas the cars of particular quality and style United Kingdom is importing.
Another explanation is that the modern economy is not based on comparative advantage, but rather on taste and quality. It is because the industrial technology has become almost universal, which allows firms to produce similar products. However, the value-added to these products add quality to them, creating a consumer base in the foreign country. Concerning packaged medicaments, it seems that the United Kingdom is exporting different medicaments than what the United Kingdom is importing. However, if these products are similar, then we can apply the rationale of first explanation.
Conclusion
In the end, from the discussion, it is very evident that trade is a major component of the modern economy. It is an instrument, which an economy or state uses to achieve political-economic and even strategic objectives. However, it is the only neo-classical economists who are strong supporters of free trade and want others (both general public and economists included) to understand modern trade from the perspective of comparative advantage. According to this theory, it is the opportunity cost that determines what a country will produce and in the production of which product will it specialise.
However, from the study of the United Kingdom’s economy and trade, we learn that the comparative advantage completely fails its industrial structure, production, and exports. For instance, United Kingdom produces and exports cars, whereas, it also import cars. It is a Ricardian dichotomy as Comparative advantage theory fails to explain that why particular kinds of goods are being exported and imported, simultaneously, by the United Kingdom. We conclude that there are two possible explanations, one of which is that countries produce a unique product and they have specialised in their production.
It is concluded that international trade, which is far more complex than how it is presented in Comparative Advantage theory, is neither based on comparative advantage nor does the comparative advantage explain it. However, we must acknowledge that some aspects of international trade are based on comparative advantage, and comparative advantage theories explain those most. For instance, the abundant resource is mostly hihglighted to achieve objectives about economic growth and international trade.
It is very evident that Ricardo’s theory of comparative advantage and Heckscher–Ohlin fail to explain international trade. Therefore, it is not wise to formulate trade strategies that are grounded in theory of comparative advantage.
References
Atlas Media, 2016. United Kingdom. [Online] Available at: https://atlas.media.mit.edu/en/profile/country/gbr/ [Accessed 13 March 2018].
Gordon, S., 2016. How a hard Brexit might affect three industries. [Online] Available at: https://www.ft.com/content/92d985c0-acd1-11e6-9cb3-bb8207902122 [Accessed 13 March 2018].
Heckscher, E.F. & Ohlin, B.G., 1991. Heckscher-Ohlin trade theory. 2nd ed. MIT Press.
Martin, L.L., 2015. The Oxford Handbook of the Political Economy of International Trade. 2nd ed. Oxford University Press.
Office For National Statistics Digital, 2015. Trends in the UK economy. [Online] Available at: https://visual.ons.gov.uk/uk-perspectives-trends-in-the-uk-economy/ [Accessed 13 March 2018].
Office for National Statistics, 2017. Labour productivity: July to September 2017. [Online] Available at: https://www.ons.gov.uk/releases/ukproductivityjulytosept2017 [Accessed 13 April 2018].
Scotch Whisky Association, 2016. Scotch Whisky – a vital UK industry. [Online] Available at: http://www.scotch-whisky.org.uk/news-publications/news/scotch-whisky-%E2%80%93-a-vital-uk-industry/#.Wqdmp-hubIU [Accessed 13 March 2018].
Senga, S., Fujimoto, M. & Tabuchi, T., 2017. Ricardo and International Trade. 1st ed. Taylor & Francis.
Siddique, A.B., 2016. Comparative Advantage Defying Development Strategy And Cross Country Poverty Incidence. Journal of Economic Development, 41(4), pp.45-78.
World Trade Organization, 2017. Merchandise trade. [Online] Available at: https://www.wto.org/english/res_e/statis_e/merch_trade_stat_e.htm [Accessed 13 March 2018].
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