Big Picture in Focus: ULO - B.

Explore the concept and theories of

international trading.

Metalanguage

Below are the essential terms that are operationally defined for you to better
understand this section of the course.

1. Comparative advantage. This refers to the concept that a certain good can be
produced more efficiently than others due to a number of factors, including productive
skills, climate, natural resource availability, and so forth.

2. Opportunity cost. This refers to the cost of an opportunity forgone (and the loss of
the benefits that could be received from that opportunity); the most valuable forgone
alternative.

Essential Knowledge

WHY TRADE?

The Heckscher-Ohlin theory explains why countries trade goods and services with
each other. One condition for trade between two countries is that the countries differ
with respect to the availability of the factors of production. They differ if one country,
for example, has many machines (capital) but few workers, while another country has
a lot of workers but few machines.

According to the Heckscher-Ohlin theory, a country specializes in the production of

goods that it is particularly suited to produce. Countries in which capital is abundant
and workers are few, therefore, specialize in production of goods that, in particular,
require capital. Specialization in production and trade between countries generates,
according to this theory, a higher standard-of-living for the countries involved.

WHAT IS AN ECONOMIC THEORY?

One can compare an economic theory with a map over of a piece of land. A map gives
an idea of what a certain piece of land looks like, even though nature is too complex
to be described completely by it. While a map can help us understand an unknown
terrain, economic theories help us understand economic interactions between
individuals or countries. For example, why individuals or countries trade with each
other and why trade may benefit the parties involved.

Machines and workers

The production of goods and services requires capital and workers. Some goods
require more capital - technical equipment and machinery - and are called capital
intensive. Examples of these goods are cars, computers, and cell phones.
Other goods require less equipment to produce and rely mostly on the efforts of the
workers. These goods are called labor intensive. Examples of these goods are shoes
and textile products such as jeans.

Gains from trade

By specializing in production, and by trading with other countries, it is possible for

countries to increase their incomes. Even though countries as a whole benefit from
specialization and international trade, all groups in society, workers and capitalists, do
not gain according to the Heckscher-Ohlin theory. If international trade leads a country
to specialize in producing goods that require lots of workers and little capital, such a
specialization increases wages (which benefits the workers) but decreases the income
of the capital owners. But the country as a whole benefits because the gain of the
workers is bigger than the loss of the capital owners.

The Heckscher-Ohlin trade theory

The Heckscher-Ohlin theory says that two countries trade goods with each other
(and thereby achieve greater economic welfare), if the following assumptions hold:

▪ The major factors of production, namely labor and capital, are not available in
the same proportion in both countries.

▪ The two goods produced either require relatively more capital or relatively more
labor.

▪ Labor and capital do not move between the two countries.

▪ There are no costs associated with transporting the goods between countries.

▪ The citizens of the two trading countries have the same needs.

Bigger differences - greater gains

Of the above conditions, the central one is the assumption that capital and labor are
not available in the same proportion in the two countries. This condition leads to
specialization. The country with relatively more capital specializes - but not necessarily
fully - in production of capital-intensive goods (which it exports in exchange for labor-
intensive goods) while the country with relatively little capital specializes in production
of labor-intensive goods (which it exports in exchange for capital-intensive goods).

According to the theory, the more different the countries are - regarding the capital-to-
labor ratio - the greater the economic gain from specialization and trade.

Example:

Imagine two countries that each produces both jeans and cell phones. Although both
countries use the same production technologies, one has a lot of capital but a limited
number of workers, while the other country has little capital but lots of workers.
The country that has a lot of capital but few workers can produce many cell phones
but few pairs of jeans because cell phones are capital intensive and jeans are labor
intensive. The country with many workers but little capital, on the other hand, can
produce many pairs of jeans but few cell phones.

According to the Heckscher-Ohlin theory, trade makes it possible for each country to
specialize. Each country exports the product the country is most suited to produce in
exchange for products it is less suited to produce. The country that has a lot of capital
specializes in the production of cell phones, whereas the country that has more labor
specializes in the production of jeans.

In this case, neither country has specialized in producing more of one of the two particular
products - both countries produce about the same number of jeans and cell phones.

Country A - having more capital than labor - has specialized in producing more cell
phones. Country B - having more labor than capital - has specialized in producing more
jeans. In this case, trade may benefit both countries involved.
ABSOLUTE ADVANTAGE AND COMPARATIVE ADVANTAGE

A country is said to have a comparative advantage in the production of a good (say

cloth) if it can produce cloth at a lower opportunity cost than another country. The
opportunity cost of cloth production is defined as the amount of wine that must be
given up in order to produce one more unit of cloth. Thus, England would have the
comparative advantage in cloth production relative to Portugal if it must give up less
wine to produce another unit of cloth than the amount of wine that Portugal would have
to give up to produce another unit of cloth.

Competitive advantage is defined as the strategic advantage one business entity has
over its rival entities within its competitive industry. This occurs when an organization
acquires or develops an attribute or combination of attributes that allows it to
outperform its competitors.

Michael Porter proposed the theory of competitive advantage in 1985 which seeks to
address some of the criticisms of comparative advantage. The competitive advantage
theory suggests that states and businesses should pursue policies that create high-
quality goods to sell at high prices in the market. Porter emphasizes productivity
growth as the focus of national strategies. This theory rests on the notion that cheap
labor is ubiquitous, and natural resources are not necessary for a good economy.

The other theory, comparative advantage, can lead countries to specialize in exporting
primary goods and raw materials that trap countries in low-wage economies due to
terms of trade. The competitive advantage theory attempts to correct this issue by
stressing maximizing scale economies in goods and services that garner premium
prices.

Absolute Advantage

In economics, the principle of absolute advantage refers to the ability of a party (an
individual, a firm, or a country) to produce more of a good or service than competitors
while using the same amount of resources. Simply put:

▪ Absolute advantage means that an economy can produce a greater total of

goods for the same quantity of inputs.

▪ Absolute advantage means that fewer resources are needed to produce the
same amount of goods and there will be lower costs than other economies.

Example:

Country Cars Bananas

In this example, Brazil has an absolute advantage in
US 5 1 producing bananas (8 to 1) while US has an absolute
advantage in producing cars (5 to 2).
Brazil 2 8
 Hours of labor required to produce In this case, England has an absolute advantage in
one unit producing cloth (only requires 60 hours compared to
Country Cloth Wine Portugal’s 120).

England 60 110 Portugal has an absolute advantage in producing wine

(only requires 70 hours compared to 110 hours in
Portugal 120 70 England)

Country Clothing Airplanes It is also possible for an economy to have an absolute

advantage in everything while some countries may
US 5 12 have no absolute advantage in any goods or services.
In this example, the US has an absolute advantage in
producing clothing (5 to 4) and also has an absolute
Brazil 4 1 advantage in producing airplanes. (12 to 1)

Having absolute advantage doesn’t necessarily mean an economy should produce

that good. It is not advisable to try and produce everything. It is more helpful to
consider comparative advantage.

As mentioned earlier, comparative advantage measures the opportunity cost of

producing a good.

If the US produces clothing, the opportunity cost is 12/5 = 2.4 airplanes foregone.
If Brazil produces clothing, the opportunity cost is 1/4 = 0.25 airplanes foregone.
Therefore, the US should specialize in producing airplanes. Brazil should specialize in
producing clothing (even though it doesn’t have an absolute advantage)

BALANCE OF TRADE
The balance of trade (or net exports, sometimes symbolized as NX) is the difference
between the monetary value of exports and imports in an economy over a certain
period.

A country that imports more goods and services than it exports in terms of value has
a trade deficit while a country that exports more goods and services than it imports
has a trade surplus.

Self-Help: You can also refer to the sources below to help you
further understand the lesson:

Elimma, E. (2018). Comparative advantage in de-globalisation. Journal of

International Trade Law & Policy, 17(1), 46-61.
doi:http://dx.doi.org/10.1108/JITLP-01-2018-0005
* Lectard, P., & Rougier, E. (2018). Can developing countries gain from defying
comparative advantage? distance to comparative advantage, export
diversification and sophistication, and the dynamics of specialization. World
Development, 102, 90. Retrieved from
https://search.proquest.com/docview/2007966599?accountid=31259

Fox, E. M. (2016). Competition policy: The comparative advantage of developing

countries. Law and Contemporary Problems, 79(4), 69. Retrieved from
https://search.proquest.com/docview/1858865391?accountid=31259