Comparative Advantage with Money

The lesson of the theory of comparative advantage is simple but powerful: You are better of specializing in what you do relatively best.  Produce (and export) those goods and services you are relatively best able to produce, and buy other goods and services from people who are relatively better at producing them than you are.

            Of course, Table 6.1 and 6.2 are both simplistic and artificial. The world economy produces more than two goods and services and is made up of more than two countries. Barriers to trade may exist, someone must pay to transport goods between markets, and inputs other than labor are necessary to produce goods. Even more important, the world economy uses money as a medium of exchange. Table 6.3 introduces money into our discussion of trade in incorporate the following assumptions:

1.      The output per hour of labor in France and Japan for clock radios and wine is as shown in   Table 6.2.

2.      The hourly wage rate in France is 12 euros (€)

3.      The hourly wage rate in Japan is 1,000 yen (¥)

4.      One euro is worth 125 yen

 

Table 6.3  : The Theory of Comparative Advantage with Money : An Example

                                    Cost of Goods in France                               Cost of Goods in Japan

	French Made	Japanese Made	French Made	Japanese Made
Wine	€3	€8	¥375	¥1000
Clock Radios	€2	€1.6	¥250	¥200

Note: For example, one hour’s worth of French labor can produce 4 bottles of wine at a total cost of €12 or an average cost of €3 per bottle. At an exchange rate of 125 yen per euro, a bottle of French made wine will cost ¥375 (375= 3 X 125).

            Given these assumptions, in the absence of trade, a bottle of wine in France costs €3, the equivalent of ¥375, and clock radios cost €€2, the equivalent of ¥250. In Japan a bottle of wine costs ¥1000 (€8), and clock radios cost ¥200(€1.60).

            In this case, trade will occur because of the self-interest of individual entrepreneurs (or the opportunity to make a profit) in France and Japan. Suppose buyers for Galeries Lafayette, a major Paris department store, observe that clock radios cost €2 in France and the equivalent of only €1.60 in Japan. To keep their cost of goods low, these buyers will acquire clock radios in Japan, where they are cheap, and sell them in France, where they are expensive. Accordingly, clock radios will be exported by Japan and imported by France, just as the law of comparative advantage predicts. Similarly, wine distributors in Japan observe that a bottle of wine costs ¥1000 in Japan but the equivalent of only ¥375 in France. To keep their cost of goods as low as possible, buyers for Japanese wine distributors will buy wine in France, where it is cheap, and sell it in Japan, where it is expensive. Wine will be exported by France and imported by Japan, as predicted by the law of comparative advantage.

            Note that none of these businesspeople needed to know anything about the theory of comparative advantage. They merely looked at the price differences in the two markets and made their business decisions based on the desire to obtain supplies at the lowest possible cost. Yet they benefit from comparative advantage because prices set in free market reflect a country’s comparative advantage.

Relative Factor Endowments

The theory of comparative advantage begs a broader questions: What determines the products for which a country will have a comparative advantage? To answer this question, two Swedish economist, Eli Heckscher and Bertil Ohlin, developed the theory relative factor endowments, now often referred to as the Heckscher-Ohlin theory. These economist made two basic observations:

1.      Factor endowments (or types of resources) very among countries. For example, Argentina has much fertile land, Saudi Arabia has large crude oil reserves, and China has a large pool of unskilled labor.

2.      Goods differ according to the types of factors that are used to produce them. For example, wheat requires fertile land, oil production requires crude oil reserves, and apparel manufacturing requires unskilled labor.

 From these observations, Heckscher and Ohlin developed their theory: A country will have a comparative advantage in producing product that intensively use resources (factors of production) it has in abundance. Thus Argentina has an comparative advantage in wheat growing because of its abundance of fertile land; Saudi Arabia has a comparative advantage in oil production because of its abundance of crude oil reserves; and China has a comparative advantage in apparel manufactured because of its abundance of unskilled labor.

            The Heckscher-Ohlin theory suggests a country should export those goods that intensively use those factors of production that are relatively abundant in the country. The theory was tested empirically after World War II by economist Wassily Leontief using input-output analysis, a mathematical technique for measuring the interrelationships among the sectors of an economy. Leontief believed the United States was a capital-abundant and labor-scarce economy. Therefore, according to the Heckscher –Ohlin theory, he reason that the United States should export capital-intensive goods, such as bulk chemicals and steel, and import labor-intensive goods, such as clothing and footwear.

            Leontief used his input-output model of the U.S. economy to estimate the quantities of labor and capital needed to produce “bundles”  of U.S. exports and imports worth $1 million in 1947 (see figure 6.3). ( Each bundle was a weighted average of all U.S. exports or imports in 1947). He determined that in 1947 U.S. factories utilized $2.55) million of capital and 182.3 person-years of labor, or $13,993 of capital per person-year of labor, to produce a bundle of export worth $1 million.  He also calculated that $3.093 million of capital and 170.0 persom-years of labor, or $18,194 of capital per person-year of labor, were used to produce a bundle of U.S. imports worth $1 million in that year. Thus U.S. imports were more capital-intensive than U.S. exports. Imports required $4,201 ($18,194 - $13,993) more in capital per person-year of labor to produce than export did.

 Figure 6.3:   U.S. Imports and Exports, 1947 – The Leontief Paradox

 

These results were not consistent with the predictions of The Heckscher-Ohlin theory: U.S. imports were nearly 30 percent more capital-intensive than were U.S. exports. The economics profession was distraught. The Heckscher-Ohlin theory made such intuitive sense, yet Leontief’s findings were the reverse of what was expected. Thus was born the Leontief Paradox.

            During the past 50 years numerous economist have repeated Leontief’s initial study in an attempt to resolve the paradox. The first such study was performed by Leontief himself. He thought trade flows might have been distorted in 1947 because much of the world economy was still recovering from World War II. Using 1951 data he found that U.S. imports were 6 percent more capital-intensive than U.S. exports were. Although this figure was less than that in his original study, it still disagreed with the predictions of the Heckscher-Ohlin theory.

Some scholars argue the measurement problem flaw Leontief’s work. Leontief assumed there are two homogeneous factors of production: labor and capital. Yet other factors of production exists, most notably land, human capital and technology –none of which were included in Leontief’s analysis. Failure to include these factors might have caused him to mismeasure  the labor intensity of U.S. exports and imports. Many U.S. exports are intensive in either land (such as agricultural goods) or human knowledge (such as computer, aircraft and services). Consider the products sold by one of the leading U.S. exporters, Boeing. Leontief’s approach measures the physical capital (the plants, property and equipment) and the physical labor used to construct Boeing aircraft but fails to gauge adequately the role of human capital and  technology in the firm’s operations. Yet human capital ( the well-educated engineers who design the aircraft and the highly skilled machinist who assembled it) and technology ( the sophisticated management techniques that control the world’s largest assembly lines) are more important to Boeing’s success that mere physical capital and physical labor. Leontief’s failure to measure the role that these other factors of production play in determining international trade pattern may account for his paradoxical results.

 

Modern Firm- Based Trade Theories

Since World War II , International business research has focused on the role of the firm rather than the country in promoting international trade. Firm-based theories have developed for several reasons: (1) the growing importance of MNC’s in the postwar international economy. (2) the inability of the country-based theories to explain and predict the existence and growth of intra industry trade (defined in the next section) : and (3) the failure of Leontief and other researches to empirically validated the country-based Heckscher-Ohlin theory. Unlike country-based theories incorporate factors such as quality, technology, brand names and customer loyalty into explanations of trade flows. Because firm’s, not countries, are the agents for international trade, the newer theories explore the firm’s role in promoting exports and imports.

Country Similarity Theory

Country –based theories, such as the theory of comparative advantage. Do a good job of explaining inter industry trade among countries. Inter industry Trade is the exchange of goods produced by one industry in country. A for goods produced by a different  industry in country B, such as the exchange of French wines for Japanese clock radios. Yet much international trade consists of intra industry trade, that is, trade between two countries of goods produced by the same industry. For example, Japan exports Toyotas to Germany while German exports BMW’s to Japan. Intra Industry trade accounts for approximately 40 percent of world trade, and it is not predicted by country-based theories.

            In 1961, Swedish economist Steffan Linder sought to explain the phenomenon of intraindustry trade. Linder hypothesized that international trade in manufactured goods result from similarities of preferences among consumers in countries that are at the same stage of economic development. In his view, firm initially manufacture goods to serve the firms’ domestic market. As they explore exporting opportunities, they discover that the most promising foreign markets are in countries where consumer preferences resemble those of their own domestic market.

                                                                                                                                          Modern Firm –Based Theories.

Since World War II, international business research has focused on the role of the firm rather than the country in promoting international trade. Firm- based theories have develop for several reason 1)the growing importance of MNC’s in the postwar international economy 2) the inability of the country-based theories to explain and predict the existence and growth of intraindustry trade ( defined in the next section) and 3)the failure of Leontief and other researchers to empirically validate the country –based Heckscher- Ohlin theory. Unlike country-based theories, firm based theories incorporate factors such as quality, technology, brand names, and customer loyalty into explanations of trade flows. Because firms not countries, are the agents for international trade, the newer theories explore the firm’s role in promoting exports and imports.

Country Similarity Theory

Country –based theories, such as the theory of comparative advantage, do a good job of explaining interindustry trade among countries. Interindustry trade is the exchange of goods produced by one industry in country A for goods produced by a different industry in country B, such as a exchange of French wines for Japanase clock radios. Yet much international trade consists of intraindustry trade, that is, trade between two countries of goods produced by the same industry. For example, Japan exports Toyotas to Germany, while Germany exports BMWs to Japan. Intraindustry trade accounts for approximately 40 percents of world trade and it is not predicted by country-based theories.

          In 1961, Sweedish economist Steffan Linder sought to explain the phenomenon of intraindustry trade. Linder hypothesized that international trade in manufactured goods results from similarities of preference among consumer in countries that are at the same stage of economic development. In his view, firms initially manufacture goods to serve the firms domestic markets. As they explore exporting opportunities, they discover that the most promising foreign markets are in countries where consumer preferences resemble those of their own domestic markets. The Japanase market, for example, provides BMW with well-off, prestige and performance-seeking automobile buyers similar to the ones who purchase its car in Germany. The German market provides Toyota with quality conscious and value-oriented customers similar to those founds in its home market. As each company targets others home markets,, intraindustry trade arises. Linder’s country similarity theory suggests that the most trade in manufactured goods should be between countries with similar per capita income and that intraindustry trade in manufactured goods should be in common. This theory is particularly useful in explaining trade in differentiated goods such as automobiles, expensive electronics equipment, and personal care products, for which brand names and products reputations lay an important role in consumer decision making.