Comparative Cost Advantage and Factor Endowment

Table of Contents

Table of Figures

Abbreviations

1 Introduction

2 Classical and Neoclassical Theories
2.1 Classical Trade Theories
2.1.1 Absolute Cost Advantage (Adam Smith)
2.1.2 Comparative Cost Advantage (David Ricardo)
2.2 Neoclassical Theories
2.2.1 Factor Endowment (Eli Heckscher / Bertil Ohlin)
2.2.2 The Leontief Paradox (Wassily Leontief)
2.2.3 The Neo-Factor Endowment Theory

3 Application of the classical theories on transnational trade
3.1 Analysis of "Ricardo-type" of trade
3.2 Analysis of "H-O-T-type" of trade
3.3 Analysis of modern trade

4 Modern trade theories
4.1 The New Trade Theory
4.2 National Competitive Advantage

5 Conclusion

References

Appendices

Table of Figures

Figure 1: Argentina's exports to Germany (Germany Trade & Invest, 2009a), data from 2008.

Figure 2: Germany's exports to Argentina (Germany Trade & Invest, 2009a), data from 2008.

Figure 3: Conceptual Framework: Alternative Bases for Specialization (Ellis & P ecotich, 2002)

Figure 4: Porter's "Diamond" of National Competitive Advantage (1990b)

Figure 5: World Merchandise Exports by region and selected economy (WTO, 2008)

Abbreviations

illustration not visible in this excerpt

1 Introduction

As a result of globalization, world merchandise exports have increased by a giant 2,253 per­cent between 1973 and 2007 (WTO, 2008). Several economists have tried to explain the benefits of supranational trade. Already in 1776, Adam Smith developed the theory of Absolute Cost Advantage through trade between two countries (1776). Four decades later, the classical economist David Ri­cardo enhanced Smith's approach by considering the implication of opportunity costs ([1817] 1911). Accordingly, even a nation without an absolute advantage in any product can still benefit from spe-cialization and exportation.

In the first half of the 20th century, the economists Eli Heckscher and Bertil Ohlin explored the theory of Factor Endowment, describing the advantages achieved through trade between two coun-tries with different ratios of capital to labor. This theory was contradicted in 1947 by Wassily Leon-tief. In his research, h e found that the United States, although well endowed with capital resources, exported relatively labor-intensive products. Leontief's Paradox was confirmed by other economists who reached similar results. However, in 1965, the Neo-Factor-Endowm ent Theory solved the para­dox by adding human capital as a new factor. Through globalization, the structures of world trade have increased in complexity within the last fifty years.

This paper will in the following chapter present the classical economic theories of the econ­omists previously mentioned and then apply them to inter- and intra-industry trade (chapter three). The fourth chapter focuses on modern trade theories with the aim of explain trade between simulta-neously endowed countries. The main objective of this paper is to analyze the relevance of (neo-) classical theories in the current global business environment in order to find out if they are able to describe inter- or intra-industry trade. This document is the result of secondary research which has been carried out by a group of international students of the University of Applied Sciences Mainz. The main sources of this paper are publications in books and economic journals by the authors of the here-mentioned theories as well as data on international trade.

2 Classical and Neoclassical Theories

This chapter aims to explain the classical theories of trade in order to give a background for the analysis of the relevance of the trade theories described in this paper. The theories of Smith, Ricardo, Heckscher-Ohlin, and Leontief will be stated chronologically because they are basically developments or falsifications of the preceding ones.

2.1 Classical Trade Theories

2.1.1 Absolute Cost Advantage (Adam Smith)

In the 17th century, the prominent economic theory was Mercantilism. This theory stated that for a country to be economically successful the governments should establish a balanced import to export ratio. Adam Smith (1776) refuted the ideas in his book, Wealth of Nations , and introduced a new theory of economics and trade. Smith combined several ideas to form an argument for free trade without government regulations, based on the theory of Absolute Cost Advantage. Smith b e-li ev ed that goods should be produced where the cost of labor is the low]est. Therefore, the country that can most cheaply produce a product should produce that product, and export it to places where it would be more costly to produce. For example, if Italy can produce clothing with the lowest costs, and France can produce glass for the lowest cost, then Italy and France should engage in trade to secure the things they cannot produce the most efficiently. It would not be sensible for Italy to pro­duce both glass and clothing. In order for Italy to produce the glass, labor resources would be taken away from producing clothes. Adam Smith's theory stressed the importance of division of labor and specializing in producing certain products and services. Opportunity Cost is one of the major tenants of Smith's theories, and is the cost of a country moving resources to produce one good instead of another good. Smith argued that countries should import products/services which they do not pro­duce most efficiently, because that will allow them to appropriate their labor resources towards the production of goods/services that they can produce better than others, and therefore export. Smith's theory of Absolute Advantage relies on several assumptions: goods can be traded without costs, all workers in a country are equally productive, and production technology is different for each country (van Marr ewijk, 2007, pp. 1-6).

2.1.2 Comparative Cost Advantage (David Ricardo)

While Adam Smith's theory was groundbreaking in its time, there are many weaknesses in it. One of these is that it is possible that developing countries may not have the technological resources to gain an absolute advantage in producing any good or service. This would suggest that developing countries are not able to benefit from free trade and would not be able to compete with other coun-tri es globally. This issue was addressed by David Ricardo in 1817. Ricardo's theory states that an ab-solut e advantage is not necessary for a country to compete in a global market. A country must only achieve a comparative advantage in producing a product. The theory of Comparative Cost Advantage states that even if a country has a disadvantage in producing all of its goods, it can still benefit from trade when exporting products with the smaller absolute disadvantage and importing products with larger absolute disadvantages (Ricardo, [1817] 1911; Landsburg, 2007).

The theory can be illustrated by the following example. Germany's costs of producing one li­ter of beer are one euro and the production costs of one liter of wine are three euro. France's produc­tion costs are two euro per liter of beer and four euro per liter of wine. Therefore, Germany has an absolute advantage in producing both goods, whereas France has a comparative advantage in pro­ducing wine. Thus, it would be the most efficient solution for both countries if Germany specialized in the production of beer and France on the production of wine. Both nations would have a comparative advantage on one product and can profit by trading their products.

2.2 Neoclassical Theories

2.2.1 Factor Endowment (Eli Heckscher / Bertil Ohlin)

In the first half of the 20th century, Eli Heckscher and Bertil Ohlin discovered further w eak-n ess es in Smith's and Ricardo's theories. They argued that in reality, several factors of production such as land, capital, and labor are utilized simultaneously, which stands in contrast to the former theories in which labor is considered to be the sole factor when determining production costs. These limitations are addressed by Heckscher and Ohlin in the Factor Endowment Th eory1 of International Trade (Subasat, 2003, pp. 148-165).

Heckscher and Ohlin argued that capital abundant countries will specialize in the production of capital-intensive goods, whereas labor abundant countries will specialize in the production of la- bor-int ensive goods. Therefore, a country exports those goods produced by its relatively abundant factor (Blaug, 1992, pp. 185-190). The Heckscher-Ohlin model assumes that different countries have equal preferences and similar technology. This is a major difference to Ricardo's theory in which it is supposed that the production technology is equal in both countries (Suranovic, 2009). The principal assumption of Heckscher and Ohlin is that countries have different factor endowments. Therefore, a specialization in the production of certain products can be beneficial. The effect can be shown by the following example.

Country A has more land for sufficient and effective production of agricultural goods than country B which is specialized in the production of capital-intensive goods like machines. Country A can export its agricultural land-intensive goods to country B which for its part can export its capital-intensive goods to country A.

2.2.2 The Leontief Paradox (Wassily Leontief)

In 1947, the Russian economist Wassily Leontief ([1947] 1953) conducted — as one of the first economic theorists — an empirical study about the validity of the Factor Endowment Theory sur-pris ed mainstream theorists by demonstrating that the theory was oversimplified and in its nature not realistic (Mehmet, 1999). Leontief analyzed the foreign trade of the capital-abundant United States. According to Heckscher-Ohlin's Factor Endowment Theory (see chapter 2.2.1), the United States should import labor-intensive goods and export capital-intensive goods. Surprisingly, Leon-tief's study reached the opposite result, and therefore became known as the Leontief Paradox (Vagh efi, Paulson, & Tomlinson, 1991). In the following years, several economic theorists (Singer, 1950; ECLA, 1950; Pr ebisch, 1959) would come to similar results (M ehm et, 1999).

Whereas Ricardo as well as Heckscher and Ohlin developed the trade theory of Smith further without confuting them, Leontief's study came to the result that the Factor Endowment Theory can­not considered to be valid universally. However, Leontief's theory has also been criticized for several reasons. First, Leontief made the assumption that every country has the same demand. Second, it was assumed that the factor of labor is homogenous. The characteristics of labor can vary; the dis-covery of which has an impact on the productivity of an enterprise. Third, during Leontief's research in 1947, the United States imported capital-intensive resources. The reason was a lack of availability and not the implied lack of competitiveness (Rubel, 2004). Further empirical studies of trade patterns between countries followed, and in some cases the results confirmed either the validity of the Leon-tief Paradox or the Heckscher-Ohlin Theory (H-O-T). Especially, tests concerning trade between in- dustrial and undeveloped countries approved the H-O Theory while tests concerning similarly devel-oped countries showed that trade is less dependent on factor endowments (Rubel, 2004).

2.2.3 The Neo-Factor Endowment Theory

The Factor Endowment Theory has been subject of several empirical studies since Leontief published his findings against H-O-T in 1953 (Krugman, 2003, p. 82). Leontief analyzed its validity on the case of the United States, other theorists tested it on a global scale. Bowen, L eam er, and Sv ei-kauskas (1987) examined the relation between countries' endowments of factors such as capital as well as different types of labor and land (pp. 791-809). Their study resulted in the confirmation of the Leontief paradox, and thus verified that trade occurs differently than Heckscher and Ohlin suggested.

In 1965, the Heckscher-Ohlin Theory was improved by introducing an additional factor of human capital. It was argued that the heterogeneity of labor as an endowment of a country has to be considered. Therefore, a differentiation was made between skilled and unskilled labor in order to recognize the capitalized value of knowledge created by education (Hughes, 1986, p. 21). This impli­cation of differently skilled labor led to the Neo-Factor-Endowm ent Theory which can be regarded as an answer to the Leontief paradox. According to the Neo-Factor-Endowm ent Theory, the USA has a comparative advantage in the production of human-capital-intensive goods and not — like Leontief assumed — in the production of labor-intensive goods. The US computer industry can be seen as an example for the production of human-capital-intensive goods because companies like Hewlett Pack­ard or IBM still have their research and development centers in the United States.

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¹ In literature, the terms Factor Endowment Theory, Factor Abundance Theory, and Factor Proportions Theory are used synonymously. In this paper, the expression Factor Endowment Theory is mainly used.