Note on Theory of Comparative Advantage and Factor Endowment Theory

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Theory of Comparative Advantage

Theory of Comparative Advantage
Theory of Comparative Advantage
Source:www.slideshare.net

 

This theory was propounded in nineteenth by an English economist David Ricardo. In his book “Principles of political economy and taxation (1817)” Ricardo argued that both the countries would still get benefit even if one country had an absolute advantage in the production of all goods. Thus, it was the comparative advantage of a nation in producing goods relative to other nation. This theory is held on the principle that nations should produce those goods for which they have the greatest relative advantage.

Ricardo gave the example of production of wine and cloth by England and Portugal in order to explain the theory more precisely. England requires 100 men for one year to produce the cloth and if it attempts to produce wine it requires 120 men for the same time period. So it would be profitable for England if it imports wine and purchases it by exporting the cloth. In the case of Portugal, only 80 men for a year produce wine and to produce cloth in the same country in the same time period it requires 90 men. It would, therefore, be economical for Portugal to export wine to exchange for cloth. Though it requires 90 men to produce cloth, it would be profitable for Portugal to import it from the country where it required 100 men to produce cloth because it is advantageous for Portugal to employ its capital in the production of wine, for which it would obtain more cloth from England. Then it should divert its capital from the cultivation of wine to manufacturing of cloth. Here the relative advantage of England is seen on the cloth while that for Portugal it is wine.

The comparative advantage of the country in producing goods can be understood through the concept of opportunity cost. The opportunity cost for a good X is a number of other goods which have to be given up in order to produce another extra unit of good X. A country has a comparative advantage in producing well if the opportunity cost of producing the good is lower at home country than in the another country. In the above example of England and Portugal, Portugal has lower opportunity cost in producing wine while England has lower opportunity cost in producing cloth. In trade between these countries, England will export cloth and import wine. Similarly, Portugal will export wine by importing cloth. As long as the opportunity cost between countries differs both the country can gain an advantage by specializing in the product having less opportunity cost.

The application of comparative advantage theory depends on the sources of comparative advantage. In today’s developed economic world, comparative advantage can be explained by difference in comparative production cost, production process and prices of production factors. The production factors include land, labor, capital, technology and natural resources. These are the inputs to production process. In present world, the quality of production factors matters for improving country’s export and attracting foreign investment. Thus in today’s international business environment factor endowment should also include the quality of factors of production which is more clearly explained by factor endowment theory of international business.

There seems a lot of similarity between absolute advantage and comparative advantage theories. However, there are few subtle differences. Absolute advantage looks at absolute productivity differences while the comparative advantage looks at comparative productivity differences. Further distinction can be seen on the part of opportunity cost which the comparative advantage theory incorporates.

Factor Endowment Theory

Also known as Hecksher-Ohlin theory, this theory was developed by Swedish economists Eli Heckscher in 1919 and Berlin Ohlin in 1933. This theory states that the comparative advantages arise from the differences in factors endowment. By factors endowments, they mean the extent to which the factors of production like land, labor, capital and natural resources are available in the country. The availability and quality of factor endowments differ between the countries. The higher the factors endowment the less will be the cost of production. The main tenant of factor endowment theory is that the countries will export those goods that make efficient and high use of those locally available factors while it imports those goods for which required resources are scare.

The theory also states that the country with capital abundance will export capital-intensive goods while the labor-abundant country will export labor-intensive goods. Capital intensive countries are those countries which have high capital accumulation rate in comparison to other countries. Such countries can invest in those sectors which require more capital investment. Similarly, labor intensive countries are those which utilize high labor force in the production of goods. Such countries are least developed countries. If these countries will not trade the prices of each good fall down due to economies of scale. When trade takes place, the price will rise as the profit-seeking firms will move their goods to other markets. Trade flows will rise until the price of both goods is equalized in both markets.

A country is relatively efficient in those sectors in which the country is better suited and it does best with what it has most of. For example, the USA is more abundant in capital relative to labor than other countries. Thus, it exports commodities which require greater use of capital (e.g., motor vehicles) and it will import labor-intensive commodities (e.g., clothing).

There are certain assumptions of factors endowment theories. Firstly, it assumes that different countries have different factors of production. Secondly, each commodity is assumed to have its own production function and the production function of particular goods is identical anywhere in the world. Production function shows the amount of output that can be produced from the given amount of labor and capital. In other words, the same level of factors of production (i.e. inputs) will produce the same amount of output in any country. Thirdly, technology is assumed to be constant in all the country and the same technology is applied everywhere during production process. Finally, demands for production factors are same in all countries. With identical demand, the difference in supply of factors production will result in difference in prices between two countries.

The major implications of factors endowment theory are mentioned below:

  • The greatest difference in economic structure between the countries will result in higher trade and trade gain between those countries.
  • Countries should export those goods that make intensive use of their relatively abundant factors.
  • Free trade should equalize factor prices between countries, especially those with fairly similar relative factor endowments and with more liberal mutual trade.

 

References

Shenkar, O., Luo, Y., & Chi, T. (2015). International Business. New York: Sage.

Yip, G. S. (n.d.). Total Global Strategy: Managing for Worldwide Competitive Advantage. 1995: Englewood Cliffs, NJ : Prentice-Hall.

  • The country would benefit from international business when it focuses on producing goods which have higher comparative advantage relative to other nation.
  •  A country has a comparative advantage in producing well if the opportunity cost of producing the good is lower at home country than in the another country.
  • Factor endowment refers to the factors of production which are the resources required for the production of goods and services. 
  • Factor endowment theory states that a country is relatively efficient in those sectors in which the country is better suited and it does best with what it has most of.
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