Theory of comparative advantage and allocation of scarce resources

The essay discusses the theory of comparative advantage and its role in allocating scarce resources in international trade. It covers different trade theories such as absolute advantage, Heckscher-Ohlin model, International Product Life Cycle theory, Porter’s Diamond model, and New Trade Theory. The essay also highlights the limitations of these theories and provides real-world examples.

Running Head: FUNDAMENTAL OF ECONOMICS
Fundamental of Economics
Name of the Student
Name of the University
Author note

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Theory of comparative advantage and allocation of scarce resources
The conflict between means and ends are the building blocks of economics. Every
economy aims at optimally allocate its scarce resources. The essay addresses the aspect of
resources allocation in context of internal trade in the global economy. Different trade
theories indicate different ways of resource allocation but all end to the conclusion trade a
country definitely better off from involving in specialization and trade.
The production capacity of nation is limited by resource availability. Nation cannot
efficiently produce all goods that it needs. One country is efficient in producing one good
while another country may be efficient in producing in some other. The country thus when
exchange these goods then both the countries are better off and world output increases
(Baumol and Blinder 2014). The theory of international trade tries to explain the basic
rationale behind specialization. The difference in technology, cost structure, factor
endowment and other factors determine the line of specialization. Different trade theories
have developed focusing on each of these factors. Countries enjoy cost advantages in its
specialized good and hence, can produce more than it need. Therefore, it can easily export
this item in exchange of goods for which it has an unfavorable production and cost structure
(Begg and Ward 2013)
The first pioneering theory of international trade is the theory of absolute advantage. Adam
Smith proposed the theory in Eighteenth century. This is known as classical theory of trade.
The theory suggests that the absolute cost different among nations is the primary basis of
trade. Thee arise an absolute cost difference between two countries when each of the two
countries has the ability to produce one good with a lower cost of production than other. The
absolute cost difference may exist due to difference in type of soil, different climatic
condition, access to technology or human resource (Chacholiades 2017). The absolute cost

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difference then determines specialization and trade between countries. Both the country
should specialize in goods in which it has a lower opportunity cost.
The absolute cost difference and trade theory can be illustrated using a simple two
good-two country framework.
Production using 1 labor unit Cotton Rice
China 4 8
US 8 4
The example shows cotton and rice production of two nations with 1 unit of labor. It
is clearly seen that China has an absolute cost advantage in rice while US has an absolute cost
advantage in Cotton.
The theory of absolute cost advantage is the simplest theory of international trade.
The theory however has less connection with practical world. The absolute cost difference
may not always exist. There might be situation in which one country has absolute advantage
over more than one goods. The line of specialization then cannot be determined following
principles of Adam Smith (Dong and Wong 2017). This lead to a new trade theory known as
theory of comparative advantage. David Ricardo built the comparative advantage theory
based on difference in opportunity cost. Opportunity cost is the cost of sacrificing unit of
other goods to have one additional unit of one particular good. The principle of comparative
advantage states that one country has an absolute cost advantage in two goods but it
definitely has a lower opportunity cost in one good. Specialization and hence pattern of trade
then follows the opportunity cost difference between nations.
The following example give a better understanding of the underlying statement of
comparative cost theory.

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Production using 1 labor unit Jute Cotton
UK 100 100
Japan 40 80
The above table provides a hypothetical example of production and underlying cost between
UK and US. In UK, one unit of labor can produce 100 units of Jute and 100 units of cotton.
Japan on the other hand by using same unit of labor can produce only 40 units of Jute and 80
units of Cotton. This therefore shows UK has a greater efficiency in terms of absolute cost
difference for both Jute and Cotton. Now, in order to determine comparative advantage and
trade pattern the opportunity cost of both the goods should be computed.
Opportunity cost of 1 unit of output Jute Cotton
UK 100/100 = 1 100/100 = 1
Japan 80/40 = 2 40/80 = ½
The opportunity cost table shows that for producing 1unit Jute UK need to forgo only 1 units
of Cotton while US need to forgo 2 units of Cotton. Therefore, UK has a lower opportunity
cost and hence comparative advantage over US in Jute production. By similar argument,
there US has a comparative advantage in cotton production. The theory of comparative
advantage therefore implies UK should specialize in Jute while Japan should specialize in
Cotton.
Both absolute and comparative advantage theory suggest that it is always mutually
beneficial for two countries to specialize and trade. Nation shifts more and more resources to
the industry in which it has a relative cost advantage (Cohen 2016). When all the countries
specialize in such a way then world output increases leading to an increase in welfare.

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The two trade theories discussed above are easy to understand. Both the theories
however based on some assumption that gave rise to criticism of these theories later. The
only factor of production considered in both the theories is labor. There is no mention of
capital or other factor of production that are integral part of production. The theories however
assume labors are homogenous which is again an unrealistic assumption. Another problem is
that neither of the theories put emphasis on transportation cost (Grant 2013). The physical
distance and high transportation cost often create troubles in international trade by offsetting
benefit of relative cost advantage.
The ending point of the traditional trade theories has prepared basis for the
development of many trade theories. The Ricardian theory of comparative advantage is
further extended by the Heckscher- Ohlin trade theory. The building block of Ricardian
theory is the existing difference of opportunity cost. The theory however does not provide
any explanatory factor for these cost difference. According to Hechscher Ohlin model the
underlying cost difference is explained by the difference in relative prices of factor input
(Jones 2018). This is again related to the relative factor endowment across countries. A
country faces a relatively low price for its abundant factors while face a relatively higher cost
for the scarce factor. The cost advantages and hence specialization under this theory is then
explained with factor endowment. A country having abundant labor supply thus has a lower
cost for labor input. The country having capital as an abundant factor has a low price for
capital (Mankiw et al. 2016). Henceforth, the former should specialize in goods that has high
labor intensity while later should focus on goods having capital intensity.
The theory however when tested in real world gave a paradoxical result. The theory
was first tested for US industries to find out its pattern of trade. In 1947, the result of the test
revealed that despite being one of the most capital endowed nation US has a tendency to
import capital intensive goods while exporting labor intensive goods. The findings thus

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directly contradicted the trade model proposed by Heckscher-Ohlin (Negishi 2014). This
paradox was first examined by Professor Wassily Leontief and became famous in trade
theory as Leontief paradox.
With passes of time and changing dimension of production pattern other trade patterns
came to be known and needed a different explanation from the existing trade theories. It is
often found that a good is imported by a country where previously the good is originated.
This surprising trade pattern is explained by the product life cycle theory. The model called
International Product Life Cycle was developed by Raymond Vernon in 1966 (Cantwell and
Salmon 2016). In the model, pattern of international trade is explained beyond the static
framework of Ricardian comparative advantage model. Vernon proved that it is beneficial for
a country enjoying absolute advantages in all goods to trade and allow specialization in
categories of goods that come with highest value added. The theory focuses on dynamic
comparative advantages and addresses the issue of a changing trade pattern overtime.
The theory explains a pattern of internalization where a local producer in a developed
nation (United States) initiates a new and advanced product and sells the product in the home
country. Building product inventory in the local market reduces associated risk and
uncertainty of a new product. However, as demand increases from other markets gradually
production units shift abroad to enable firm benefit of economies of scale and by pass
obstacles in free trade. This is the time when the product enters to the maturity phase (Samli,
Fields and McHale 2015). Ultimately the increased number of competitors imposes challenge
to the advanced country of origin becoming a net importer of the good.

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Figure 1: Different phases of Product Life Cycle
(Source: Corsi, Minin and Piccaluga 2015)
In the world economy, it is observed that half of the developed nation involve in
trading similar type of goods instead of exchanging alternative goods. These high income
nations include United States, Canada, Japan, Mexico, the European Union and China. When
two nation involve in trade of similar industrial products, then it is termed as intra industry
trade (Madeira 2016). United State for example both imports and exports autos. In fact, the
worth of imported auto exceeds that for exported autos. More than 60 percent of European
Union is of intra-industry trade. For machinery also the intra-industry trade pattern is
observed. There are different variety of machinery. It might be the case that US export
machines made with wood but importing machines used for photographic processing
(Besanko et al. 2013). The underlying factor for intra-industry trade is not that workers in
these country have a higher or lower skill rather it is due to the fact that countries focusing on
specific products is able to develop a different and unique skills.
Another evolving theory of international trade is the Porter’s Diamond model of
national advantage. According to classical theories of international trade the comparative
advantage of a nation derived from the factor endowment that countries fortunately inherit.

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These factors include land, labor, natural resources and size of population. Michael E. Porter
suggested that it is possible for a nation to develop advanced factor endowments like skilled
labor force, sound knowledge and technological base, support from the government and
culture (Huggins and Izushi 2015) In the model the factors responsible for creating national
advantage are represented in the shape of a diamond.
Figure 2: Porter’s diamond model of national advantage
(Source: Grant 2013)
The four ingredients leading to national comparative advantage include resource availability
and relevant skills of the workforce, the information used by firms to find opportunities to use
these resources and skills, the objective of individual companies and the need for companies
to invest and innovate.

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Paul Krugman developed a trade model called ‘New Trade Theory’ as a collection of
existing economic models of international trade with particular focus on network effect and
increasing return to scale (Ranjan and Raychaudhuri 2016). The new theory redundant the
assumption of constant return to scale.
The essay focus on dynamic evaluation of international trade theories. In addition to
theoretical ground of these theories, the essay has picked example from real world following
the above discussed trade pattern. The essay begins with pioneering trade theory of absolute
advantage that explains specialization based on absolute cost difference. The absolutes cost
advantage theory is succeeded by Ricardian theory of comparative advantage. The Ricardian
trade theory is based on the difference in opportunity cost. The Heckscher-Ohlin model tries
to explain trade pattern depending on factor endowment and relative intensity of goods. The
theory however is contradicted by the trade pattern of US as evidenced during 1947.
Raymond Vernon developed a trade model of dynamic comparative advantage known as
International Product Life Cycle theory. This states that passing through different stage of
product life cycle how a good once invented in a nation gradually become import of the
original country. An interesting trade pattern is the intra-industry trade gaining popularity in
advanced nations. The national comparative advantage of a nation is determined by the
factors considered in Porter’s Diamond model. The new trade theory model has made a sharp
contradiction with the classical assumption of constant return to scale and diverted focus on
increasing return overtime.

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References
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Chacholiades, M., 2017. The pure theory of international trade. Routledge.
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