Theory of Comparative Advantage

This article discusses the theory of comparative advantage in economics and its application to the trade between the United States and Nigeria. It covers the foundation of the theory, empirical tests of the Ricardian model, theoretical framework and methodology, data description, and conclusions.

Running Head: THEORY OF COMPARATIVE ADVANTAGE 1
THEORY OF COMPARATIVE ADVANTAGE
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Table of Contents

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1.0 Introduction................................................................................................................................4
1.1 Comparative Advantage in US vs Nigeria.............................................................................5
2.0 The foundation of the comparative advantages theory..............................................................6
2.1 Empirical tests of the Ricardian model of comparative advantage........................................7
2.2Theoretical framework and methodology...............................................................................9
2.3 Data description...................................................................................................................10
2.4 Relative productivity and relative exports...........................................................................11
3.0 Conclusions..............................................................................................................................12
4.0 References................................................................................................................................13

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1.0 Introduction
The focus of this theory is based on the comparing the advantages of one factor of
production between two countries (Baiman, 2017). Comparative advantage is a term in
economics that refers to the ability to produce goods and services at a reduced opportunity cost
than other trade partners. The advantage of this comparative advantage is that it enables
companies produce goods and services at a lower cost hence helping it sell to customers at a
lower price. This will help the company have larger market share than its competitors because of
greater sales it makes. In this case, comparative advantage is used to compare the type of trade
that exists between the United States and the Nation of Nigeria. The trade we put a lot of
concentration are the manufacturing industries. A panel data approach of 20 industries that do
manufacturing was used to test the model of comparative advantage. Stationary panel technique
and both the one-way and two-way error components were used to perform estimations to the
equations (Brim, 2017). The progress from cross-sectional estimation to panel data technique is
advantageous because there will be improvement in the efficiency of the estimation parameters.
Introduction
Globalization which is a key term used in reference to the economies of the current world
getting connected or in other words coming together in the area of international trade. in a more
clear way, globalizations means the economies of the world entering into free trade among each
other (Low, 2016). With reference to this, we get to see that the ability of an economy to enter
the international trade community depends on the level at which this economy normally gets
involved in international trade as it is evident in its balance of payment. The techniques of
production are facilitated by the economy’s openness and trade increase. In this case, when the

THEORY OF COMPARATIVE ADVANTAGE 5
number of goods sold out of the country increases, then the bottlenecks of foreign exchange
becomes weak (Cuñat & Melitz, 2012).
1.1 Comparative Advantage in US vs Nigeria
For some years now the United States of America has been one of the biggest trade
partners with the nation of Nigeria. Over some time now, it has been witnessed that the trade
between the two countries has been on an increase (Sun, Peng, Ren & Yan, 2012). This is
because exports from Nigeria that include cocoa, rubber, antiques and food waste has been on
increase as compared to any other country in the west Africa. Same to the United States, Export
Exports to the U.S has increase rapidly in the form of wheat, vehicles, machinery, petroleum
products, civilian and private aircrafts, and last but not the least plastics over the past few years
than any other country in the West Africa (Watson, 2017). The African Growth and Opportunity
Act (AGOA) together with the bilateral co-operation forum between the two countries has been
boosting trade between the two countries. AGOA has been able to promote and grow trade
between the two countries because it provides duty-free exports to the U.S.
The Nigerian economy has been able to acquire certain characteristics that make it be
able to compete effectively in the global market. Among them are; well established economy,
manufacturing sector that is diversified etc (Nunn & Trefler, 2014).
The goal of writing this paper is to check whether this theory of comparative advantage is
applicable to South Africa as it has been specified. The next thing is to check if the theory has
been ascertained by the differences in the production of the differences in the cost of labour (Vis,
2012). From there, the rest of the paper is arranged as follows; the second part presents the
foundation of the theory, the third section is about the findings based on the comparative
advantages theory and the fourth section talks about the framework and methods used in this

THEORY OF COMPARATIVE ADVANTAGE 6
paper to describe data that is used. The fifth section does the analysis of the results of the
estimations made and diagnose tests made in the paper are presented and finally we have the
conclusion of the paper.
2.0 The foundation of the comparative advantages theory
This as a free trade theory put forward by Adam Smith. According to Adam Smith, an
inquiry in nature and what causes Nations wealth has contributed a lot into the international trade
literature the work also states that having free restrictions in trade leads to free trade in and as a
result competition at home and in other countries (Brim, 2017). Being one of the philosophers
who led to the fall of the school of mercantilists, the theory of free trade was based on the
Mercantilists critical doctrines. His arguments were that no economy can produce all of what it
needs and said that all the countries can be beneficiaries of each other if each one produces a
certain type of goods (Shohibul, 2013).
The theory of absolute advantage by Adam Smith was followed by the theory of
comparative advantage by Ricardo. Among the many points said by Ricardo is that specialization
by a country in the production of goods which have highest advantage will be of the greatest
benefit. In such a case there will be trade among the countries and each country will benefit from
comparative advantage. Thus countries will export goods to where their comparative advantages
are (Andersson et al, 2012).
Ricardo says that both countries will benefit from the trade if there is difference in the
opportunity cost of production. He also added that no trade can occur if the two countries have
the same opportunity cost of production (Levchenko, & Zhang, 2016). The major assumptions of

THEORY OF COMPARATIVE ADVANTAGE 7
Ricardian theory are; there only exists two countries, two goods, constant cost, one factor of
production and can only be practiced in the world of perfect competition.
The strength of this theory that makes it more relevant in analyzing trade patterns is the
assuming of technological differences across the countries (Baiman, 2017) . Ricardo also says
that the technological strength of one country over the other can be a source of comparative
advantage and this is what makes Ricardo’s comparative advantage theory greater than other
theories.
2.1 Empirical tests of the Ricardian model of comparative advantage
Putting aside all other assumptions underlining trade theories, the foundation of any
theory mostly begins with the classical Ricardian theory of comparative advantage. The serious
emphasis placed on the assumptions that technology differs across counties is a contribution in
the field of international trade (Keuschnigg, 2012). The theory has been built on the fact that
trade patterns are determined on the assumptions of relative productivity. The examination that
was made by Solacha in the year 1991 was the relationship that exists among the components of
unit labour, wages and productivity of the U.S trade flows in the industries of manufacture. He
also got to find that differences in productivity of labour in the industries that do manufacturing
are of great advantage in determining patterns of trade in the U.S.
Golub is the one who performed the tests of time-series and cross sectional of the
Ricardian model based on the behavior of the trade balances. He found that the cost of labour per
unit for U.S and Japan explains the changes that occur in sectoral trade balances which comply
with the Ricardian theory. He further said that research should be done to finish some of the
shortcomings of the data used in the paper (Anheier & Seibel, 2013).

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The Ricardian model for the U.S trade was assessed by Golud and Hsieh in the 2000 and
performed the professional seemingly Unrelated Regression of the flows of the sectoral trade on
relative productivity of labour and unit of labour cost. Their findings give a strong support on the
Ricardian theory that despite its simplicity, its performance continues doing very well (Bahar,
Hausmann & Hidalgo, 2014). Doing further investigation of export shares and relative cost of
labour were carried out in various places such as Carlin, Glyn and Van Renen and what they
found out was strong correspond to the theoretical function of the Ricardian model. It was also
found out that there were other variations such as technology, institutional factors that can
influence the performance of exports.
Based on the empirical analysis above, few tests of the same for the Ricardian theory
have been carried out in Nigeria and papers have been written and presented based on the
performance of exports in the same country (Deardorff, 2014). The difference is that they are not
testing weather Ricardian theory holds in Nigeria. Regardless of the same, there are some that
have been carried out and are as stated below.
Empirical test on the Nigeria’s exports was carried out based on the Ricardian model.
The focus was made on the changes that occurred to cost competitiveness at sectoral level.
Comparison was made across many countries and found out that Nigeria is not more cost
competitive with developing countries but for developed countries cost competition was high. In
the estimations to determine long-run relationship between the cost of labour and performance of
the exports, they applied the use of dynamic panel data analysis (Edoumiekumo & Opukri,
2013).
Another study contacted found out that trade competitiveness in the manufacturing
industries was determined by the cost of labour per unit of output. This study gave evidence on

THEORY OF COMPARATIVE ADVANTAGE 9
the Ricardian theory of comparative advantage (Ishchukova & Smutka, 2013). Contrary to the
findings, it was also found that the relative wages were not that convincing to support the
Ricardian theory of comparative advantage.
2.2Theoretical framework and methodology
This paper uses the framework of Golu and Hseih (2000). The two presented this
framework which is based on international comparison of unit labour cost for international
competitiveness analysis (Brack, 2017). The same framework is the one used to achieve its
usefulness in this case Nigeria. The framework is as below.
With the assumption of existence of only two countries, in this case A and B represented as both
domestic and foreign countries respectively.
ai represented as labour requirements is as shown
ai = Li
Qi
In this case Q is the value addition for i, refers to the labour employment for i .the labour cost per
unit of output is the unit labour cost.
X = ai Wi
Y = ai*Wi*
(ai) is the unit of requirement and also the inverse of marginal productivity (1 ai), and with
respect to variations in Li can be assumed to be constant.

THEORY OF COMPARATIVE ADVANTAGE 10
The two Ricardian assumptions of two countries are strictly followed by this framework.
Since the number of industries to be investigated is more than two, the assumptions of two goods
will be relaxed (Levchenko, & Zhang, 2016). What this means is that it is impossible to maintain
strong Ricardian theorem which states that the factors of production are the ones that determine
the trade patterns. Thus the level of competition between industries i in the two countries is X
and Y also will be dependent on the wages (iw) and the exchange rates between the two
countries. The above two variables determine the relative labour cost that serves as the factors
that drives the patterns of trade.
Among the major assumptions underlying Ricardian theory as a factor of production is
labour. Therefore in the average unit labour cost of production for country X and Y will be as
illustrated by the equations 2(a) and equations 2(b). Thus, to have a common currency, the ULC
(unit labour cost) in the two countries, equation 2(b) is multiplied by the bilateral exchange rate
to express it in domestic currency (Hendrischke, 2013).
2.3 Data description
The data that is needed to be used in all the above specifications is obtained from the
trade data websites. The data obtained from the UNIDO industrial Statistics includes Labour
employment, value added, and wage data. The bilateral exchange rates were obtained from the
Reserve bank of Nigeria database (Sunley, & Martin, 2017). The calculation of the relative
export variable was done from finding the ratio of Nigeria export to Nigerians imports to and
from the U.S. All the calculations of relative wages, relative unit labour cost and relative
productivity was calculated for the ratio of Nigeria to United States.
During the entire process, it was unnecessary to include all the industries. Thus the
industries that have not exceeded one-third of their production in both countries were not

THEORY OF COMPARATIVE ADVANTAGE 11
included in the estimations (Brack, 2017). The explanation behind all this is that these industries
are not the representation of the industries as a whole to the whole country. Thus, after carrying
out examination on the major industries in Nigeria the study covered only 25 industries in
Nigeria. There are some of the industries that lacked data i.e. data was unavailable and therefore
lead to their elimination from the study. Although there was data unavailability for some of the
industries, this didn’t affect much the final results because there have been minimal changes over
the period (Schneider & Paunescu, 2012).
The usage of bilateral export ratios follows the original formulation of Ricardian theory.
MacDougall (1951) and Stern (1962) specifications made earlier have been used total exort
ratios in their studies on the US-UK trade pattern. Their intention was to analyze the relationship
between the total export ration and labour productivity ratio and unit labour cost ratio (Laursen,
2015). The trade comparison that was made b Balassa (1963) compared the American exports
and the British exports and found out that tariffs between the two countries influenced trade
between them. Balassa however abandons trade between two countries and thus uses the total
export ratio to a third market. Golub and Hseih have criticized this and used bilateral trade flows
in testing of Ricardian theory. They found out that the results were consistent to the Ricardian
theory.
The data used was tested for Im, Shin and Pesaran (IPS) (2012) unit rooted test. Each of
the units are tested first with the assumptions of a constant but without trend, and then for a
second time tested for a constant and a trend. We get to realize that the Relative Labour cost
(RLC) and Relative Productivity (RelProd) is trend stationary, but when stationary, they are non-
constant, no trend and constant and trend.

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2.4 Relative productivity and relative exports
The trade pattern between the United Stated and the nation of Nigeria has been affected
by the manner in which productivity differs. The one-way error component model shows that the
output per worker in Nigeria for over the years has contributed in the exports of manufacturing
products to the U.S. In other terms, when Nigeria-U.S. productivity increases by one percent, it
leads to approximately o.5 percent export share increase (Bils, Chang & Kim, 2012). There is
existence of variation which about 97 percent. This variation is caused by difference in
productivity. This behavior is in conformity with earlier empirical tests. It is evident that the
labour productivity in Nigeria is playing a significant role in the explanation of pattern trade with
the U.S. The results from the two-way error component model reveal similarity and there is no
change in the relationship that exists between the two variables. The coefficient that is estimated
is double the coefficient of the one way error component model (Jang & Hyun, 2012).
The revelation that is exists is that increased productivity in one percent will lead to 1.2
percent increase in the ratio of export. What might cause this is as a result of the time dimension
incorporated in the model.
3.0 Conclusions
The estimates that were done on this paper about the Ricardian theory of comparative
advantage tried just to extend Golub’s (2000) framework. The differences in productivity and
wage differentials were the main determiner of trade patterns between the United States and
Nigeria. Also analysis by the use of differences in the unit labour costs determined trade patterns
between the two countries. The paper made the use of only trade values instead of using trade
volumes. The paper also makes the assumptions that there were no cost of transporting goods

THEORY OF COMPARATIVE ADVANTAGE 13
and other barriers of trade such as taxations. The reason for assuming inexistence of such
expenses is because inclusion of this may result into big differences between the two countries in
terms of their list of exports.
Basing my argument on the estimated results, it is evident that production by labour is
playing a big role in the explanation of trade with the United States (Laursen, (2015). Therefore
an improvement in labour in the country of Nigeria is necessary for increased production because
it will lead to the growth of its exports in the United States. The determination and the estimation
of the relative cost of labour have been found to be the same as that of the relative productivity.
What this means is that the two variables play a significant role in the explanation of the export
ratio, but in a different direction.
When it comes to decomposition of the relative unit labour cost to relative wages and
relative production, we get to realize that relative productivity is the main determinant of the
trade rather than relative wages. This is because the wage differences didn’t make any
improvements in the explanation of trade between Nigeria and the United States. In support of
this findings, Taussig (1921:481) defending the Ricardian theory made an expression of his
opinion which stated that wages and capital cost are not enough to make certain changes to the
trade flow as determined by the relative differences in productivity. Thus from this paper, the
major finding are that the relative cost of labour unit and relative productivity are the major trade
pattern determiners in the nation of Nigeria and the United States. To conclude, the researches
that can be made in the future should focus on the implication of policy in enhancing the
potential of these important sectors.

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