International Trade - Grade: B+ PDF

Preview

Summary

KEY FEATURES AND IMPLICATIONS OF A RICCARDIAN MODEL OFINTERNATIONAL TRADEBy Harsha Madujith Punchihewage Reg No: 010821 LMU No: 18031375BBA Top-Up Degree Program E-Soft Metro Campus Kandy, Sri LankaCONTENTSIntroduction.....................................................................................

Description

KEY FEATURES AND IMPLICATIONS OF A RICCARDIAN MODEL OF INTERNATIONAL TRADE

By Harsha Madujith Punchihewage Reg No: 010821 LMU No: 18031375

BBA Top-Up Degree Program E-Soft Metro Campus Kandy, Sri Lanka

1

CONTENTS Introduction......................................................................................................................................3 Recardian Model..............................................................................................................................3 Explanation......................................................................................................................................3 Illustration........................................................................................................................................4 Assumptions....................................................................................................................................5 Limitations.......................................................................................................................................6 Conclusion.......................................................................................................................................7 Bibliography....................................................................................................................................8

Word Count - 1841

2

Introduction International trade refers to exchange of goods and services and when it takes place across the boundary of countries. All countries are not sufficient in themselves. Different countries are endowed with different resources. These resources can either tangible or intangible. Generally, while a country has the abundances or surplus of some resources it suffers the scarcity of certain others. For example, countries in the Middle East have vast deposits of oil which is beyond what they would need, but there are scarce of food and industrial goods. In such situations, international trade helps to exchange your surplus goods with those who do not have. A country engaging in international trade will experience positive growth by technological advancements, infra-structure upgrades, institutional advancement and capital accumulation (Sun & Heshmai, 2010). Lee (1995) argued that import of capital goods gives rise to improvement in manufacturing productivity while Wagner (2007) specified that intense competition generated by exports will lead to improvement in productivity of the country. There are certain terms to describe economies when it comes to international trade. An economy that engages in international trade is called open economy. A country that does not involve in international trade is called closed economy and situation in which a country conducts no foreign trade is called autarky. The advantages which are gained from trade with other country fare called the gains from trade. The importance of international trade was recognized by early political economist likes Adam Smith and David Ricardo. Among the many theories set out on international trade the Recardian model of comparative advantage between countries is regarded high by economist to explain how trade affects the prosperity of nations (Bauer, 2007). It is also considered the most simplest and basic general equilibrium model of international trade, though it is being superseded by models with much more complexity (Deardorff, 2007).

RECARDIAN MODEL EXPLANATION Adam Smith (1776, cited in Bauer, 2007) states that “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the 3

produce of our own industry employed in a way in which we have some advantage”. The advantage can be classified in to two: absolute advantage and comparative advantage. Absolute advantage is when a country has the best technology for producing a good. Comparative advantage if it produces a particular good or service at a lower opportunity cost than another country. In other words what it means is it can produce a product with the highest relative efficiency compared to other products it can produce. Comparative advantage is the primary reason for international trade between countries. (Montalbano, 2018) The Mercantilists school of thought was to increase exports and curtail imports by imposing higher Tariffs (Montalbano, 2018). Against to this argument, David Ricardo (1817, cited in Feenstra & Taylor, 2010) introduced the concept of comparative advantage, demonstrating that countries could benefit from trade with each other. This comparative advantage can occur due the technological differences between the countries (Montalbano, 2018). Ricardo also stated that countries that have a comparative advantage in the production of commodities can achieve a higher standard of living and consumption by trading the goods with other countries (Bauer, 2007). His ideology has been foundation for international institutes such as United Nations, World Trade Organization and World Bank (Feenstra & Taylor, 2010). Illustration This can be explained using an example (Feenstra & Taylor, 2010). The home country, one worker can produce either 6 bushels of wheat or 4 yards of cloth per labor hour. This is called marginal product labor hour (MPL). The MPL for a worker in the foreign country is 3 bushel of wheat and 3 yard of cloth. Marginal Product Labor Hour Wheat

Cloth

(Bushels

(Yards)

) Home

6

4

Foreign

3

3

It is said that the home country has an absolute advantage in the production of both goods as it can produce a higher volume compared to the foreign country. 4

This scenario would be different when opportunity cost is looked at. The opportunity cost is the amount of resources that should be given up to produce one type of good. Refer the table below. Opportunity Cost 1

Bushel

of 1 Yard of Cloth

Wheat Home

2/3 Yards

3/2 Bushels

Foreign

1 Yards

1 Bushels

The opportunity cost of 1 bushel of wheat in terms of yards of cloth in the home country is lower than that in the foreign country. What this means is that the home country has to give up less amount of resources allocated cloth to produce 1 bushel of wheat than foreign country. Due to the lower opportunity cost the home country will have a comparative advantage in wheat, whereas the foreign country will have comparative advantage in cloth. This is despite the home country having absolute advantage in the production of both goods. Assumptions Ricardo’s theory was based on three assumptions (Alexa and Toma, 2013). 1. The relative immobility of the factors of production This is the main assumption in this model. Ricardo assumed that productions factors such as labor and capital, and goods to be mobile and freely transferable within the country. Only goods were transferable at international, the only factor influencing competition between countries. Labor was thought to be homogeneous within the domestic boundary while its productivity varied across the boundary due to the technological capabilities between the countries.

2. Perfect market competition A perfect market is a hypothetical market condition. In a perfect market of a country, no firm has the power to influence the price and supply of the market and goods can be 5

moved between sectors without restriction. According to Ricardo’s labor theory, described above, trade flow within each country depends on the amount of labor required to produce the goods. For example if the production for one unit of cloth and wheat is 2 labor hours and 1 labor hours respectively, a unit of wheat will be exchanged for 2 units of cloth.

3. Existence of static equilibrium The model is developed based on general equilibrium framework. Production of goods involves the production factors and in well defined propositions. In other words production takes place under condition of fixed coefficients without the possibility of substitution. Furthermore, there is no advantage or disadvantage in producing on a large scale rather than small. Hence, production occurs at a costs or return to scale.

Ricardo’s model, based on these assumptions, was able to paint an original analysis of international trade, explaining the fundamentals of efficiency, specialization and economic growth.

Limitations Ricardian model of trade, which incorporates differences in technologies between countries, concludes that everyone benefits from trade, whereas the Heckscher-Ohlin model, which incorporates endowment differences, concludes that there will be winners and losers from trade. Change the basis for trade and you may change the outcomes from trade. In the real world, trade takes place because of a combination of all these different reasons. Each single model provides only a glimpse of some of the effects that might arise. Consequently, we should expect that a combination of the different outcomes that are presented in different models is the true characterization of the real world. Unfortunately, because of this, understanding the complexities of the real world is still more of an art than a science. Ricardian Model assumes only labor as the only factor of production and that it is fully employed. This is inaccurate in economic sense point of view, since of unemployment, a reality 6

that every country has to face. Additionally, it’s rather simplistic to assume labor as the only factor of production, when capital plays an important role in production as well as decision making (Alexa and Toma, 2013). The logic of the model is based on the existence of a perfect market competition. This is a hypothetical scenario as there is no such perfect market in actual existence. In a perfect market it is assumes that firms to do not have an influence over price of the commodity and factors of production. However firms have the option of choosing the own production capacity that’s will maximize their profit by establishing a price equal to the marginal production cost. Further to this, in perfect markets firms are assumed to wield little power, however globalization have made firms powerful with some multinational corporations holding assets more than the GDP of some small countries. (Alexa and Toma, 2013) Homogeneity implies a complete substitutability between goods and workers, in other words, the goods that are produced by various firms have the same utility for all consumers and the easy transfer of labor between firms. This assumption to be incorrect since it cannot assumed that all goods have the same quality and the difference is given by the technological differences between countries. (Alexa and Toma, 2013) Ricardo believes that international trade flows depend on the opportunity costs of each country (of one good in terms of another). In reality, international trade flows are influenced by the prices on different international markets. (Alexa and Toma, 2013)

Conclusion Nowadays no country is self-sufficient. Each and every country will need to rely on international trade not only to satisfy needs of its population but also economic growth. The Recardian model is one of the earliest theories set out for international trade. The Recardian model has been logical and intuitively appealing. For almost 200 years Recardo’ theory on comparative advantage has been seen as a useful tool with little empirical content. Economist have used Ricardo’s model as a base to develop much more advance models in the coming years with multiple production factors. However in contemporary economics it has proven to be unattractive as it produces a series of special cases rather than general results (Eaton 7

and Joe tum, 2012). The Recardian model has not generated considerable amount of empirical work compared to the Heckser Ohlin model, which emphasizes the role of cross country differences in factor endowments (Costinot and Komunjer, 2007). The main reason is because of the mismatch between its extreme assumptions and the real world. Although there are deficiencies in the model, it has lead to studies on relationship between technology and trade.

Bibliography Bauer, M. (2007). The importance of the Ricardian theory of international trade. [online] Grin.com. Available at: https://www.grin.com/document/88873 [Accessed 11 May 2019]. Economywatch.com. (2010). Ricardian Model of International Trade: An Overview | Economy Watch. [online] Available at: https://www.economywatch.com/international-trade/ricardianmodel.html [Accessed 11 May 2019]. Feenstra, R. and Taylor, A. (2010). Instructor Manual for use with international trade. 2nd ed. [ebook] New York: Worth Publishers. Available at: http://www.masterhdfs.org/masterHDFS/wpcontent/uploads/2014/05/Feenstra-Int.-Trade-book.pdf [Accessed 11 May 2019]. Lee, J. (1995). Capital goods imports and long-run growth. Journal of Development Economics, [online] 48(1), pp.91-110. Available at: https://www.nber.org/papers/w4725.pdf. Wagner, J. (2007). Exports and Productivity: A Survey of the Evidence from Firm-level Data. The World Economy, 30(1), pp.60-82. Alexa, I. and Toma, S. (2013). Testing the Ricardian Model: Do the Data Confirm the Assumptions?.

[online]

Available

http://www.inase.org/library/2013/rhodes/bypaper/EBA/EBA-13.pdf [Accessed 15 May 2019].

8

at:

9...