Comparative Advantage - International Economics Paper

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International Economics, 1

International Economics

Alexandre Brito

International Economics – ECO305

Strayer University

Professor Bipin Khana

July, 24, 2011

International Economics, 2 COMPARATIVE ADVANTAGE (1) The theory or “principle of Comparative Advantage” explains why trade occurs between two countries, regions or individuals; when they trade the results may be beneficial for both parties, even when one is more productive in manufacturing of all goods because the most important is not the cost of absolute production but the ratio of productivity that each party have. (International Economics, pg. 93) To make a brief analysis we have to make the following assumptions: - Goods are identical - There are no transportation costs - There is no economy of scale and costs are constant - There are just two economies producing two goods - Factors of production are mobile - Buyers and sellers know where the cheapest goods can be found worldwide - There are no trade barriers and tariffs We can explain the principle of Comparative advantage between two countries with a simple example as following. Let’s consider two farms, one located in France and another one in Belgium that produce two products: rice and beans. The French property have a structure that allows them to produce 5 tons per hectare per year of rice and 3 tons of beans, while Belgium has a productivity of 2 tons per hectare per year for both the rice and beans. French farm has an Absolute Advantage in relation to the property in Belgium, both in the production of beans as well as rice because their productivity is higher in both cases. However, when comparing the relative productivity between the two products in two properties we will find that the French property has five times the productivity of rice production only three times in the production of beans. According to theory, the French property has a comparative advantage in rice production and property in Belgium; even if it has Absolute Advantage it has also a Comparative Advantage for the production of beans.

David Ricardo's theory (International Economics, pg. 36) advocates that companies and countries should engage and specialize in sectors that enjoy Comparative Advantage and seek to establish business relations involving part or all of their production. To better explain let’s consider that

International Economics, 3 each of the available properties of 2000 hectares for the production of each crop. The full production of the two is presented in the table below:

Property

Product

Cropped Area (He)

Production (Tons)

France

rice

2000

5000

French

beans

2000

3000

Belgium

rice

2000

2000

Belgium

beans

2000

2000

For each company can devote to the production of what has comparative advantage, we will didactically designed in French property, 1000 acres of the culture of rice and beans to Belgian property, 1,000 hectares of rice production, are being exploited for culture the beans.

Within this new structure of production have the picture below:

Property

Product

Cropped Area (He)

Production (Tons)

France

rice

3000

7500

French

beans

1000

1500

Belgium

rice

1000

1000

Belgium

beans

3000

3000

The French farm had their property rice increase production of 3500 tons while production of beans was reduced by 1500 tons. A trade agreement between the companies can allow the French company to buy from Belgium, the 1500 tons of beans that are no longer produced, paying them with the rice price ratio between products that must be less than 2 tons of beans to 3.32 tons of rice, which is the cost of production in France (if the cost is higher than it is worth re-producing beans in the 1000 acres that were directed to the planting of rice). Likewise the maximum price that the Belgian company will accept to pay per ton of rice will be 2 tons of beans. Imagine that the agreement is set to 1 ton of beans to 2.6 tons of rice.

The framework consists of production for this commercial transaction will be as follow:

International Economics, 4

Property

Product

Cropped Area (He)

Production (Tons)

Agreement

result

France

rice

3000

7500

-1950

5550

French

beans

+1500

3000

-1500

1500

Belgium

rice

+1950

2950

1000

1000

Belgium

beans

3000

3000

-1500

1500

The French property still disposing of 3,000 tons of beans and 550 tons of rice added to the joint operation. Let consider another basis of business operation in order to restore the original conditions of availability of the property rice for Belgium, which was reduced by the allocation of 2000 acres for beans. It should be clear that the basis of agreements must benefit both partners:

Property

Product

Cropped Area (He)

Production (Tons)

Agreement

Result

France

rice

3000

7500

-1000

6500

French

beans

+768

2268

1000

1500

Belgium

rice

+1000

2000

1000

1000

Belgium

beans

3000

3000

-768

2232

The property is still offering the Belgian 2000 tons of rice and had an increase of 232 tons of beans as a result of the operation that has enjoyed its comparative advantage in production of beans. The analysis of on which product the company is more efficient and the search for increased efficiency is evident where a comparative advantage is a business strategy that should guide actions for the better future of the company.

SOURCES OF COMPARATIVE ADVANTAGE IN NATIONAL ECONOMIES (2)

According to classical Heckscher-Ohlin's model (Factor-Endowments Theory), a country's sources of Comparative Advantage will be its factors of productions, or factor endowments: labor, skills, capital, and land. (International Economics, pg.81). Beyond that through a modern approach we can consider also Comparative Advantage as anything that may create a difference on the productivity of this country as follow:

International Economics, 5 2.1

Technology

2.2

Cheap raw materials (or easy access to raw materials)

2.3

Tax incentives

2.4

Intellectual Propriety (Patent and trademark laws)

2.5

Access to major trade routes

2.6

Cheap transportation (or special arrangements on transportation such as consolidation)

2.7

Wealth and also Culture

One of the most impacts on global trade as a comparative advantage today I think will be the labor, or special arrangements to explore and reduce costs of labor such as outsource, once developed countries invest massively in researching, Intellectual Property laws and education, as well as its global companies invest on design, new technologies and creation of products throughout local design and R&D centers, the low skilled and manual has been done overseas through outsourcing on the developing countries. The first thing I can imagine if China has geographically changed its place with Canada will be the gains for the United States because of the low cost labor China provide now with cheaper costs of transportation by ground, both countries and also the world will gain because this will be favorable for global trade, and also helping on researching and development bringing new ideas to China.

INTERNATIONAL FACTOR MOVEMENTS: ITS OPPORTUNITIES AND TREATS (3)

International factor movements are the movements of capital, labor and other factors of production between countries; it occurs in the following ways:

3.1

International labor mobility (Immigration and Emigration)

This is a fundamental characteristic of the international economy. For example, several industries in the United States are heavily dependent on labor of Mexico; Middle East economic development has been fueled by workers from countries of European and Asian countries. The United Nations estimates today that more about 3 percent of world population lives in a country other than where they born. New international economic theories said that the reduction of barriers on labor mobility will result in the equalization of wages between countries.

International Economics, 6

3.2

Capital transfers through international borrowing and lending

International lending and borrowing is another type of international factor movement, here the factor being moved is not physical as it is with labor mobility but financial. This is also known as Portfolio Investment. International credit is available through two private commercial banks and through international organizations, public banks, such as multilateral development banks.

3.3

2

Foreign Direct Investment: Fully Owned Subsidiary overseas / Joint-Ventures

In order to expand overseas companies should decide between exporting and 2FDI, opening a fully owned subsidiary or a Joint-venture, a partnership with a local company. Nations frequently restrict immigration, capital flows, and 2FDI, since it could lead to political and social issues not present in trade in goods and services.

NON-TARIFF BARRIERS AND ITS EFFECTS (4)

While trade can create economic benefits, the governments sometimes impose barriers to international trade as a protectionism way to ‘protect’ its nation.

Governments use several ways to restrain trade in order to control the movement of goods, money across its borders such as:

Import Quotas: An import quota is a limit on the quantity of a product that is allowed to be imported into a country during a given period, such as per year. It is a control by the government to restrict foreign goods and to protect domestic industries. Like a tariff, an import quota benefits local manufacturers but lead to higher prices for consumers, and often leading to corruption in order to get a quota position, smuggling, etc. Licenses: One of the most common instruments of regulation of imports the license requires that state issues permits for foreign trade transactions of import and export commodities included in the lists of licensed merchandises.

International Economics, 7 Embargo: As well as quotas, embargoes may be imposed on imports or exports of specific goods regardless of destination, in respect of certain goods supplied to specific countries, or in respect of all goods shipped to certain countries. Although the embargo is usually introduced for political purposes, the consequences, in essence, could be economic. Voluntary Export Restraint: VER is an agreement between two nations in which the government of the exporting country agrees to restrain the volume of its own exports. (International Economics, pg. 39) Foreign firms and governments sometimes will agree to limit their exports to a country to avoid the imposition of other types of trade barriers. The economic impact is similar of a 'quota'. Non-tariff barriers may arise as a result of government policies to protect domestic companies from international competition and can distort prices and quantities of goods and services traded overseas, restrict international investment and also economic welfare.

References Carbaugh R. (2011). International Economics (13th ed.) South-Western College Publishing/Cengage Learning.

Sullivan, A., Sheffrin S., Perez S (2008). Microeconomics: Principles, Applications, and Tools (5th ed.) New Jersey: Pearson Education.

Hodgetts, R. M., Luthans, F., Doh, J. P. (2009). International management: Culture strategy and behavior: 2009 custom edition (7th ed.). Boston: McGraw-Hill.

Citations 1. MNE – Multinational Enterprise 2. FDI – Foreign Direct Investments

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