The rise of bangladesh's textile trade case study answers

chapter 6 International Trade Theory

LEARNING OBJECTIVES

1 Understand why nations trade with each other.

2 Summarize the different theories explaining trade flows between nations.

3 Recognize why many economists believe that unrestricted free trade between nations will raise the economic welfare of countries that participate in a free trade system.

4 Explain the arguments of those who maintain that government can play a proactive role in promoting national competitive advantage in certain industries.

5 Understand the important implications that international trade theory holds for business practice.

opening case The Rise of India's Drug Industry

One of the great success stories in international trade in recent years has been the strong growth of India's pharmaceutical industry. The country used to be known for producing cheap knockoffs of patented drugs discovered by Western and Japanese pharmaceutical companies. This made the industry something of an international pariah. Because they made copies of patented products, and therefore violated intellectual property rights, Indian companies were not allowed to sell these products in developed markets. With no assurance that their intellectual property would be protected, foreign drug companies refused to invest in, partner with, or buy from their Indian counterparts, further limiting the business opportunities of Indian companies. In developed markets such as the United States, the best that Indian companies could do was to sell low-cost generic pharmaceuticals (generic pharmaceuticals are products whose patent has expired).

In 2005, however, India signed an agreement with the World Trade Organization that brought the country into compliance with WTO rules on intellectual property rights. Indian companies stopped producing counterfeit products. Secure in knowledge that their patents would be respected, foreign companies started to do business with their Indian counterparts. For India, the result has been dramatic growth in its pharmaceutical sector. The sector generated sales of close to $25 billion in 2010, more than double the figure of 2005. Driving this growth have been surging exports, which grew at 15 percent per annum between 2006 and 2011. In 2000 pharmaceutical exports from India amounted to around $1 billion. By 2011, the figure was around $11.5 billion!

Much of this growth has been the result of partnerships between Western and Indian firms. Western companies have been increasingly outsourcing manufacturing and packaging activities to India, while at the same time scaling back some of these activities at home and in places such as Puerto Rico, which historically has been a major manufacturing hub for firms serving the U.S. market. India's advantages in manufacturing and packaging include relatively low wage rates, an educated workforce, and the widespread use of English as a business language. Western companies have continued to perform high value-added R & D, marketing, and sales activities, and these remain located in their home markets.

During India's years as an international pariah in the drug business, its nascent domestic industry set the foundations for today's growth. Local start-ups invested in the facilities required to discover and produce pharmaceuticals, creating a market for pharmaceutical scientists and workers in India. In turn, this drove the expansion of pharmaceutical programs in the country's universities, thereby increasing the supply of talent. Moreover, the industry's experience in the generic drug business during the 1990s and early 2000s gained it expertise in dealing with regulatory agencies in the United States and European Union. After 2005, this know-how made Indian companies more attractive as partners for Western enterprises. Combined with low labor costs, all these factors came together to make India an increasingly attractive location for the manufacturing of pharmaceuticals.

The U.S. Federal Drug Administration (FDA) responded to the shift of manufacturing to India by opening two offices there to oversee manufacturing compliance and make sure safety was consistent with FDA-mandated standards. Today, the FDA has issued approvals to producing pharmaceuticals for sale in the United States to some 900 plants in India, giving Indian companies a legitimacy that potential rivals in places such as China lack.

For Western enterprises, the obvious attraction of outsourcing drug manufacturing to India is that it lowers their costs, enabling them to protect their earnings in an increasingly difficult domestic environment where government health care regulation and increased competition have put pressure on the pricing of many pharmaceuticals. Arguably, this also benefits consumers in the United States because lower pharmaceutical prices mean lower insurance costs, smaller co-pays, and ultimately lower out-of-pocket expenses than if those pharmaceuticals were still manufactured domestically. Offset against this economic benefit, of course, must be the cost of jobs lost in U.S. pharmaceutical manufacturing. Indicative of this trend, total manufacturing employment in this sector fell by 5 percent between 2008 and 2010.•

Sources: H. Timmons, “A Pharmaceutical Future,” The New York Times, July 7, 2010, pp. B1, B4; K. K. Sharma, “On the World Stage,” Business Today, January 9, 2011, pp. 116–17; and M. Velterop, “The Indian Perspective,” Pharmaceutical Technology Europe, September 2010, pp. 40–41.

Introduction

The growth of the Indian pharmaceutical industry is an example of the benefits of free trade and globalization. Before 2005, Indian pharmaceutical companies were shut out of many developed markets by legal barriers to trade. The fact that India did not respect drug patents—and allowed domestic companies to make counterfeit versions of patented medicines—meant that Indian companies were prohibited from selling these products in developed nations. In 2005, India signed an agreement that brought it into compliance with global patent rules. Indian companies stopped making counterfeit medicines, so they could now trade freely with developed countries. This opened up a host of legitimate business opportunities. Today, the fast-growing Indian pharmaceutical industry manufactures low-cost generic and patented medicines for sale around the world, often in partnership with Western drug companies. Western companies continue to perform R&D and marketing activities at home, while contracting out some of their manufacturing activities to Indian enterprises. This practice has lowered manufacturing costs for Western companies and, in turn, led to lower prices and lower insurance costs for Western consumers. At the same time, it has helped create jobs and wealth in India, enabling Indians to boost their purchases of goods and services produced by Western nations.

If there are losers in this process, it is in manufacturing employees in the pharmaceutical industry in developed markets such as the United States, where the number of jobs is starting to fall. In the world of international trade, there are always winners and losers, but as economists have long argued, the benefits to the winners outweigh the costs borne by the losers, resulting in a net gain to society. Moreover, economists argue that in the long run, free trade stimulates economic growth and raises living standards across the board. For example, as India gets richer, the nation's citizens will consume more goods and services produced in the United States, raising U.S. living standards. On balance, free trade, in the view of economists, is a win–win situation.

The economic arguments surrounding the benefits and costs of free trade in goods and services are not abstract academic ones. International trade theory has shaped the economic policy of many nations for the past 50 years. It was the driver behind the formation of the World Trade Organization and regional trade blocs such as the European Union and the North American Free Trade Agreement (NAFTA). The 1990s, in particular, saw a global move toward greater free trade. It is crucially important to understand, therefore, what these theories are and why they have been so successful in shaping the economic policy of so many nations and the competitive environment in which international businesses compete.

This chapter has two goals that go to the heart of the debate over the benefits and costs of free trade. The first is to review a number of theories that explain why it is beneficial for a country to engage in international trade. The second goal is to explain the pattern of international trade that we observe in the world economy. With regard to the pattern of trade, we will be primarily concerned with explaining the pattern of exports and imports of goods and services between countries. The pattern of foreign direct investment between countries is discussed in Chapter 8.

An Overview of Trade Theory

We open this chapter with a discussion of mercantilism. Propagated in the sixteenth and seventeenth centuries, mercantilism advocated that countries should simultaneously encourage exports and discourage imports. Although mercantilism is an old and largely discredited doctrine, its echoes remain in modern political debate and in the trade policies of many countries. Next, we will look at Adam Smith's theory of absolute advantage. Proposed in 1776, Smith's theory was the first to explain why unrestricted free trade is beneficial to a country. Free trade refers to a situation in which a government does not attempt to influence through quotas or duties what its citizens can buy from another country, or what they can produce and sell to another country. Smith argued that the invisible hand of the market mechanism, rather than government policy, should determine what a country imports and what it exports. His arguments imply that such a laissez-faire stance toward trade was in the best interests of a country. Building on Smith's work are two additional theories that we shall review. One is the theory of comparative advantage, advanced by the nineteenth-century English economist David Ricardo. This theory is the intellectual basis of the modern argument for unrestricted free trade. In the twentieth century, Ricardo's work was refined by two Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the Heckscher-Ohlin theory.

Free Trade

The absence of barriers to the free flow of goods and services between countries.

THE BENEFITS OF TRADE

LEARNING OBJECTIVE 1

Understand why nations trade with each other.

The great strength of the theories of Smith, Ricardo, and Heckscher-Ohlin is that they identify with precision the specific benefits of international trade. Common sense suggests that some international trade is beneficial. For example, nobody would suggest that Iceland should grow its own oranges. Iceland can benefit from trade by exchanging some of the products that it can produce at a low cost (fish) for some products that it cannot produce at all (oranges). Thus, by engaging in international trade, Icelanders are able to add oranges to their diet of fish.

The theories of Smith, Ricardo, and Heckscher-Ohlin go beyond this commonsense notion, however, to show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself. This is a difficult concept for people to grasp. For example, many people in the United States believe that American consumers should buy products made in the United States by American companies whenever possible to help save American jobs from foreign competition. The same kind of nationalistic sentiments can be observed in many other countries.

ANOTHER PERSPECTIVE Outsourcing: Putting Jobs into Growing Markets

Another way of looking at the hollowing out of the American knowledge-based economy through outsourcing is to see the process from the perspective of developing nations. To them, outsourcing brings with it the benefits of trade. It is one of the positive outcomes of globalization. Multinational corporations doing some business in their markets can locate their production in the very markets into which they are selling. As India, the Philippines, and China develop a knowledge-based labor supply, companies such as Intel and EMC that are selling into these markets may want to locate some of their research and development and other knowledge-based activities in these markets as a commitment to a local presence, as a way to learn more about the customer, and as a way to establish sustained and sustaining relationships. Yes, there are cost savings, especially on labor, but long term, such cost savings may be secondary.

However, the theories of Smith, Ricardo, and Heckscher-Ohlin tell us that a country's economy may gain if its citizens buy certain products from other nations that could be produced at home. The gains arise because international trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, while importing products that can be produced more efficiently in other countries. Thus, it may make sense for the United States to specialize in the production and export of commercial jet aircraft, because the efficient production of commercial jet aircraft requires resources that are abundant in the United States, such as a highly skilled labor force and cutting-edge technological know-how. On the other hand, it may make sense for the United States to import textiles from Bangladesh because the efficient production of textiles requires a relatively cheap labor force—and cheap labor is not abundant in the United States.

Of course, this economic argument is often difficult for segments of a country's population to accept. With their future threatened by imports, U.S. textile companies and their employees have tried hard to persuade the government to limit the importation of textiles by demanding quotas and tariffs. Although such import controls may benefit particular groups, such as textile businesses and their employees, the theories of Smith, Ricardo, and Heckscher-Ohlin suggest that the economy as a whole is hurt by such action. One of the key insights of international trade theory is that limits on imports are often in the interests of domestic producers, but not domestic consumers.

THE PATTERN OF INTERNATIONAL TRADE

The theories of Smith, Ricardo, and Heckscher-Ohlin help to explain the pattern of international trade that we observe in the world economy. Some aspects of the pattern are easy to understand. Climate and natural resource endowments explain why Ghana exports cocoa, Brazil exports coffee, Saudi Arabia exports oil, and China exports crawfish. However, much of the observed pattern of international trade is more difficult to explain. For example, why does Japan export automobiles, consumer electronics, and machine tools? Why does Switzerland export chemicals, pharmaceuticals, watches, and jewelry? Why does Bangladesh export garments? David Ricardo's theory of comparative advantage offers an explanation in terms of international differences in labor productivity. The more sophisticated Heckscher-Ohlin theory emphasizes the interplay between the proportions in which the factors of production (such as land, labor, and capital) are available in different countries and the proportions in which they are needed for producing particular goods. This explanation rests on the assumption that countries have varying endowments of the various factors of production. Tests of this theory, however, suggest that it is a less powerful explanation of real-world trade patterns than once thought.

One early response to the failure of the Heckscher-Ohlin theory to explain the observed pattern of international trade was the product life-cycle theory. Proposed by Raymond Vernon, this theory suggests that early in their life cycle, most new products are produced in and exported from the country in which they were developed. As a new product becomes widely accepted internationally, however, production starts in other countries. As a result, the theory suggests, the product may ultimately be exported back to the country of its original innovation.

New Trade Theory

The observed pattern of trade in the world economy may be due in part to the ability of firms in a given market to capture first-mover advantages.

In a similar vein, during the 1980s economists such as Paul Krugman developed what has come to be known as the new trade theory. New trade theory (for which Krugman won the Nobel Prize in 2008) stresses that in some cases countries specialize in the production and export of particular products not because of underlying differences in factor endowments, but because in certain industries the world market can support only a limited number of firms. (This is argued to be the case for the commercial aircraft industry.) In such industries, firms that enter the market first are able to build a competitive advantage that is subsequently difficult to challenge. Thus, the observed pattern of trade between nations may be due in part to the ability of firms within a given nation to capture first-mover advantages. The United States is a major exporter of commercial jet aircraft because American firms such as Boeing were first movers in the world market. Boeing built a competitive advantage that has subsequently been difficult for firms from countries with equally favorable factor endowments to challenge (although Europe's Airbus Industrie has succeeded in doing that). In a work related to the new trade theory, Michael Porter developed a theory referred to as the theory of national competitive advantage. This attempts to explain why particular nations achieve international success in particular industries. In addition to factor endowments, Porter points out the importance of country factors such as domestic demand and domestic rivalry in explaining a nation's dominance in the production and export of particular products.

TRADE THEORY AND GOVERNMENT POLICY

Although all these theories agree that international trade is beneficial to a country, they lack agreement in their recommendations for government policy. Mercantilism makes a crude case for government involvement in promoting exports and limiting imports. The theories of Smith, Ricardo, and Heckscher-Ohlin form part of the case for unrestricted free trade. The argument for unrestricted free trade is that both import controls and export incentives (such as subsidies) are self-defeating and result in wasted resources. Both the new trade theory and Porter's theory of national competitive advantage can be interpreted as justifying some limited government intervention to support the development of certain export-oriented industries. We will discuss the pros and cons of this argument, known as strategic trade policy, as well as the pros and cons of the argument for unrestricted free trade, in Chapter 7.

• QUICK STUDY

1. What is the major benefit of trade identified in theories of international trade?

2. What do theories of international trade teach us about the pattern of trade in the world economy?

3. How do trade theories inform government policy?

Mercantilism

The first theory of international trade, mercantilism, emerged in England in the mid-sixteenth century. The principle assertion of mercantilism was that gold and silver were the mainstays of national wealth and essential to vigorous commerce. At that time, gold and silver were the currency of trade between countries; a country could earn gold and silver by exporting goods. Conversely, importing goods from other countries would result in an outflow of gold and silver to those countries. The main tenet of mercantilism was that it was in a country's best interests to maintain a trade surplus, to export more than it imported. By doing so, a country would accumulate gold and silver and, consequently, increase its national wealth, prestige, and power. As the English mercantilist writer Thomas Mun put it in 1630:

LEARNING OBJECTIVE 2

Summarize the different theories explaining trade flows between nations.

Mercantilism

An economic philosophy advocating that countries should simultaneously encourage exports and discourage imports.

The ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule: to sell more to strangers yearly than we consume of theirs in value.1

Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. The mercantilists saw no virtue in a large volume of trade. Rather, they recommended policies to maximize exports and minimize imports. To achieve this, imports were limited by tariffs and quotas, while exports were subsidized.

COUNTRY FOCUS Is China a Neo-Mercantilist Nation?

China's rapid rise in economic power (it is now the world's second largest economy) has been built on export-led growth. The country takes raw material imports and, using its cheap labor, converts them into products that it sells to developed nations. For years, the country's exports have been growing faster than its imports, leading some critics to claim that China is pursuing a neo-mercantilist policy, trying to amass record trade surpluses and foreign currency that will give it economic power over developed nations. This rhetoric reached new heights in 2008 when China's trade surplus hit a record $280 billion and its foreign exchange reserves exceeded $1.95 trillion, some 70 percent of which are held in U.S. dollars. Observers worry that if China ever decides to sell its holdings of U.S. currency, this could depress the value of the dollar against other currencies and increase the price of imports into America.

Throughout 2005–2008, China's exports grew much faster than its imports, leading some to argue that China was limiting imports by pursuing an import substitution policy, encouraging domestic investment in the production of products such as steel, aluminum, and paper, which it had historically imported from other nations. The trade deficit with America has been a particular cause for concern. In 2011, this reached a record $295 billion. At the same time, China has long resisted attempts to let its currency float freely against the U.S. dollar. Many claim that China's currency is too cheap, and that this keeps the prices of China's goods artificially low, which fuels the country's exports.

So is China a neo-mercantilist nation that is deliberately discouraging imports and encouraging exports in order to grow its trade surplus and accumulate foreign exchange reserves, which might give it economic power? The jury is out on this issue. Skeptics suggest that going forward, the country will have no choice but to increase its imports of commodities that it lacks, such as oil. They also note that China did start allowing the value of the yuan (China's currency) to appreciate against the dollar in July 2005, albeit at a slow pace. In July 2005 one U.S. dollar purchased 8.11 yuan. By January 2012, the one dollar purchased 6.38 yuan, a decline of 21 percent. As a result, China's trade surplus has started to contract as export growth has slowed and imports have increased. In 2011, the surplus was $155 billion, down substantially from the $290 billion in 2008. While this suggests that China's trade surplus may have peaked for now, it is still a cause for concern in many developed nations, and particularly the United States.

Sources: A. Browne, “China's Wild Swings Can Roil the Global Economy,” The Wall Street Journal, October 24, 2005, p. A2; S.H. Hanke, “Stop the Mercantilists,”Forbes, June 20, 2005, p. 164; G. Dyer and A. Balls, “Dollar Threat as China Signals Shift,” Financial Times, January 6, 2006, p. 1; Tim Annett, “Righting the Balance,” The Wall Street Journal, January 10, 2007, p. 15; “China's Trade Surplus Peaks,” Financial Times, January 12, 2008, p. 1; W. Chong, “China's Trade Surplus to U.S. to Narrow,” China Daily, December 7, 2009; A. Wang and K. Yao, “China's Trade Surplus Dips, Taking Heat of Yuan,” Reuters, January 9, 2011; and Aaron Back, “China's Trade Surplus Shrank in '11,”The Wall Street Journal, January 11, 2012.

The classical economist David Hume pointed out an inherent inconsistency in the mercantilist doctrine in 1752. According to Hume, if England had a balance-of-trade surplus with France (it exported more than it imported) the resulting inflow of gold and silver would swell the domestic money supply and generate inflation in England. In France, however, the outflow of gold and silver would have the opposite effect. France's money supply would contract, and its prices would fall. This change in relative prices between France and England would encourage the French to buy fewer English goods (because they were becoming more expensive) and the English to buy more French goods (because they were becoming cheaper). The result would be a deterioration in the English balance of trade and an improvement in France's trade balance, until the English surplus was eliminated. Hence, according to Hume, in the long run no country could sustain a surplus on the balance of trade and so accumulate gold and silver as the mercantilists had envisaged.

The flaw with mercantilism was that it viewed trade as a zero-sum game. (A zero-sum game is one in which a gain by one country results in a loss by another.) It was left to Adam Smith and David Ricardo to show the shortsightedness of this approach and to demonstrate that trade is a positive-sum game, or a situation in which all countries can benefit. Unfortunately, the mercantilist doctrine is by no means dead. Neo-mercantilists equate political power with economic power and economic power with a balance-of-trade surplus. Critics argue that many nations have adopted a neo-mercantilist strategy that is designed to simultaneously boost exports and limit imports.2 For example, critics charge that China is pursuing a neo-mercantilist policy, deliberately keeping its currency value low against the U.S. dollar in order to sell more goods to the United States and other developed nations, and thus amass a trade surplus and foreign exchange reserves (see the accompanying Country Focus).

Zero-Sum Game

A situation in which an economic gain by one country results in an economic loss by another.

Absolute Advantage

LEARNING OBJECTIVE 2

Summarize the different theories explaining trade flows between nations.

In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game. Smith argued that countries differ in their ability to produce goods efficiently. In his time, the English, by virtue of their superior manufacturing processes, were the world's most efficient textile manufacturers. Due to the combination of favorable climate, good soils, and accumulated expertise, the French had the world's most efficient wine industry. The English had an absolute advantage in the production of textiles, while the French had an absolute advantage in the production of wine. Thus, a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it.

Absolute Advantage

A country has an absolute advantage in the production of a product when it is more efficient than any other country at producing it.

According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these for goods produced by other countries. In Smith's time, this suggested the English should specialize in the production of textiles while the French should specialize in the production of wine. England could get all the wine it needed by selling its textiles to France and buying wine in exchange. Similarly, France could get all the textiles it needed by selling wine to England and buying textiles in exchange. Smith's basic argument, therefore, is that a country should never produce goods at home that it can buy at a lower cost from other countries. Smith demonstrates that, by specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade.

Consider the effects of trade between two countries, Ghana and South Korea. The production of any good (output) requires resources (inputs) such as land, labor, and capital. Assume that Ghana and South Korea both have the same amount of resources and that these resources can be used to produce either rice or cocoa. Assume further that 200 units of resources are available in each country. Imagine that in Ghana it takes 10 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between these two extremes. The different combinations that Ghana could produce are represented by the line GG' in Figure 6.1. This is referred to as Ghana's production possibility frontier (PPF). Similarly, imagine that in South Korea it takes 40 resources to produce 1 ton of cocoa and 10 resources to produce 1 ton of rice. Thus, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination between these two extremes. The different combinations available to South Korea are represented by the line KK' in Figure 6.1, which is South Korea's PPF. Clearly, Ghana has an absolute advantage in the production of cocoa. (More resources are needed to produce a ton of cocoa in South Korea than in Ghana.) By the same token, South Korea has an absolute advantage in the production of rice.

FIGURE 6.1 The Theory of Absolute Advantage

Now consider a situation in which neither country trades with any other. Each country devotes half of its resources to the production of rice and half to the production of cocoa. Each country must also consume what it produces. Ghana would be able to produce 10 tons of cocoa and 5 tons of rice (point A in Figure 6.1), while South Korea would be able to produce 10 tons of rice and 2.5 tons of cocoa. Without trade, the combined production of both countries would be 12.5 tons of cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15 tons of rice (5 tons in Ghana and 10 tons in South Korea). If each country were to specialize in producing the good for which it had an absolute advantage and then trade with the other for the good it lacks, Ghana could produce 20 tons of cocoa, and South Korea could produce 20 tons of rice. Thus, by specializing, the production of both goods could be increased. Production of cocoa would increase from 12.5 tons to 20 tons, while production of rice would increase from 15 tons to 20 tons. The increase in production that would result from specialization is therefore 7.5 tons of cocoa and 5 tons of rice. Table 6.1 summarizes these figures.

TABLE 6.1 Absolute Advantage and the Gains from Trade

Resources Required to Produce 1 Ton of Cocoa and Rice

Cocoa

Rice

Ghana

10

20

South Korea

40

10

Production and Consumption without Trade

Cocoa

Rice

Ghana

10.0

5.0

South Korea

2.5

10.0

Total production

12.5

15.0

Production with Specialization

Cocoa

Rice

Ghana

20.0

0.0

South Korea

0.0

20.0

Total production

20.0

20.0

Consumption After Ghana Trades 6 Tons of Cocoa for 6 Tons of South Korean Rice

Cocoa

Rice

Ghana

14.0

6.0

South Korea

6.0

14.0

Increase in Consumption as a Result of Specialization and Trade

Cocoa

Rice

Ghana

4.0

1.0

South Korea

3.5

4.0

By engaging in trade and swapping 1 ton of cocoa for 1 ton of rice, producers in both countries could consume more of both cocoa and rice. Imagine that Ghana and South Korea swap cocoa and rice on a one-to-one basis; that is, the price of 1 ton of cocoa is equal to the price of 1 ton of rice. If Ghana decided to export 6 tons of cocoa to South Korea and import 6 tons of rice in return, its final consumption after trade would be 14 tons of cocoa and 6 tons of rice. This is 4 tons more cocoa than it could have consumed before specialization and trade and 1 ton more rice. Similarly, South Korea's final consumption after trade would be 6 tons of cocoa and 14 tons of rice. This is 3.5 tons more cocoa than it could have consumed before specialization and trade and 4 tons more rice. Thus, as a result of specialization and trade, output of both cocoa and rice would be increased, and consumers in both nations would be able to consume more. Thus, we can see that trade is a positive-sum game; it produces net gains for all involved.

Comparative Advantage

LEARNING OBJECTIVE 2

Summarize the different theories explaining trade flows between nations.

David Ricardo took Adam Smith's theory one step further by exploring what might happen when one country has an absolute advantage in the production of all goods.3 Smith's theory of absolute advantage suggests that such a country might derive no benefits from international trade. In his 1817 book Principles of Political Economy, Ricardo showed that this was not the case. According to Ricardo's theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.4 While this may seem counterintuitive, the logic can be explained with a simple example.

Assume that Ghana is more efficient in the production of both cocoa and rice; that is, Ghana has an absolute advantage in the production of both products. In Ghana it takes 10 resources to produce one ton of cocoa and 13½ resources to produce one ton of rice. Thus, given its 200 units of resources, Ghana can produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or any combination in between on its PPF (the line GG' in Figure 6.2). In South Korea it takes 40 resources to produce 1 ton of cocoa and 20 resources to produce 1 ton of rice. Thus, South Korea can produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or any combination on its PPF (the line KK' in Figure 6.2). Again assume that without trade, each country uses half of its resources to produce rice and half to produce cocoa. Thus, without trade, Ghana will produce 10 tons of cocoa and 7.5 tons of rice (point A inFigure 6.2), while South Korea will produce 2.5 tons of cocoa and 5 tons of rice (point B in Figure 6.2).

FIGURE 6.2 The Theory of Comparative Advantage

In light of Ghana's absolute advantage in the production of both goods, why should it trade with South Korea? Although Ghana has an absolute advantage in the production of both cocoa and rice, it has a comparative advantage only in the production of cocoa: Ghana can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice.

Without trade the combined production of cocoa will be 12.5 tons (10 tons in Ghana and 2.5 in South Korea), and the combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade each country must consume what it produces. By engaging in trade, the two countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods.