Comparative Advantage in International Trade

Introduction

International trade is one of the fundamental economic aspects that governments consider in their quest to foster their economic growth. Higino and Schneider (2005) contend that the international trade promotes economic growth through two main avenues, which include optimal resource distribution and productivity. Imports received from the international market stimulate competition on top of adding variety in the domestic market. Thus, consumers benefit by accessing a variety of products and services. Conversely, exports to the international market leads to an expansion of domestic production, hence benefiting local firms. Higino and Schneider (2005) argue that trade “exposes firms to the best practices of foreign firms and to the demands of discerning customers, thus encouraging greater efficiency” (p. 530).

According to Bentley and Silberston (2007), the concept of comparative advantage forms the foundation of international trade. The existence of comparative advantage between two countries is beneficial to both parties in their economic growth processes. However, the comparative advantage is not static, but it is subject to change. Thus, a country that previously possessed comparative advantage with regard to production of certain products might lose its competitiveness to another. During the early 1800s, the UK was characterized by a high comparative advantage with regard to the production of textile product. However, currently, China is characterized with a high comparative advantage with regard to textile manufacturing (Carbaugh, 2013).

Over the past few decades, the world economy has experienced diverse economic events. One of the most notable economic events entails the emergence of a culture of economic globalization. Tisdell and Kumar (2004) affirm that the “process of growing economic globalization creates new economic adjustments and political opportunities challenges for us all” (p. 5).This paper entails a case study on the concept of economic globalization as one of the global events currently being experienced across the world. However, the case specifically focuses on the impact of economic globalization between China and the US and it is based on the comparative advantage theory. Moreover, the case assesses the alternative economic choices, which respective governments can consider in their quest to stimulate economic growth.

Economic globalization

Tisdell and Kumar (2004) define economic globalization as the growing economic integration across the world with reference to investments, trade, and financial flow. Tisdell and Kumar (2004) assert that despite the fact that economic globalization is not a new occurrence, as its growth over the past few years has been extraordinary. One of the issues that illustrate the trend in economic globalization entails the increase in Foreign Direct Investment [FDI] in comparison to the total world GDP. Moreover, the global economy has experienced remarkable increment with regard to short-term financial capital flows.

Economic globalization is also evidenced by inter-country interaction through the establishment of production facilities in a foreign market and technology and knowledge transfer. Moreover, Carbaugh (2013) affirms that trade between countries is based on the David Ricardo’s comparative advantage theory. The theory argues that if “each country produces what it does best and allows trade, all will realize lower prices and higher levels of output, income, and consumption than could be achieved in isolation” (Carbaugh, 2013, p. 66). Different countries have appreciated the concept of economic globalization, as evidenced by their increased adoption of open economic policies. China is one of the countries that have recently appreciated economic globalization as an avenue to achieving high economic performance.

The country’s ascension to the World Trade Organization in 2001 has significantly increased its trade with other countries such as the US. For example, the volume of trade between the US and China during the period ranging from 1979 to 2013 grew from $ 2 billion to $ 562 billion. Thus, China has become the second-largest US trading partner. Morrison (2014) posits, “China is estimated to be a $ 300 billion market for US firms” (p. 1). For example, General Motors’ sales volume in China between 2010 and 2013 was considerably higher as compared to its domestic market (Morrison, 2014). Thus, a considerable number of US firms perceive China as a key player in their international trade processes.

Factor endowment theory

Aswathappa (2010) emphasizes that the comparative advantage emanates from labor productivity. Alternatively, other economists argue that the comparative advantage is derived from “national factor endowments, which refer to the availability of factors of production or resources in a particular country such as capital, labor, and land” (Aswathappa, 2010, p. 89). Different countries are characterized with diverse factor endowments, which explain the existence of different in factor costs. The theory argues that a high factor endowment reduces its cost.

The factor endowment theory is further supported by the Heckscher-Ohlin theory, which proposes that countries “will export those goods that make intensive use of the factors that are locally abundant , while importing goods that make intensive use of factors that are locally scarce” (Aswathappa, 2010, p. 89). Thus, countries endowed with high labor abundance tend to export labor-intensive products while countries characterized by high capital abundance tend to export capital-intensive products.

The propensity of attaining cost advantage by manufacturing labor-intensive products in economies characterized by high labor abundance is high. Similarly, the benefits achieved by producing capital-intensive goods in economies endowed with high capital abundance are high. The factor endowment differences offer profit-making entities an opportunity to maximize their profit by moving their products into the respective countries (Aswathappa, 2010). Trade between the two countries occurs until price equalization is attained. However, it is not possible to attain full factor price equalization due to uneven ownership of human capital, technology, and the existence of trade barriers and transportation costs, which limit the volume of trade (Carbaugh, 2013).

China is considered to have a high comparative advantage with regard to manufacturing due to low cost of production arising from the availability of cheap labor. The cheap labor has arisen from the lack of skilled labor as opposed to the US, which is characterized by abundance of skilled human capital. Subsequently, a substantial amount of the US exports to China is comprised of products that require intensive skilled labor during the production process. Alternatively, the country imports products that require intensive unskilled labor.

Furthermore, the factor endowment theory explains why a significant number of the US firms outsource their manufacturing processes from China. However, the adoption of the one-child policy by the Chinese government has significantly reduced the pool of cheap labor within the country. Moreover, China is increasingly investing in research and development in an effort to improve its competitiveness with reference to innovation. The availability of cheap labor in China has increased the country’s comparative advantage with regard to the assembly of iPhones. However, a study conducted by US federal agency shows that China is increasingly gaining a high comparative advantage with reference to the manufacture of iPhones due to its investment in research and development (Wertime, 2014).

Stolper-Samuelson theorem

Ricardo’s comparative theory argues that countries characterized with diverse factor endowment benefit from each other by engaging in free trade. However, Carbaugh (2013) asserts that such trade is characterized by both gains and losses, as highlighted by the Stolper-Samuelson theorem. The theorem argues that the “export of a product that embodies large amounts of a relatively cheap and abundant resource makes it scarcer in the domestic market” (Carbaugh, 2013, p. 74).

A direct relationship exists between the price of the abundant and the level of income earned. Therefore, if the price of a particular factor of production that is intensively used in the production process increases, the income earned by the country that possess the abundant resource increases. Similarly, a decline in the price of the factor of production leads to a decline in the level of income earned. Therefore, the theorem contends that some parties tend to lose from free trade while others tend to gain. Carbaugh (2013) is of the opinion that countries “characterized with abundant resources favor free trade while owners of relatively scarce factors tend to favor trade restrictions” (p. 75).

Challenges posed by economic globalization

Despite the contribution of economic globalization in increasing the volume of trade between China and the US, the comparative advantage between the two countries is increasingly being hindered by the existence of international trade obstacles. Bentley and Silberston (2007) contend that the removal of obstacles can lead to considerable changes. The increased bilateral economic relationship between the two countries notwithstanding, the association has been marred with controversy and suspicion. One of the factors that have led to the tension entails China’s failure to transform itself into a free market economy. Subsequently, over the past few years, China’s trade practices have stimulated economic crisis in the US. For example, the US has experienced a considerable increment in the size of its trade deficit. Furthermore, the size of unemployment within the US manufacturing sector increased to 2.7 million in 2014 (Scott, 2014).

One of the factors that have led to an increase in the size of unemployment within the US manufacturing sector relates to the existence of a higher comparative advantage in the Chinese manufacturing sector as compared to the US. The availability of cheap labor has significantly increased China’s attractiveness to diverse manufacturing companies. Scott (2014) asserts that China is pressurizing wages downwards in an effort to attract foreign direct investment. The government’s repression on the wage level has reduced the manufacturing wages especially amongst the manufacturing workers by 86% (Scott, 2012). Shijian (2012) posits, “A Chinese worker earns $ 1.5 per hour while the wage rate in the US is estimated to be between $ 18 and $ 20 per hour” (par. 6). Moreover, the increased investment in the education sector has improved the quality of labor in China.

Another strategy being adopted by the Chinese government in an effort to boost its attractiveness entails offering subsidies especially in the key industry. The tax intensive reprieves offered by the Chinese authorities to potential investors are extensive, hence distorting the US economy due to the relocation of manufacturing investments to China.

In addition to incentives, another trade-distorting policy adopted by the Chinese government entails currency manipulation, which has significantly increased the size of the US trade deficit. The Chinese government manipulates the currency by adopting a fixed exchange rate regime. Subsequently, the Chinese Yuan is pegged on the US dollar, hence limiting it from fluctuating in accordance to the prevailing market conditions. China’s motivation to adopt a fixed-exchange rate regime arises from the need to increase the size of its trade surplus originating from trade with the US (Scott, 2012). Due to its currency manipulation practices, China has managed to subsidize its exports into the international market, hence increasing the likelihood of maximizing its foreign exchange reserve. By the end of 2012, it was estimated that the country’s foreign exchange reserve amounted to $ 3.24 trillion of which over 70% of the country’s foreign exchange reserves were denominated in US dollars (Scott, 2014). The chart below indicates the change in China’s foreign exchange reserves between 2006 and 2013 because of currency manipulation.

Year Billion US $
2006 247
2007 461.8
2008 419
2009 466.8
2010 450
2011 336.7
2012 128.3
2013 328.9
Change in the size of China's foreign exchange reserves (2006-2013)
Change in the size of China’s foreign exchange reserves (2006-2013)

Moreover, China has eliminated non-tariff barriers with reference to imports. Subsequently, the country has been in a position to increase the volume of imports from the US (Scott, 2014). Scott (2014) further asserts that the volume of imports from China to the US market has increased considerably, hence leading to loss of market for products manufactured in the US due to high-cost differentials. The electronics and computer-product market segment is the most affected.

Increase in the volume of imports relative to exports destroys an economy. It is estimated that over, 1,064,800 US jobs were lost in the US electronics and computer products segment between 2001 and 2011. Thus, a substantial number of households in the US experienced a remarkable decline in their wage rate. Scott (2012) estimates that the net loss per individual employee to be $13,505. Moreover, the trade deficit between China and the US increased to $ 318.4 billion by the end of 2013 as illustrated by the graph below (Scott, 2014).

Scott, 2014
Source: (Scott, 2014)

Possible alternative; new trade theory

The above case shows that focusing on comparative advantage as a source of economic growth might limit an economy’s ability to exploit the benefits associated with economic globalization. Furthermore, the case study shows that some trade partners might adopt negative economic policies, hence distorting the likelihood of benefiting from the comparative advantage associated with their resource/factor endowment. Additionally, the case shows that trade partners might tend to boost the areas characterized with low comparative advantage in order to improve their economic performance. For example, China’s commitment to research and development is reducing its resource endowment with regard to unskilled labor and increasing its skilled labor endowment. Therefore, the US might lose its comparative advantage with regard to skilled human capital.

Wertime (2014) emphasizes that the Chinese “start-up scene is abuzz with new products, new ideas, and new investments with some indigenous innovations like mobile messaging app WeChat” (par. 2). The high rate of innovation in China might position it as a net exporter with regard to high-tech products, hence reducing the volume of technology imports from the US. This situation might worsen the US trade deficit.

In order to deal with such an occurrence, it is imperative for the US government to incorporate other trade economic practices. Thus, the country will be in a position to overcome the challenges associated with comparative advantage. One of the economic aspects that governments should consider entails the adoption of the new trade theory. The theory emphasizes the importance of focusing developing cost advantage from economies of scale and specialization. Thus, the US government and firms should position themselves as first movers. This move will play a fundamental role in creating entry barriers with reference to production of a particular product/service.

Aswathappa (2010) contends that the “new trade theory emphasizes on productivity rather than a country’s resources and it is in line with the theory of comparative advantage, but at odds with the factor endowments theory” (p. 93). By focusing on improving the level of specialization within its labor force, a country is in a position to improve its production efficiency. Moreover, focusing on economies of scale minimizes the cost of production because the overall cost is spread over to different production units.

In order to develop economies of scale, it is imperative for the US government to outsource its production activities from other emerging economies other than China. It is estimated that 47.1% of all manufactured goods in the US originated from the Pacific Rim countries such as Japan, Hong Kong, China, and Taiwan. However, the volume of imports from these countries has reduced to 46.2%, which shows that the Pacific Rim countries are a major source of the US imports. During the same period, the volume of manufactured goods exported into the US from China increased from 3.6% to 25.9%. This aspect shows that China continues to be a major source of the US imports (Morrison, 2014). However, the high rate at which different manufacturing companies are off-shoring their manufacturing processes into China might reduce its comparative advantage, with regard to abundance of cheap labor; therefore, it is imperative for the US government to identify new markets that it can establish trade relations with in order to boost its competitiveness.

Some of the countries that the US firms should outsource the manufacturing activities include countries characterized with a relatively lower wage rate as compared to the local market such as Brazil, India, Mexico, Canada, and Russia.

Conclusion

The case study shows that economic globalization has become a major phenomenon that is influencing global economic growth. First, economic globalization has led to an increment in the volume of trade between countries. Subsequently, the global economy has experienced a high rate of integration. Moreover, trade relationship between countries is facilitated by the existence of comparative advantage between economies. For example, China’s comparative advantage with regard to cheap and unskilled labor is relatively higher as compared to the US. The theory of comparative advantage enables countries to specialize in areas of production that are most cost effective. Economic globalization has presented challenges that might diminish the benefits associated with comparative advantage, hence affecting a country’s economic growth. For example, some countries might distort the free trade agreement in an effort to attain a high economic growth at the expense of their trade partners. However, it is imperative for countries to deal with such trade practices, for example, by adopting the new trade theory, which emphasizes on improving the comparative advantage.

References

Aswathappa, K. (2010). International business. New Delhi, India: Tata McGraw-Hill Education.

Bentley, P., & Silberston, A. (2007). Anti-dumping and countervailing; limits imposed by economic and legal theory. Cheltenham, UK: Edward Elgar.

Carbaugh, B. (2013). International economics. Mason, OH: South- Western Cengage Learning.

Higino, P., & Schneider, H. (2005). International trade, economic growth and intellectual property rights; a panel data study of developed and developing countries. Journal of Development Economics, 78(3), 529-547.

Morrison, W. (2014). China-US trade issues. New York, NY: Congressional Research Service.

Scott, R. (2014). Hearing on US-China economic challenges; the impact of US-China trade. Web.

Scott, R. (2012). The China toll: growing US trade deficit with China cost more than 2.7 million jobs between 2001 and 2011. Web.

Shijian, Z. (2012). US trade with China; more good than harm by far. Web.

Tisdell, C., & Sen, R. (2004). Economic globalization; social conflicts, labor and environmental issues. New York, NY: Edward Elgar.

Wertime, D. (2014). Its official; China is becoming a new innovation powerhouseWeb.