EC-228 Essay - Comparative Advantage Final

8/3/2019 EC-228 Essay - Comparative Advantage Final

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633799 Lewis Marty

“Comparative advantage, being a dynamicconcept, can provide an economic argument infavour of short term protectionism”. Discuss.

Within this essay I shall take the time to discuss the statement, “Comparative advantage,

being a dynamic concept, can provide an economic argument in favour of short term

protectionism”. I intend to consider the fundamentals of international trade, comparative

advantage and product cycle theory. Each theory will be thoroughly critiqued and defined;

creating the perfect environment for this paper to look into the widely believed idea that free

trade is the optimum state in which international trade should take place and how dynamic

comparative advantage may disagree with that notion. In order to do this I will implement the

use of real world examples, economic techniques and graphical analysis. Finally I will

summarise the essay and provide a conclusion in which I shall answer the question of

whether Comparative advantage does provide an argument in favour of short term

protectionism or whether older trade theories should be believed and protectionism in the

short term should never be desired due to the threat of harmful consequences.

Sloman (2006, pg. 636) states that “International trade levels have been increasing rapidly

over the last 60 years and at consistently higher rates than World GDP”. As the world has

become smaller, nations have been able to specialize in an effort to export what is notconsumed domestically. The problem countries are then faced with is; ‘what shall we

specialize in?’ This question has had several answers over time. Mercantilist views were

adhered to until around the 18th Century when Adam Smith developed his Absolute

Advantage theory. The Absolute Advantage theory dictated that nations should specialise

their production towards the industry in which they can produce maximum output using

minimal resources. The plan was for nations to utilize their differing relative productivity

levels, making trade beneficial (Begg et al, 2003). Over time Absolute Advantage Theory

evolved into today’s Comparative Advantage Theory. A country is said to have acomparative advantage over another in the production of a good, but only if it can produce

the good at a lower opportunity cost i.e. if it has to forgo less of other goods in order to

produce it (Sloman 2006). The theory can be better explained through a worked theoretical

example as seen below.

1

Unit Labour Requirement Opportunity Cost

Germany Refrigerators 30 6 Dress

Dresses 5 1/6 Refrigerator

France Refrigerators 60 10 Dress

Dresses 6 1/10 Refrigerator



633799 Lewis Marty

According to the table shown above, it takes German labour 5 hours to make a dress and 30

hours to make a Refrigerator. Productivity is lower in France and therefore the Unit Labour

Requirement is greater. 60 hours of French labour is required to make a refrigerator and 6

hours are needed to make a single dress. In this example Germany has an absolute

advantage in the production of both goods. However, German production is relatively more

productive in the creation of refrigerators than dresses. French labour takes double the time

to make a refrigerator, but only 6/5 as long to make a dress, compared with German

production. “The opportunity cost of making a unit of one good is the quantity of the other

good that must be given up to create the extra production resources” (Begg et al. pg 254).

The table shows the opportunity cost for each nation, before trade has begun. The

opportunity costs differ due to discrepancies in relative productivity levels in each country. In

Germany the opportunity cost of making a dress is 1/6 of a refrigerator. In France the

opportunity cost is less at 1/10 of a refrigerator. Therefore, France can produce 60 dresses

giving up 6 refrigerators. These 6 refrigerators can be made in Germany at the loss of only

36 dresses.

To summarise, trade between Germany and France means that the overall world economy

would benefits from 24 more dresses with no fewer refrigerators as the opportunity cost is, in

a sense, paid for.

This definition, of comparative advantage, was previously thought of as perfectly acceptable

in the world of Economics and used by countries to determine what they should export.

However, it seems in recent years there has been a need for new trade theory. A theory that

would take into account Stephen Redding’s 1999 theory. He stated that; “The fact that

comparative advantage evolves endogenously over time in theoretical models of growth and

trade has led a number of authors to speak of ‘dynamic comparative advantage’” (Redding,

1999, pg. 32). This new contemporary theory also had to answer why exactly factors of

production had become abundant in places that were previously believed to be relatively

expensive places to produce.

One of the aforementioned new trade theories is the Product Cycle Theory (PCT),

developed by Raymond Vernon in 1966. PCT states that the location of production and trade

activities shifts as the product moves through its individual life cycle. This shifting of

production shows the dynamic nature of comparative advantage very well. Increases in both

capital and labour mobility have meant that producing firms can move all over the world in

search of the cheapest factors of production. The Product Cycle Theory is very effective in

representing the dynamic nature of comparative advantage through its four stages and

careful consideration of both the “innovator” and “imitator”. The stages are outlined below.

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633799 Lewis Marty

Stage one of the theory is known as the New Product Stage. During the New Product Stage,

the product is developed domestically by ‘the innovator’. This can often be very costly as it

requires high levels of capital and skilled labour. Once this is complete the product will be

launched to the domestic market and sold to those with high levels of disposable income.

Stage two (The Product Growth Stage) sees consumption move overseas to other wealthy

countries as the innovator beings to export. The scale of production also increases to a

standardized level as economies of scale begin to take effect.

Stage three, or the Maturing Product Stage, features foreign direct investment taking effect

and production transferring to other technologically advanced countries across the globe.

Competing substitutes begin to gain market share at the expense of the innovator and the

innovators export levels begin to decrease due to competition.

The fourth and final stage of PCT is known as the Standardized Product Stage. This stage

sees production shifted as the innovator commits it’s efforts to searching for ways to reduce

cost and improve efficiencies. The majority of production, by this point, will be done by

imitating countries that have achieved a comparative advantage as a result of abundant

factors of production. By this point in time the previously mentioned innovator will have

gained a comparative advantage in a new product that it has recently developed. This

product will then follow the same path as those before it, continuing the cycle.

The product development and market share growth of the personal computer strictly

followed the Product Cycle Theory. The personal computer saw its development in the

United States, under IBM, before maturing as a product and shifting mass production

overseas. When produced overseas the personal computer was cloned by, inferior, imitation

companies. Eventually the PC became a “standardized” product. Production had more or

less entirely shifted and the saturation stage was complete. By that time the innovator, the

USA, had moved on to bigger and better things.

Nevertheless, the PCT is not optimal by any means. It would be in the USA’s best interest to

continue computer production domestically and export the good overseas. This creates the

question, how can we protect our young domestic industries and continue production within

our own borders. Many believe the answer lies with the implementation of trade protection

methods. There are several prominent trade protection methods that can all be applied to

various degrees with the intention of increasing the competitiveness of the nation’s domestic

industry on an international scale and protecting home-grown production from the fickle

nature of dynamic comparative advantage.

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633799 Lewis Marty

The varying abundance of factors of production plays a major role in encouraging

comparative advantage to act dynamically. Therefore, in order to ensure comparative

advantage does not desert a country the countries government must do what it can to retain

those factors of production and keep relative costs of production down.

Protectionism in the form of tariffs may be very effective by lengthening the maturity stage of

the product cycle theory. It is in this stage of the theory that production shifts and immigrates

overseas, resulting in the innovator starting to see domestic demand for their product begin

to fall. This creates a strong argument that tariffs should be used to keep domestically

produced goods competitive. This can be done very simply as “a tariff is, in effect, a tax

levied on imported goods, usually with the intention of raising the price of imports and

thereby discouraging their purchase.” (Griffiths and Wall 2007, pg 576) This suggests that

the strategic use of tariffs would be the perfect protection for domestic industry and provide

the countries firms with a home field advantage per-se.

Furthermore, a tariff levied on imports would provide the government with a new source of

revenue; which could then find itself given back to domestic firms in the form of a subsidy.

Subsidies can be paid in several different manners such as; cash payments, low-interest

loans and tax breaks. This would allow domestic firms the ability to price themselves at such

a level in which they can compete with previously market dominating foreign firms.

The effects of a subsidy on domestic production can be seen on the graph above. Initially,

domestic production, without a subsidy, is at the point Q1 with imports making up the rest of

the markets supply (Q1-Q2). Post-subsidy, domestic supply increases (shown above as the

4

Domestic

Demand

Domestic Supply

Domestic Supply + Subsidy

World Price & World Supply

Price

Quantity

0 Q1 Q3 Q2



633799 Lewis Marty

parallel shift of the supply curve) and at this level of supply domestic production accounts for

supply from 0 to Q3. Imports have fallen and now only account for Q3-Q2. As you can see a

subsidy is a very effective method of protectionism in the short term. It can provide an

economy with the boost it needs to stay competitive, a boost that can prove vital when

considering the terrible consequences that can arise from a nation losing its comparative

advantage to foreign competition.

Tariffs and subsidies alone may not be enough to protect a country’s domestic industry from

dynamic comparative advantage. Quotas are a very effective method in restricting the

amount of imports a country receives. A quota is a physical limit that restricts the amount of

an imported good that can be sold in a country in a given period. Having such a tight grip on

import levels gives a government the ability to ensure its domestic industries can be

protected, at least in the short term. An example of a quota being placed into practice and

fulfilling its objectives, in the short term, was the Multi-Fibre Agreement (MFA). Brought into

place in 1974 the quota allowed newly developed countries to expand their textile industries

overseas whilst at the same time the quota set a limit to be sure that developed countries

could retain a sense of self sustainability. Eventually the MFA was phased out and replaced

by other forms of protectionism but nevertheless the MFA is a prime example of the way a

quota can protect a countries domestic industry and prevent shifting factor endowments from

migrating overseas.

The dynamic nature of comparative advantage warrants the creation of strategic policy

making. A government that has begun to feel its comparative advantage fade away

internationally must take it upon itself to put in place a series of plans to prevent or slow this

movement. This cannot always be achieved through high profile policy decisions and can

often be prevented through a series of smaller policy decisions. The implementation of

public sector contract schemes and procurement policies is a prime example of this. By

giving preference to domestic firms for public sector contracts a government can inflate

domestic demand at a slight cost to itself. This is often found to be the case in the defencesector and despite this method of protection being against EU regulations it is very rare that

public contracts are given to foreign companies. It is safe to say that it seems, in the real

world, domestic company bias is common.

Like the aforementioned infant industries that require protection from dynamic comparative

advantage in the short term. Senile Industries are also said to require a similar level of short

term protection. A senile industry, as defined by H.P. Gray (cited in Hillman, 1977, pg.155) is

“an efficient industry becoming extinct at a socially unacceptable rate due to economic

developments outside of its control.” The industry cannot harness this comparative

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633799 Lewis Marty

advantage as it is not able to make the necessary profit to pay for needed investment;

without government protection. By protecting these industries in the short term the industry

will be able to compete and achieve supernormal profits. The industry may then re-invest its

profits within itself and improve becoming more competitive in the future. In theory the

protection of senile industries in the short term can be seen as a way for governments to

invest in their own economy and recoup the benefits in the future. This was the case in

Russia after the recession of the late 2000’s. In 2008 the Russian government rereleased

plans for five billion dollars worth of protectionist measures with the hope of reducing

pressure on the Russian Automotive industry and allowing it to find its feet internationally.

The money was vital in encouraging economic growth and since then the Russian

automotive industry has found its feet.

In summary, protectionist measures can be invaluable in preventing failing industries from

losing their factor endowments and with that retaining their competitive edge. As outlined

earlier the dynamic nature of comparative advantage makes retaining a comparative

advantage no easy task and it can be argued that protectionist measures give an industry

enough time to achieve greater levels of efficiency and economies of scale. Therefore

protectionist methods, at least in the short term, are invaluable in preventing nations industry

can uproot and immigrate overseas.

The above arguments for protectionism are all referring to the use of protection in the short

term. Economists and policy setters are left with a conundrum in that protection can have

very negative effects in the long term. What seems like the obvious response to prevent this

is to ensure that protection methods are set with a time frame or a series of targets but it is

not that simple. Once implemented it can be very hard to remove protectionist trade policies

and in actual fact governments very rarely remove protection policies themselves. Friedman

and Friedman (1979, pg 49) summed this up well when, referring to the infant industry

argument they said “The so-called infants never grow up. Once imposed, tariffs are seldom

eliminated.”

A massive consequence of protectionism is the threat of a trade war through international

retaliation. What a nation, say the UK, may see as a job saving protection policy may be

viewed by other nations as a policy directly aimed to restrict their exports and with that their

international market share. This will usually lead to retaliation in the form of tariffs and quotas

levied on British goods. Britain may then retaliate itself leading to a cycle of tariffs and

quotas that make international trade less mutually beneficial. This series of events has

occurred time and time again throughout history between many different nations. This was

seen during the 1990s, when economic wars began between Britain, the United States, Latin

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633799 Lewis Marty

America, and the Caribbean. These “wars” which were fought over tariffs, import licenses,

and the question of free trade, continue until today (Cohen 2007).

As well as the threat of trade wars excessive levels of protection policies may cause a state

in which international resources are misallocated. By artificially increasing the costs of imports, domestic supply increases. If domestic goods cannot be produced as cheaply as

imports then it is possible to argue that encouraging expensive domestic production is a

misallocation of international resources (Griffiths & Wall 2007). Furthermore a World Bank

report (2005) cited in (Griffiths & Wall 2007) concluded that if all trade protection were

eliminated then the global welfare gain would amount to $278bn, with $173bn resulting from

removing agricultural subsidies.

Ultimately protection will artificially manipulate competition and this can create a state in

which the consumer is worse off. By reducing the supply of imports a situation of excess

demand can take effect. This coupled with higher domestic prices will create an environment

in which consumer surplus is reduced. Moreover, lowered competition levels will create

situation in which a country’s overall economic welfare falls.

To summarise, protection based policies can be incredibly useful however they come with

significant drawbacks in the long run. As international trade is growing at a faster rate than

international overall GDP it is imperative that every nation must exploit the incredible gains

that can be found in prosperous trade. A government can do this through strategic protection

policy. Despite this there are many in the world that believe in free trade. They would rather

see trade governed by Adam Smith’s invisible hand theory. I would argue that “to often it is

presumed that the opposite is true: that free trade is welfare enhancing” (Cypher, J and

Dietz, J, 1998, pg 309). I think it is obvious that the international trade of the future will

feature protectionist policies. Countries will be forced to use effective trade policies to retain

comparative advantage; especially as the comparative advantage of the future will be

susceptible to the aforementioned product cycle theory. I think that the Stolper-Samuelson

theorem is very accurate as it “states that when both labour and capital are mobile between

sectors and certain other conditions are satisfied, labour may benefit or suffer from

protection depending on whether labour is the countries scarce or plentiful factor.”

Ultimately, comparative advantage is dynamic and must be retained through protection as it

is essential in the short term. The most successful countries of the future will be those who

can, through effective fiscal and perhaps supply-side policies, prevent the negative long term

effects of protectionist trade policies.

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633799 Lewis Marty

ReferencesBegg, D. Fischer, S. and Dornbusch, R (2003) Foundations of Economics, 2nd Edition, New

York, McGraw-Hill Education.

Cohen, R (2011) Global Issues for Breakfast: The Banana Industry and its Problems, The

Science Creative Quarterly, [online] Available at: http://www.scq.ubc.ca/ [Accessed 14

November 2011]

Cypher, J & Dietz J, (1998) Static and dynamic comparative advantage: multi-period

analysis with declining terms of trade, Journal of Economic Issues (Association for

Evolutionary Economi;Jun98, Vol. 32 Issue 2, p305 - 316

Friedman, M and Friedman, R (1979) Free to Choose – A personal statement, [online] Available at:

http://www.philosophy.thecastsite.com/readings/godwantsyoudead/freetochoose.pdf

[Accessed 17 November 2011].

Griffiths, A and Wall, S (2007) Applied Economics 11th Edition, London, Prentice Hall

Hillman, A. (1977) The Case for Terminal Protection for Declining Industries, Southern

Economic Journal, 44 (1) pp 155 – 160 [online] Available

at:http://www.jstor.org/pss/1057310 [Accessed 27 November 2011]

Redding, S (1999) Dynamic Comparative Advantage and the Welfare Effects of Trade,Oxford Economic Papers, 51 pg 15 - 39

Sloman, J (2006) Economics 6th Edition, London, Prentice Hall.

BibliographyNaumov, I (n.d) Prime Minister Vladimir Putin is confident that the automotive industry in

Russia's Far East has a future

IBM Corporate Archives (2002) IBM Global Services: A Brief History

Neumann, E (Working Paper 2006) The Multifibre Agreement – WTO Agreement on Textiles

and Clothing

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http://www.scq.ubc.ca/global-issues-for-breakfast-the-banana-industry-and-its-problems-faq-cohen-mix/


http://www.scq.ubc.ca/


http://www.jstor.org/pss/1057310


http://www.scq.ubc.ca/


http://www.jstor.org/pss/1057310

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EC-228 Essay - Comparative Advantage Final

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