Today trade policy tends to focus more on " competitive advantage " as opposed to "comparative advantage".
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One of the most in-depth research undertakings on "competitive advantage" was conducted in the s as part of the Reagan administration 's Project Socrates to establish the foundation for a technology-based competitive strategy development system that could be used for guiding international trade policy. Several arguments have been advanced against using comparative advantage as a justification for advocating free trade, and they have gained an audience among economists.
For example, James Brander and Barbara Spencer demonstrated how, in a strategic setting where a few firms compete for the world market, export subsidies and import restrictions can keep foreign firms from competing with national firms, increasing welfare in the country implementing these so-called strategic trade policies.
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However, the overwhelming consensus of the economics profession remains that while these arguments against comparative advantage are theoretically valid under certain conditions or assumptions, these assumptions do not usually hold. Thus, these arguments should not be used to guide trade policy.
There are some economists who dispute the claims of the benefit of comparative advantage. James K. Galbraith has stated that "free trade has attained the status of a god" and that " But this is not generally the case. For manufactured products, increasing returns, learning, and technical change are the rule, not the exception; the cost of production falls with experience.
With increasing returns, the lowest cost will be incurred by the country that starts earliest and moves fastest on any particular line. Potential competitors have to protect their own industries if they wish them to survive long enough to achieve competitive scale. Galbraith summarizes: "Comparative advantage has very little practical use for trade strategy. Diversification, not specialization, is the main path out of underdevelopment, and effective diversification requires a strategic approach to trade policy.
It cannot mean walling off the outside world, but it is also a goal not easily pursued under a dogmatic commitment to free trade. According to historian Cecil Woodham-Smith , Ireland in the s is an example of the dangers of over-specialization. When the union with Great Britain was formed in , Irish textile industries protected by tariffs were exposed to world markets where England had a comparative advantage in technology, experience and scale of operation which devastated the Irish industry.
Ireland was forced to specialize in the export of grain while the displaced Irish labor was forced into subsistence farming and relying on the potato for survival. When the potato blight occurred the resulting famine killed at least one million Irish in one of the worst famines in European history. As Woodham-Smith would later comment, "the Irish peasant was told to replace the potato by eating his grain, but Trevelyan once again refused to take any steps to curb the export of food from Ireland.
The classical and neoclassical formulations of comparative advantage theory differ in the tools they use but share the same basis and logic. Comparative advantage theory says that market forces lead all factors of production to their best use in the economy. It indicates that international free trade would be beneficial for all participating countries as well as for the world as a whole because they could increase their overall production and consume more by specializing according to their comparative advantages.
Goods would become cheaper and available in larger quantities. Moreover, this specialization would not be the result of chance or political intent, but would be automatic. However, at least some theories of free trade and comparative advantage require certain assumptions to achieve an ideal, or optimal, scenario. While these assumptions are not necessary for comparative advantage to produce positive results, situations where these assumptions are not true will produce less effective results . These assumptions include:.
The international immobility of labour and capital is essential to the theory of comparative advantage. Without this, there would be no reason for international free trade to be regulated by comparative advantages. Classical and neoclassical economists all assume that labour and capital do not circulate between nations. At the international level, only the goods produced can move freely, with capital and labour trapped in countries.
David Ricardo was aware that the international immobility of labour and capital is an indispensable hypothesis. He devoted half of his explanation of the theory to it in his book. He even explained that if labour and capital could move internationally, then comparative advantages could not determine international trade.
Ricardo assumed that the reasons for the immobility of the capital would be: . However, this criticism does not apply to modern theories. Neoclassical economists, for their part, argue that the scale of these movements of workers and capital is irrelevant. They developed the theory of price compensation by factor that makes these movements superfluous  :.
While ricardo assumes that capital and labour cannot move internationally, modern theories assume that international mobility is unnecessary because international commodity trade will lead to the same result through an equalisation of factor prices.
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An externality is the term used when the price of a product does not reflect its cost or real economic value. The classic negative externality is environmental degradation, which reduces the value of natural resources without increasing the price of the product that has caused them harm. The classic positive externality is technological encroachment, where one company's invention of a product allows others to copy or build on it, generating wealth that the original company cannot capture.
If prices are wrong due to positive or negative externalities, free trade will produce sub-optimal results. For example, goods from a country with lax pollution standards will be too cheap. As a result, its trading partners will import too much. And the exporting country will export too much, concentrating its economy too much in industries that are not as profitable as they seem, ignoring the damage caused by pollution. On the positive externalities, if an industry generates technological spinoffs for the rest of the economy, then free trade can let that industry be destroyed by foreign competition because the economy ignores its hidden value.
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Some industries generate new technologies, allow improvements in other industries and stimulate technological advances throughout the economy; losing these industries means losing all industries that would have resulted in the future. Comparative advantage theory deals with the best use of resources and how to put the economy to its best use. But this implies that the resources used to manufacture one product can be used to produce another object. If they cannot, imports will not push the economy into industries better suited to its comparative advantage and will only destroy existing industries.
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For example, when workers cannot move from one industry to another - perhaps because they do not have the right skills and cannot be trained, or do not live in the right place and cannot move - changes in the economy's comparative advantage will not shift them to a more appropriate industry, but rather to unemployment or precarious and unproductive jobs. Comparative advantage theory allows for a "static" and not a "dynamic" analysis of the economy.
That is, it examines the facts at a single point in time and determines the best response to those facts at that point in time, given our productivity in various industries. But when it comes to long-term growth, it says nothing about how the facts can change tomorrow and how they can be changed in someone's favour. It does not indicate how best to transform factors of production into more productive factors in the future. According to theory, the only advantage of international trade is that goods become cheaper and available in larger quantities.
Improving the static efficiency of existing resources would therefore be the only advantage of international trade. And the neoclassical formulation assumes that the factors of production are given only exogenously. Exogenous changes can come from population growth, industrial policies, the rate of capital accumulation propensity for security and technological inventions, among others. Dynamic developments endogenous to trade such as economic growth are not integrated into Ricardo's theory. And this is not affected by what is called "dynamic comparative advantage". In these models, comparative advantages develop and change over time, but this change is not the result of trade itself, but of a change in exogenous factors.
However, the world, and in particular the industrialized countries, are characterized by dynamic gains endogenous to trade, such as technological growth that has led to an increase in the standard of living and wealth of the industrialized world. In addition, dynamic gains are more important than static gains. A crucial assumption for ideal results in both the classical and neoclassical formulation of comparative advantage theory is that trade is balanced, which means that the value of imports is equal to the value of each country's exports.
The volume of trade may change, but international trade will always be balanced at least after a certain adjustment period. The balance of trade is essential for theory because the resulting adjustment mechanism is responsible for transforming the comparative advantages of production costs into absolute price advantages.
And this is necessary because it is the absolute price differences that determine the international flow of goods. Since consumers buy a good from the one who sells it cheapest, comparative advantages in terms of production costs must be transformed into absolute price advantages. In the case of floating exchange rates, it is the exchange rate adjustment mechanism that is responsible for this transformation of comparative advantages into absolute price advantages. In the case of fixed exchange rates, neoclassical theory suggests that trade is balanced by changes in wage rates. So if trade were not balanced in itself and if there were no adjustment mechanism, there would be no reason to achieve a comparative advantage.
In the short term, trade imbalances are the norm and balanced trade is in practice only an exception. However, this criticism becomes irrelevant in the long term . The assumption that trade will always be balanced is a corollary of the fact that trade is understood as barter.