Evolution Of The Principle Of Comparative Advantage Economics Essay

From the early 19th century, new outlooks on trade theory have influenced how countries have engaged in production. One of the most significant developments in this area was that of ‘comparative advantage’. Comparative advantage refers to the ability of a country to produce one good at a lower opportunity cost than another. Comparative Advantage argues that all countries will gain from trade, even those that are relatively inefficient in the production of goods. All countries will gain, even those with an absolute disadvantage in the production of all goods, as opposed to with Absolute Advantage, which refers to the ability of a country to produce one good at a lower opportunity cost than another.

In this essay, I intend to discuss how the theory of comparative advantage has come into being, from its inception in the early 1800s, through the neo classical period and into the modern era. This discussion will look at the variations on the theory proposed by some of the leading economists in the field of international trade, and how they viewed and expanded upon the original law of comparative advantage.

In looking at how the law has developed over the past two centuries, my aim is to show the principle’s uses in describing how international trade is conducted to this day. In the latter sections of the essay, I will refer to empirical evidence that tests if comparative advantage predicts accurately patterns of international trade.

Comparative Advantage

Adam Smith illustrated an early understanding of the benefits that could be gained by focusing on the production of goods that the population was most efficient at producing: ‘If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage’ (Smith,1776,295). This idea demonstrated Smith’s understanding of the concept of absolute advantage, whereby gain is realised in exchange between two men who are superior in the production of one good.

The principle of comparative advantage was first presented in the work of Robert Torrens in his 1815 ‘Essay on the External Corn Trade, where Torrens discussed Absolute Advantage in substantial detail and explained how it was beneficial for a country to engage in trade for a commodity even if the host country could produce the same good at a lower actual cost than the country it was trading with. However, it is David Ricardo who is widely credited with the first complete formulation of the theory of comparative advantage in 1817.

Ricardo recognised that absolute advantage was only a limited version of a more general theory. His early understanding of the theory of comparative advantage is displayed in the quote: ‘Two men can both make shoes and hats, and one is superior to the other in both employments; but in making hats he can only exceed his competitor by one-fifth or 20 per cent; and in making shoes he can excel him by one-third or 33 per cent: will it not be in the interest of both that the superior man should employ himself exclusively in making shoes, and the inferior man in making hats?’ (Ricardo,1817, p136).

The assumptions in his reasoning can be seen in Kemp & Okawa’s review of the formulation of comparative advantage, where they set out a model in which both countries are initially autarkical, then subsequently open up to a free trade environment, that all countries have at their disposal the potential to produce all possible commodities, and that in a state each country involved is able to consume all of these commodities. (2006,468).

John Aldrich was recorded as saying, ‘Torrens, Ricardo and Mill all made contributions to the discovery of comparative advantage, not by a major multiple discovery but through a sequence of insights and arguments’ (Aldrich, 2004, 379). James Mill studied and subsequently ratified Ricardo’s view on the existence and viability of comparative advantage in 1821 when he said ‘When two men have more than they need, it will be a great accommodation to both if they can perform an exchange of a part of the food of the one for a part of the cloth of the other, and so in other cases’ (1821,63). In his treatment of the principle, he provided one of the clearest explanations and examinations of the workings of comparative advantage, rectifying much of the ambiguity of Ricardo’s exposition. His work enhanced the status of the principle of comparative advantage in economic circles by illustrating its viability through the use of numerous numerical examples.

John Stuart Mill, son of James Mill, studied and subsequently made refinements to the theorem introduced by his father. Through his work, comparative advantage gained more universal acceptance as an explanation of the benefits of trade in the mid 19th century. He was responsible for ‘the rational reconstruction of Ricardo in which the labour cost coefficients were interpreted as the amounts used in each unit of a good produced rather than Ricardo’s labour cost of producing the amounts contained in a typical trading bundle'(Ruffin,2002,727-748). Some of Mill’s most prominent work in the field of comparative advantage can be seen in his 1844 “Theory of international values” which aided the economic community to come to ‘a fuller understanding and appreciation of the centrality of comparative cost in trade theory’ (Gomes,2003).

In 1930, Gottfried Haberler of the neo-classical school of economics provided a modern interpretation of the theory of comparative advantage which generalised and separated it from David Ricardo’s labour theory of value, helping to form the foundations of modern trade theory. Haberler believed that it was ‘possible to reformulate the theory in such a way that its analytical value and all conclusions drawn from it are preserved, rendering it at the same time entirely independent of the labor theory of value’ (Bernhofen,2005,998). His work indicated that comparative advantage is about resource allocation, and adapted it into a more general principle that accommodated non-linear production frontiers. Kemp and Okawa state that Haberler indicated that the relative opportunity costs of producing determines both the direction of free international trade and the manner in which gains from this trade are shared by trading partners (2006,1).

The next significant progression in the development of the theory was through the work of two Swedish economists – Eli Heckscher and Bertil Ohlin. Their theory examined the reasons behind the differences in comparative costs. The Heckscher-Ohlin model introduced new ideas which differed from the classical approach. Factors of production are taken into account for the first time, of which the two primary ones were labour and land (Eicher, Mutti & Turnovsky,2009,68). The theory explains how countries of similar technological levels can trade, how trade affects the distribution of wealth in the economy and how growth in an economy affects trade.

Their model was based on two assumptions. Firstly; that countries would no longer differ in terms of technology, but rather by their endowment of factors of production. This meant that countries would be concerned with relative differences in labour and capital abundances compared to their trading partner. The second assumption was that goods differ by the factors of production they require. They explained that the more abundant a factor of production was, the greater the likelihood that it would be cheaper to produce their specialised goods and hence, the opportunity cost of producing goods which were reliant on this factor would be lower – in other words, that the source of comparative advantage resided in the factor endowments of a country (Viner,1937). This implies that countries would have a comparative advantage in producing goods that their abundant factor of production. For example, countries with an abundant supply of labour would reap the greatest benefits by focusing their specialism on labour intensive products.

The benefits of the H-O theory compared to the theory of comparative advantage were that: it offered; a better means of explaining observed trade patterns, the ability to develop implications about how trade affects wages and returns on capital, it shows the economic growth on trade and it offers a more thorough explanation of political groups on trade.

A further development of H-O theory was the Stolper-Samuelson theorem which shows that the owners of scarce/abundant factors are disadvantaged/benefited when an economy opens up for trade and specializes in the production of the good that is intensive in its use of the abundant factor – a discovery that was beneficial in the understanding of the politics behind free trade and protectionism. The theory states that during increase in the price of an abundant factor and the fall in the price of the scarce factor, and that the owners of the abundant factor will find their incomes rise the owners of the scarce resource will see their real incomes fall. Rogoff states that their paper was the first to demonstrate the ‘Heckscher-Ohlin theorem’ in a two good, two country, two factor (labour and capital) model. The H-O theorem shows that with identical technologies at home and abroad, the country with the larger endowment of labour relative to capital should export the labour intensive good.

This advancement of the theory aided the thinking about trade between countries with widely different capital-labour ratios. (Rogoff,2005,8).

Chipman and Inoue state that for their theory, the following assumptions are made:

1. All trade takes place in a free trade environment, with no transport costs attached.

2. The factors of production, labour and capital, are freely mobile between industries within countries, while at the same time being immobile between countries.

3. The production functions neoclassical and constant over time.

4. The endowment of labour in each country is constant over the two periods (2001,2).

Contemporary research by economists such as Helpman & Krugman (1985) adapts traditional comparative advantage theory by relaxing some of the assumptions that underlie the contemporary specification of the principle, such as economy of scales and product differentiation. Nowadays, the comparative advantage theory can be further developed by including new aspects, such as specialization, technological differences and aspects of game theory (Tian, 2008).

Comparative advantage may appear to be somewhat paradoxical, in the sense that it states that, under a certain set of conditions, a country should produce and export a good that its workforce is not particularly skilled at producing when compared directly to the workforce of another country. However, it holds true when it is explained that when two countries who each hold a comparative advantage in a particular good engage in trade with one another, trade between these nations raises both of their real incomes, on the condition that there is a relative gap between the costs of the same types of products in production by the countries engaging in trade. Ricardo’s model shows that, if a country wants to maximise gain, it must strive to fully employ all of its resources. It should then allocate its resources to each these resources to its comparative advantage industries, and subsequently, it should aim to operate in a free trade environment, which will benefit all trading partners involved.

It can be seen how comparative advantage is still a useful and important concept in explaining international trade. Jones and Neary conferred their opinion on the ongoing validity of the theory: ‘While the principle of comparative advantage may thus be defended as a basic explanation of trade patterns, it is not a primitive explanation, since it assumes rather than explains inter-country differences in autarkic relative prices’ (Reinert, Rajan & Glass,2009,199).

Revealed comparative advantage is an index devised by Bella Balassa used to calculate the relative advantage or disadvantage a country may have in a specific class or category of goods or services. This advantage can be assessed through analysing trade flows. The index attempts to uncover a revealed comparative advantage by assessing the country’s specialism in exports in relation to others. It is a highly useful means of assessing how useful Comparative advantage is in explaining contemporary trade patterns.

A large number of empirical tests of comparative advantage have been undertaken to test the theory of comparative advantage. MacDougall tested the hypothesis that the export ratios of two countries to a third market were a function of labour productivity ratios of the two countries in question. The results were supportive of the Ricardian model, and his work demonstrated that trade between the United States and the United Kingdom in 1937 followed Ricardo’s prediction.

CONCLUSION

Throughout this essay, it can be seen how the ideas forged in the original theory of comparative advantage have eminently formed a large part of the basis for understanding how international trade is conducted today. Since its advent, attaining a comparative advantage has been heavily reliant on recognising and exploiting the natural resources and competencies that are present within a country. Even to this day, countries specialise their economies depending on the factors of production that enable them to produce most efficiently, all the while recognising that holding a comparative advantage is a cornerstone of effective trade practices.

In the modern era and most likely in the coming years, comparative advantage is likely to continue to become an increasingly more man made factor, with the utilisation of new technologies resulting in the likelihood of significantly increasing production efficiency, and thus affecting the areas on which a country holds an absolute and comparative advantage.

Although the original theory of comparative advantage may not subscribe to the current economic environment, it is still a relevant means of determining the most beneficial trading strategy for a country’s economy. Adaptations to the theory since its inception have facilitated the continued utilisation of the idea in the current climate. According to Gale, the changes that have taken place over time are a product of globalisation, for example, new ‘trade barriers and changes in agricultural policy have caused a decrease in some countries manufacturing prowess and has resulted in a subsequent reduction in its comparative advantage’ (2002,27).

The current trend of globalization means that the assumptions associated with comparative advantage are becoming increasingly more difficult to apply.  Despite this, it is still a relevant means of describing international trade patterns today and the ways in which a country can best exploit its natural endowment of resources. To reinforce this point, Paul Samuelson has stated that comparative advantage ‘is the only law of economics which can stand comparison with the laws generated by hard sciences. Modern conditions may cloud “our” law but, suitably qualified, it still holds’ (Gray,2000,316). Through my research into the growth of comparative advantage from its inception, I believe that the concept still aptly demonstrates the fundamental importance of the effects, determinants and nature of international trade.

Bibliography

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Introduction

In the course of this essay, I intend to outline the development of the principle of the quantity theory of money, from its initial inception in the 16th century right up to the current outlook on the theory in the 21st century. Subsequently I hope to outline the theory’s importance as a catalyst for the development of monetarism in the 20th century, and outline how monetarism has progressed since that point in time.

The quantity theory of money provides a means of answering the question ‘what gives money value?’ We know that intrinsically, a bank note is a valueless piece of paper and ink, and that its perceived value stems from the quantity of it in supply. Due to the value of money being variable, a change in money demand or supply will yield a change in the value of money and in the price level. The more money that is in circulation means that each individual bill becomes worth less. This will result in it taking more bills to purchase goods and services, and as a result, price level will increase accordingly.

The quantity theory of money states that the value of money is based on the amount of money in the economy – that the nominal money supply is a function of the equivalent changes in price levels as it relates to the demand for money necessary to meet the needs of current transactions. For example, in Ireland, according to the theory, when the central bank increases the money supply, the value of money falls and the price level increases.

Main body

The theory states that a one-time change in the stock of money has no lasting effect on real variables but will lead to a proportionate change in the money price of good. In other words, it declares that money’s value or purchasing power varies inversely with its quantity.

To this day, there exists prevalent academic discussion as to who developed the theory. The first possible statement of the quantity theory of money originated in the work of Nicholaus Copernicus In 1526, when Copernicus wrote a study on the value of money, ‘Monetae cudendae ratio’, in which he noted the increase in prices following the import of gold and silver from the new world. He expressed the findings of his studies into the value of money, and in this work, he formulated a version of the quantity theory of money. Copernicus observed that the value of money would fall if it was issued to excessive quantities, to the point where it was almost valueless.

Volckart notes that “Money can lose its value through excessive abundance, if so much silver is coined as to heighten people’s demand for silver bullion. For in this way, the coinage’s estimation vanishes when it cannot buy as much silver as the money itself contains. The solution is to mint no more coinage until it recovers its par value” (1997,433).

Jean Bodin took a different stance in the middle of the sixteenth century. In 1568, he drew attention to the influx of gold and silver into Spain, and consequently the rest of Europe, from the Americas. He argued that the price level had risen along with the stock of bullion available for monetary purposes and was able to draw a conclusion about the link between these events. John Locke accepted this idea and stated the Quantity Theory of Money as a general rule, that if the supply of money increased, the prices of all goods will rise. If money supply fell and the prices of goods fell, than the prices of foreign goods would rise relative to domestic goods “both of which will keep us poor” (Locke, 1692).

The first concise statement about the existence of a quantity theory was that made by David Hume in 1752. His theory stated that the general level of prices depended upon the quantity of money currently in circulation.

“Where coin is in greater plenty; as a greater quantity of it is required to represent the same quantity of goods; it can have no effect, either good or bad that great plenty of money is rather disadvantageous, by raising the price of every kind of labour.” (Hume, 1752, Pg 15)

He also outlined the relationship between supply of money and prices ‘All augmentation (of gold and silver) has no other effect than to heighten the price of labour and commodities; and even this variation is little more than that of a name (Hume, 1752, 296-7)’.

Alfred Marshall’s version of the quantity theory was an attempt to give microeconomic underpinnings to the macroeconomic theory that prices and the quantity of money varied directly. He did this by elaborating a theory of household and firm behaviour and integrating it with the macroeconomic question with the macroeconomic question of the general level of prices to explain the demand for money. Marshall reasoned that households and firms would desire to hold in cash balances a fraction of their money income

In the late nineteenth and early twentieth centuries, two versions of the theory competed. One advanced by the American economist Irving Fisher, treated the theory as a complete and self-contained explanation of price level. The other, propounded by the Swedish economist Knut Wicksell, saw it as part of a broader model in which the difference between market and natural rates of interest jointly determine bank money and price level changes.

Fisher, in particular spent considerable effort in discussing ‘the temporary effects during the period of transition separately from the permanent or ultimate effects (which) follow after a new equilibrium is established – if, indeed, such a condition as equilibrium may be said ever to be established’ (Fisher,1911,p55-6). In this statement, he finds that the quantity theory will not hold true strictly during transition periods. His work was a forerunner in what would later become known as monetarism. He attempted to take the classical school’s equation of exchange and convert it into a general theory of price and price level.

The contrasts between the two approaches were striking. Fisher’s version was consistently quantity theoretic throughout and focused on the classical propositions of neutrality, money-to-price causality, and independence of money supply and demand. By contrast, Wicksell’s version contained certain elements seemingly at odds with the theory.

These elements included a real shock explanation of monetary and price movements, the absence of currency in the hypothetical extreme case of a pure credit economy, and the identity between deposit supply and demand at all price levels in that same pure credit case rendering prices indeterminate.

Wicksell tried to develop a theory of money that explained fluctuations in income as well as fluctuations in price levels. He argued that the quantity theory of money failed to explain why the monetary demand for goods exceeds or falls short of the supply of goods in given conditions.

The quantify theory fell into disrepute in the 1930s, in part because it seemed at the time that the theory could not explain the Great Depression, and partly because of the publication in 1936 of Keynes’s theory. Although some economists continued to advocate the quantity theory, many economists became Keynesians and simply viewed the quantity theory as a historical curiosity. Only in the mid and late 1950s did the quantity theory once again emerge as a plausible rival to the Keynesian theory.

There were several reasons for the revival. Contrary to the prediction of many Keynesians, upon the conclusion of World War II, the American economy did not revert to the depressed conditions of the 1930s, but instead underwent inflation. Secondly, one of the benefits of the Keynesian revolution had been its demonstration that by manipulating expenditures and taxes, governments can keep the economy close to full employment. In fact, it emerged that there were serious political as well as economic difficulties in actually changing government expenditures and tax rates in this ways, and that Keynesian theory in this area was less useful than it had been thought originally.

However the resurgence of the quantity theory should not be attributed merely to impersonal historical events. It is also due to the fact that several influential economists advocated this theory. Don Patinkin of Hebrew University restated the quantity theory in a rigorous way that avoids many of the crudities that infested earlier expositions.

Milton Friedman, of the University of Chicago was influential in providing a framework that allowed one to test empirically the proposition that changes in the quantity of money dominate changes in income. Moreover Friedman and Anna Schwartz of the National Bureau of Economic Research argued in a lengthy study that the experience of the Great Depression should be interpreted as confirming the prediction of the quantity theory rather than that of Keynesian theory.

Subsequently they showed that in both the United States and Britain, longer run movements in nominal income were highly correlated with movements in the money stock.

Despite the resurgence of the Quantity Theory in the 1970s and early 1980s it is still far from universally accepted by economists. Controversies about the theory’s validity and applicability still exist, featuring similar questions and themes regarding the Quantity Theory of Money that have arisen since the 18th century. These include the definition of money, the relationship between correlation and causation, and the transmission mechanism. Controversy has continued because of the technical difficulty of sorting out the direction of causation running between money and prices, and because ideological concerns about the viability of market mechanisms are at stake.

The first instance of Monetarism stems from the ideas of Irving Fisher. The ideas that produced the quantity theory of money go back to the time of David Hume, and arguably earlier. However, the equation of exchange and the transformation of the quantity theory of money into a tool for making quantitative analyses and predictions of the price level, inflation, and interest rates were due to the contributions of Irving Fisher. The theory provides a theoretical basis for monetarism, and there is empirical evidence to show that the quantity theory does operate. For example, as the Spanish brough gold back from the new world, the money supply increased in their native Spain. In line with the theory, prices rose because there was no corresponding increased in the transactions demand for money which is a function of an increase in output.

This initial formulation of monetarism fell short on the question of understanding business cycle fluctuations in employment and output. Due to a flaws and a lack of sophistication of this first form of monetarism, some economists became disillusioned with monetarist analysis. One of these economists, John Maynard Keynes, stated that the quantity-theoretic analysis was of little use expanded on these initial contributions.

Many economists agreed with Keynes’s evaluation of monetarism, most notably Milton Friedman. According to Friedman, there was a belief in the value provided by the quantity theory of money, the quantity theory of money provides the best way of understanding monetary behaviour (1971, 2-3), and that ‘substantial changes in prices and nominal income are almost invariably the result of changes in the nominal supply of money (Friedman, 1968, 434)’.

Following this, came the emergence of the Old Chicago Monetarism of Viner, Simons and Knight. This form of Monetarism emphasised the variability of velocity and its potential correlation with the rate of inflation. In economic policy they blamed monetary forces that caused deflation as the source of depression. According to Viner, in order to remedy economic depression, use of large scale stimulative monetary expansion, large government deficits or policies which encouraged deflation, should be balanced. The exponents of Old Chicago Monetarism did not believe that the velocity of money, in other words – the rate at which money is exchanged from one transaction to another, was stable. They also did not believe that control of the money supply was straightforward or that the velocity of money was stable, because inflation lowered and deflation raised the opportunity cost of holding real balances.

Classic monetarism emerged from Old Chicago Monetarism. It was described by Friedman in 1953, as well as in the works of Brunner (1968) and Brunner and Meltzer (1972). Classic Monetarism contained elements of institutional reform, analytical thinking and views on the political economy. J. Bradford De Long discusses how classic monetarism contained empirical demonstrations which showed that money demand functions could retain stability under the most extreme hyperinflationary conditions. It contained studies which analysed the limits imposed on stabilization policy by lags of policy instruments and also the belief that the natural rate of unemployment is close to the average rate of unemployment. (2000, 83-94).

Political Monetarism argued not that velocity could be made stable if monetary shocks were avoided, but that velocity was in fact already stable. As a result, money stock emerged as a sufficient statistic for forecasting nominal demand. Political Monetarism argued that the central bank controlled shifts in the money supply. As a result, the view was taken that everything that went wrong in the macroeconomy was a direct result of the central bank failing to make the money supply grow at the appropriate rate. Political Monetarism concluded that any policy that does not affect “the quantity of money and its rate of growth” simply cannot “have a significant impact on the economy.”

Conclusion

Since it was first proposed, the quantity theory of money has continually remained at the forefront of contemporary economic discussion. It has survived through profound changes to the worldwide currency structure over several hundred years, as well as through rigorous critiquing from the minds at the forefront of economics thinking.

Theory has withstood the test of time, but has in turn been expanded upon by Neo-classical economists to facilitate the addition of precautionary and speculative demands for money to the transactions demand for money.

The quantity theory may be the oldest theory that still features prominently in economics. The vitality of the quantity theory lies in the fact that it has been able – explicitly or implicitly – to apply an identity, the equation of exchange, to ever changing historical circumstances and institutional change. From its origins, it has been used as a means of explaining why inflation was occurring thus resulting in a population’s purchasing power was being eroded, such as during the exploration of the New World. More recently, the theory has been used as a more contemporary means of assessing how prices and output can affect the quantity of money.

The theory contributed to the understanding of the price revolution, whereby excessive inflation was recorded due to the large influx of bullion, while later the theory has formed the theoretical basis for controversies about the links between bank money, paper money and bullion. When the last remainders of the gold standard vanished, the theory was referred to as one that advocated monetary targeting. Nowadays, it continues mainly as a theory of inflation. As the history of money shows, the quantity theory has survived profound changes to the currency system, so that we can be confident that it will also cope with the next set of challenges it faces and continue to produce predictions with empirical content.