Theory of Comparative Advantage and Factor Endowment Theory

Theory of Comparative Advantage

Theory of Comparative Advantage

In the nineteenth century, English economist David Ricardo proposed this hypothesis. In his book "Principles of Political Economy and Taxation (1817)," Ricardo made the case that both countries would still gain from the production of all goods by one country even if it had a clear advantage. Therefore, a nation's comparative advantage in manufacturing things in comparison to other nations. According to the tenet of this theory, countries should produce the items for which they have the greatest comparative advantage.

In the nineteenth century, English economist David Ricardo proposed this hypothesis. In his book "Principles of Political Economy and Taxation (1817)," Ricardo made the case that both countries would still gain from the production of all goods by one country even if it had a clear advantage. Therefore, a nation's comparative advantage in manufacturing things in comparison to other nations. According to the tenet of this theory, countries should produce the items for which they have the greatest comparative advantage. Portugal may export wine in exchange for fabric since doing so would be cost-effective. Despite the fact that it takes 90 men to create fabric, Portugal would benefit from importing it from a nation where it takes 100 men to do so since it is advantageous for Portugal to use its capital to produce wine, for which it would import additional cloth from England. Then, instead of investing in the production of wine, invest in the production of fabric. Here, England's comparative advantage can be observed in the fabric whereas Portugal's is in the wine.

Through the concept of opportunity cost, one may comprehend the country's comparative advantage in producing goods. The opportunity cost of a good X is the quantity of other products that must be sacrificed in order to generate an additional unit of that good. If a country has a cheaper opportunity cost to produce a good at home than in another country, it has a comparative advantage in doing so. Portugal has a lower opportunity cost for producing wine than England does for creating cloth in the example of England and Portugal given above. England will import wine and export fabric in commerce with these nations. Similar to this, Portugal will import cloth and export wine.

The sources of comparative advantage have an impact on how the theory of comparative advantage is applied. In the modern, industrialized economy, differences in comparative production costs, production methods, and pricing of production inputs can be used to explain comparative advantage. Land, labor, capital, technology, and natural resources are all production-related elements. These serve as the production process' inputs. In the modern world, raising a nation's exports and luring international investment depend on the quality of its production elements. Due to the fact that the factor endowment theory of international business provides a clearer explanation, factor endowment in today's global business environment should also take into account the quality of the production elements.

The concepts of absolute advantage and comparative advantage appear to be very similar. There are, however, a few minute variations. Comparative advantage examines disparities in productivity, whereas absolute advantage examines differences in productivity. On the opportunity cost component that the comparative advantage theory includes, more distinction can be noted.

Factor Endowment Theory

This idea, also referred to as the Hecksher-Ohlin theory, was created by the Swedish economists Berlin Ohlin and Eli Heckscher in 1933. According to this idea, variations in factor endowment cause competitive advantages. When people talk about a country's factor endowments, they're referring to how much land, labor, money, and other natural resources are readily available there. The countries have different levels of factor endowments' accessibility and excellence. The cost of production will be lower the bigger the factor endowment. The basic tenet of the factor endowment theory is that countries will export commodities that utilize locally accessible components effectively and extensively while importing things for which resources are scarce.

The theory also states that the country with capital abundance will export capital-intensive goods while the labor-abundant country will export labor-intensive goods. Capital intensive countries are those countries which have high capital accumulation rate in comparison to other countries. Such countries can invest in those sectors which require more capital investment. Similarly, labor intensive countries are those which utilize high labor force in the production of goods. Such countries are least developed countries. If these countries will not trade the prices of each good fall down due to economies of scale. When trade takes place, the price will rise as the profit-seeking firms will move their goods to other markets. Trade flows will rise until the price of both goods is equalized in both markets.

A nation performs best with its resources and is generally efficient in those areas where it is more suited. For instance, compared to other nations, the USA has greater capital abundance than labor. Therefore, it imports labor-intensive commodities and exports goods that employ more capital, such motor cars (e.g., clothing).

The theories of factor endowment make specific assumptions. It starts off by assuming that different nations have various production factors. Second, it is assumed that each commodity has a unique production function and that the production functions of specific items are the same everywhere in the globe. The output that can be created using the specified amount of labor and capital is shown by the production function. In other words, the same level of inputs (also known as factors of production) will result in the same quantity of output in every nation. Thirdly, it is assumed that technology is constant throughout the nation and that it is used uniformly throughout the production process. Finally, the needs for production inputs are the same across all nations. Despite the same demand, the supply of production elements varies.

The following is a list of the theory's main implications:

• Higher trade and trade benefit between such countries will arise from the greatest economic structural differences between them.
• Exports of items that heavily rely on locally plentiful resources are encouraged.
• Between nations, especially those with very similar relative factor endowments and more open mutual trade, free trade should bring factor prices closer to parity.

References

Shenkar, O., Luo, Y., & Chi, T. (2015). International Business. New York: Sage.

Yip, G. S. (n.d.). Total Global Strategy: Managing for Worldwide Competitive Advantage. 1995: Englewood Cliffs, NJ : Prentice-Hall.