Evaluating comparative advantage and its limits

Overview

Difference between static and dynamic comparative advantage, three sources from which a country's comparative advantage can arise and inter-industry and intra-industry trade.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Evaluate the usefulness of comparative advantage as an explanation of the pattern of world trade.

   Model answer

   It is genuinely useful because it explains why trade is mutually beneficial even between very unequal partners, it identifies opportunity cost rather than productivity as the driver, and it supplies the case for reducing trade barriers. Against this, it is a two-country two-good model with constant costs, no transport costs, perfect factor mobility within countries, immobile factors between them and no scale economies, none of which holds exactly. It also predicts inter-industry trade, whereas a large share of actual trade is intra-industry exchange of similar goods between similar rich economies, better explained by variety, branding and increasing returns to scale. The theory therefore remains a powerful organising idea for broad patterns while needing supplementary explanations for the detail.

2. 2

   How do transport costs weaken the case for specialising according to comparative advantage?

   Model answer

   Transport, insurance and handling costs are a wedge between the price the exporter receives and the price the importer pays, and this wedge narrows the range of terms of trade at which both parties gain. If the cost of shipping exceeds the difference in opportunity costs, the trade that the theory recommends will not be worth making. This is why heavy, bulky or perishable goods such as aggregates, fresh milk and ready-mixed concrete are traded far less than their comparative cost differences alone would suggest.

3. 3

   Why does the assumption that factors of production move freely within a country but not between countries matter for judging comparative advantage?

   Model answer

   The model needs internal mobility so that workers and capital released by the contracting industry are absorbed by the expanding one, which is what turns a change of specialisation into a national gain. In practice labour is occupationally and geographically immobile, so displaced workers in an import-competing industry may face structural unemployment rather than a new job in the export sector. The national gain is then real but unevenly distributed, and the losers are concentrated in identifiable regions and occupations while the gains are thinly spread across all consumers.

4. 4

   What is the difference between static and dynamic comparative advantage, and why does it matter for policy?

   Model answer

   Static comparative advantage takes technology, skills and capital as given and asks what a country should specialise in today. Dynamic comparative advantage recognises that these endowments themselves change, through education, investment, research and learning by doing, so a country can acquire an advantage it did not have. It matters because it supplies the strongest argument against simply accepting current specialisation: a country locked into low value-added primary production might, with investment in human capital and infrastructure, build an advantage in higher value-added activities over time.

5. 5

   Give three sources from which a country's comparative advantage can arise.

   Model answer

   It can arise from natural factor endowments such as fertile land, mineral deposits, climate or a deep-water port. It can arise from acquired endowments such as an educated workforce, accumulated capital stock, technological knowledge or institutional quality. It can also arise from scale, where a large domestic market or an established industrial cluster lowers average costs enough to give a country the cheaper trade-off in a good.

6. 6

   A country specialises heavily in a single primary commodity in line with its comparative advantage. Analyse the risks this creates.

   Model answer

   Commodity prices are volatile because demand and supply are both price inelastic in the short run, so export earnings and government tax revenue swing sharply from year to year and planning becomes difficult. Heavy specialisation means a single bad harvest, a new competitor or a substitute technology can hit the whole economy at once, since there is no diversified base to absorb the shock. Over the longer run there is also the risk that the terms of trade for primary products drift against the country, and that resources drawn into the commodity sector crowd out the manufacturing and service activities that would have carried faster productivity growth.

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