Comparative Advantage and Factor Endowments: Implications for Poor Countries

Written by Siyaduma Biniza*

Comparative advantage and factor endowments theories of international trade share the same normative prescription; that free trade is a maximally efficient and mutuallybeneficial policy for trade. However whilst the comparative advantage theory sought to explain why free trade is beneficial all countries; the factor endowments theory sought to explain how countries have comparative advantage. Also, the theories are underpinned by the same assumption that there are constant returns to specialisation which are conflated with constant returns to free trade after specialisation by only acknowledging higher output and consumption as the only outcome of free trade. Based on this assumption and the permitted outcomes of free trade, free trade is asserted as the best end that countries trade policies should pursue. The theories deductions imply that free trade is beneficial regardless of a countrys historical or export-commodity-specific factors. In this essay, I argue that these theories overlook significant empirical and practical facts about trade such that, according to the theories, the only outcome of specialisation and free trade is higher total output and consumption. However the empirical and practical facts of trade suggest that the outcomes of specialised free trade depend on historic and export-commodity-specific factors. For instance, due to historical and export-commodity-specific factors, many poor countries have a comparative advantage in labour-intensive primary commodities with low income elasticity of demand and deteriorating terms of trade. This implies that their foreign exchange may be insufficient to balance their trade which has a cumulatively negative impact on their economic growth and development if these countries cannot make up the deficit in international payment through financial flows such as loans and foreign investment. Besides, given this, poor countries would not experience constant returns to specialisation. Therefore, although specialised free trade can be mutually beneficial in terms of high output and consumption, it is neither equally beneficial nor is it maximally efficient if we consider historic and export-commodity-specific factors which determine the nature of gains from free trade. Thus free trade is not necessarily the best end for poor countries trade policies, as the theories imply, because the theories have a dubious assumption of constant gains from specialisation which ignores the practical outcomes of trade of output and consumption gains.

Comparative advantage (CA) theory is concerned with explaining why free trade is beneficial to all countries. The argument is that countries stand to gain from free trade because they have a CA which creates the incentive to specialise in order to maximising the gains from free. CA is a result of different costs of producing various commodities that countries can trade in. The CA does not arise from the absolute costs of production solely; opportunity costs have an influence on CA too. For instance, if we consider a hypothetical case in international trading of cars and maize, South Africa would have a CA against a foreign country even if South Africa has an absolute disadvantage in producing either of these commodities. This is because the countries have different opportunity cost of producing these commodities which allows South Africa to have CA. For example, assume South African and foreign costs of producing cars and maize are given by: South Africa Foreign Country Cost of Producing 3 Cars 5 3 Cost of Producing 100 kg of Maize 10 1
Table 1: Comparative Advantage

From the table above, the opportunity cost of producing 3 cars in South Africa is 50 kg of maize since that is the amount of maize that could have been produced. Similarly the opportunity cost of 3 cars is 300 kg of maize in the foreign country. Therefore South Africa has a CA in producing cars because it has lower opportunity costs related to specialising in the production of cars as opposed to maize; conversely the foreign country has a CA in producing maize. The lesson to be learned from this illustrative example is that even if countries are at an absolute disadvantage they can still gain from specialisation and free trade because of their CA. Consequently, CA theory asserts that it would be advantageous for all countries to specialise according to their CA and trade freely (Schumacher, 2013). Thus opportunity costs of production result in CA which creates an incentive to specialise according to their CA and trade freely because everyone stands to gain if that occurs. But what do countries gain from free trade? The theory only acknowledges the higher output and consumption related to specialised free trade as the only benefits (Schumacher, 2013). If there is free trade between the countries in the example above, and each specialised according to their comparative advantage, the overall output would be higher than the autarkic state. In the autarkic state there can only be a total 200 kg of maize and 6 cars produced. But if

each country specialised according to its CA there would be a total of 9 cars and 400 kg of maize. Also, with free trade and specialisation there would higher consumption than the autarkic state. Under autarky each country would have 100kg and 3 cars. But with free trade and specialisation the countries would trade commodities and possible have a higher share of each commodity for its consumers. So each country would gain in that its consumer would have higher consumption and there would be a high total output than under autarky. These are the only gains from free trade according to the CA theory (Schumacher, 2013). Factor endowment (FE) theory can be seen as a development of CA theory as it is one way of explaining how countries have comparative advantage. The emphasis is on the relative abundance of certain factors of production which allows for CA. Similarly to CA, absolute abundance in specific factors of production does not guarantee a CA since the production of specific commodities requires relative more, or less, of a certain factor. So it is the relative abundance, or scarcity, of factor that matters. The central thesis of FE theory is that countries will specialise and trade commodities that make relatively intensive use of their relatively abundant and cheap factor of production; and import those commodities that make relatively intensive use of their relatively scarce factor of production (Todaro, 1996; Schumacher, 2013). From example, we can assume that the relevant factors to producing cars and maize are car factories and arable land and that South Africa and the foreign country have the following endowments: South Africa Foreign Country Car Factories (Number) 3 10 Arable Land (Area) 4 25 Car Factories / Arable Land 3/4 2/5
Table 2: Factor Endowment

From this, South Africa has a higher ratio of capital relative to labour. This means that South Africa has a CA in production of commodities that are more car factory intensive because it has a higher car factor-arable land ratio; and it would import commodities that are arable land intensive. Similar to the case of CA theory, even if a country is at an absolute disadvantage in its endowments it can have a CA by specialising in producing commodities that use its relatively more abundant factor. Therefore, because production of commodities can be characterised according to relative factor intensity, free trade is beneficial to all because countries have unique endowments of factors and

ratios which allows for CA (Todaro, 1996). With free trade, countries have an incentive to specialise in producing commodities that they have CA in depending on their factor endowments. This means that global inequalities in factor endowments can be a source of CA (Leamer, 1995). More importantly free trade will lead to factor price convergence through price and demand mechanisms. As demand for the abundant factor increases, the price of that factor increases and demand for the scarce drops which reduces its price allowing countries to overcome absolute disadvantages of their factor endowments. Therefore free trade will lead to mutual benefit for trading partners with unequal factor endowments because their CA will lead to high output and consumption; and there would be a global convergence in factor prices (Leamer, 1995) which allows for income convergence in the world. But there is significant global divergence and growing income inequality even though there is a strong political and ideological push towards trade liberalisation (Deraniyagala & Fine, 2001; Pritchett, 1997). So, contrary to what these theories imply, trade does not simply lead to high output and consumption that benefits all. CA and FE theories overlook significant empirical facts about the gains associated with free trade such that, according to the theories, free trade always increases a countrys output and consumption. However free trade can also impact on its economic growth and development depending on historic and export-commodity-specific factors which determine the gains from free trade. There are various challenges to testing the impact of free, or liberalised, trade on economic growth and development which relate to operationalising variables that measure how free trade is in a country (Rodriguez & Rodrik, 2000); moreover free trade is not empirically observed due to even miniscule transaction and transport costs related to international trade. Nevertheless, I wish to scrutinise the theories within their own theoretical bounds to examine their validity and soundness. I argue that even if we accept CA and FE theories they still have deficiencies in that they cannot account for various empirical and practical facts about trade which determine the benefits from trade. A countrys historic and export commodities characteristics are significant in determining the gains it receives from free trade. For instance, if a country has CA and specialises in the

production of commodities that have volatile prices it faces uncertain foreign exchange earnings which can affect its balance of trade and payments; thus free trade would not lead to high consumption, at least in the commodities it needs to import. The same is true if a countrys exports face deteriorating terms of trade. In many cases, a countrys factor endowments and CA are a consequence of historic factors. This is definitely the case in many post-colonial African countries. Since colonialism was largely motivated by economic-driven exploitation of raw materials to catalyse the expansion of capitalism and the European industrialism; most of the African colonies were forced to grow one or two cash crops which resulted in neglecting food production and import-substitution (Boahen, 1987). This is not to say that the African countries specialised in growing cash crops because they had a relative abundance in the relevant factor. In addition, the monetary policies in the colonies meant that the colonies were deeply entrenched in an economic imperialism which encouraged all expatriate companies and banks to repatriate surplus capital to metropolitan states instead of reinvesting in the colonies (Boahen, 1987). This means that the gains that could have led to some convergence between the African countries and metropolitan state were negated by historic factors; even if there was free trade between the colony and metropolis. These objections point to the dubious separate treatment of trade and industrial policy in the free trade discourse (Deraniyagala & Fine, 2001) which overlooks significant practical facts about international trade surrounding historical facts that determine the gains from trade. Furthermore, export-commodity-specific factors such as the terms of trade, price and income elasticity of demand for the exported commodity significantly determine the gains from trade. Terms of trade is described by the relative prices of a countrys exports and its imports. Deteriorating terms of trade is the situation where the price of a countrys exports is decreasing relative to the price of its imports which means that the country needs to increase the volume of its exports in order to balance its trade (Todaro, 1996). Therefore, free trade may lead to diminishing gains from specialisation if a countys CA is in the production of commodities with deteriorating terms of trade. If a country has a CA or is relatively abundantly endowed with a factor used in the production of commodities with volatile prices; the country could face uncertain foreign exchange earnings from its exports which can affect its balance of trade (Todaro, 1996). This could possibly also lead to sovereign debt or currency crisis if the

country cannot balance its trade and payments; or if a country has to repeatedly revalue its currency in order to realise its exports. In other words it matters what a country specialises in and what it exports because of the export-commodity-specific. There is sufficient empirical evidence showing that there is a lower income elasticity of demand for primary commodities, that predominantly poor countries have a comparative advantage in (Todaro, 1996). That is to say, as incomes rise in a foreign country, there is diminishingly increased demand for the export commodities from poor countries which has a negative impact on the gains from specialisation. In other words, poor countries may reap marginally less increases in consumption if their commodities have lower income elasticity of demand than their imports. Moreover, if poor countries have a CA or they specialise in commodities with deteriorating terms of trade and lower income elasticity of demand, they will realise diminishing returns to specialisation. So if poor countries export commodities that have low income elasticity of demand; they will not have constant returns to specialisation. The outcomes described are practical and empirical facts about trade. Yet even deductively they are clearly counterfactual to the outcomes of the CA and FE theory. This means that the policy recommendations that arise from these theories cannot be asserted as always conducive to mutual benefit as the theory suggests; more especially in relation to the economic growth and developmental outcomes of poor countries. Both theories lead to neoliberal policy recommendations which emphasise the importance of trade liberalisation as a requirement for development and economic growth but none of the empirical evidence conclusively supports this conclusion (Deraniyagala & Fine, 2001; Rodriguez & Rodrik, 2000). Therefore poor countries should not blindly or ideologically engage in free trade as the theories suggest because the theories have the inadequacy of not acknowledging other impacts of free trade besides output and consumption gains. By poor countries I mean those countries that are characterised by less-industrialised economies, low income per capita and low economic growth rates which are seen economically divergent from rich and industrialised countries (Pritchett, 1997). If poor countries, which often have a relative abundance in unskilled labour, export commodities that use their more relatively abundant factors with relative intensity such as primary commodities, this means that poor countries will always look up to

industrialised countries as a source of commodities that relatively more intensely use their scarce factors such as manufactured commodities. Primary commodities are also characterised by volatile prices, deteriorating terms of trade and lower income elasticity (Todaro, 1996). This means that poor countries will face the challenges related to foreign exchange earnings and they will not experience constant returns to specialisation and free trade. Moreover, the kind of policies that come from these theories will ensure that the structural inequality in the global economy is maintained in favour of industrialised countries at the expense of the poor countries. Under free trade, poor countries will remain needing to increase the volume of their exports and face uncertain foreign exchange earnings whilst facing lower income elasticity of demand and depending on imports with higher income elasticity of demand. Besides, most industrialised economies actually followed a route to industrialisation that was followed by heavy protectionism and in fact some of the causes of great wars were the protection or monopolising of specific trade-related inputs (Chang, 2004). As a result it is very suspicious that most developed countries, which are often in control of multilateral financial institutions, require policies that they themselves did not follow in their route to development. If history is laden with examples of what to do, and what to avoid, poor countries ought not to embark of trade liberalisation with the end goal of free trade. The implication is that poor countries development and industrialisation is at the very least throttled or prohibited by free trade. This is closely related to what Erik Reinert calls primitivisation. Primitivisation is situation where countries specialise in producing commodities with diminishing due to the technologies being no longer profitable which leads to economic regress and impoverishment or primitivisation (Reinert, 2007). This is because certain sectors of an economy are closely related in a way that specialisation overlooks. For example, Reinert (2007) argues that agriculture will be more productive if manufacturing exists, and since many poor nations rely on agricultural primary commodity exports to rich nations and importing manufactured commodities, this means that many poor nations are forced to primitive economic activities under specialisation and free trade. And this means that poor countries specialisation in the production of such commodities, which have diminishing returns to scale as a result of specialisation, undermines the theories central assumption of constant returns to

scale. Also, like the African states, many poor countries were colonies and they faced the same fate that determined their FE and CA leading to specialisation in agricultural primary commodities which do not have constant returns to specialisation; and thus resulted in primitivisation as a result of free trade (Reinert, 2007). So, again, it matters what a country specialises in and free trade can lead to diminishing returns depending on historic and export-commodity-specific factors. The solutions to what kind of trade policy poor countries should pursue is not something that can be deductively derive (Schumacher, 2013). In other words, we cannot analyse theories in order to decide on what policies would best suit poor countries. Moreover, the issue of trade policy is not dichotomous as the literature and theory make it out to be (Deraniyagala & Fine, 2001). So its not the case that if free trade is bad for poor countries the only other option is protectionism. Nor is it the case that because free trade is not always mutually beneficial that free trade is absolutely bad or undesirable for poor countries. The decision on what kind of trade policy to follow is a challenging exercise that needs to take contextual, historic and exportcommodity-specific considerations into account. Thus, the only recommendation I can make is that poor countries ought not to pursue free trade blindly or ideologically because there are theoretical and empirical deficiencies in the arguments put forward by the free trade advocates (Rodriguez & Rodrik, 2000; Deraniyagala & Fine, 2001). In fact the most useful recommendation is that, although there might be gains to free trade according to CA and FE theory, this should not be take precedence over countryspecific development strategies (Rodriguez & Rodrik, 2000). In closing, both CA and FE theory outcomes assert that trade is always mutually beneficial by the mere fact that specialisation leads to higher output and consumption. The theories also imply that it doesnt matter what a country specialises in because there are constant returns to specialisation. I have argued that by focusing on output and consumption gains related to specialisation and free trade; these theories overlook practical and empirical issues related to trade which undermine the gains from free trade. The practical issues of historical and export-commodity-specific factors undermine the assumption of constant returns to specialisation. Moreover, it is these factors which have a significant role in determining the gains from free trade depending on characteristics like the path-dependent factor endowments, elasticity of demand and the terms of trade. This means that although free trade can be mutually

beneficial it certainly is not de facto mutually beneficial if we understand that there are varying returns to specialisation which is associated with historical and exportcommodity-specific factors. This is to say that factor endowments are not just naturally given and they depend on historic facts that create path-dependence on poor countries CA. Also, if poor countries export commodities that have low income elasticity of demand; they will not have constant returns to specialisation. In other words, poor countries will reap marginally less benefits from specialisation and free trade if their commodities have lower income elasticity of demand. Moreover, if poor countries have a CA or they specialise in commodities with deteriorating terms of trade and lower income elasticity of demand, they will realise diminishing returns to specialisation. Thus, poor countries should not blindly pursue trade liberalisation or free trade since the issue of what trade policy to follow cannot be deductively derived; and the choice is not dichotomously divided between protectionism and liberalisation as the discourse presents the problem.

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*Siyaduma Biniza is currently a B.Com. (Hon) in Development Theory and Policy student at the University of the Witwatersrand, holding a B.Soc.Sci in Politics, Philosophy and Economics from the University of Cape Town.