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The Kaldorian-Ricardian Impasse

Written by Siyaduma Biniza 1

The issue of the impact of trade to economic growth and development is highly contested. Although there is some agreement that under very specific conditions, trade liberalisation can lead to growth there is little consensus regarding those conditions and the empirical evidence is inconclusive. Therefore the relation is still an empirical issue and some argue that the inconclusiveness of empirical evidence results from ineffective liberalisation or the methodological and theoretical problems of the comparative advantage theory that underpins trade liberalisation. The idea that trade liberalisation can lead to economic growth is at the centre of the Ricardian approach to trade and development which is based on comparative advantage. In more contemporary economics comparative advantage is underpinned by the Hecksher-Ohlin Model. The Ricardian and Hecksher-Ohlin approaches are respectively based on the theory of comparative advantage and factor endowment theory. Comparative advantage and factor endowments theories of international trade share the same normative prescription; that free trade is a maximally efficient and mutually-beneficial policy for trade.

In this essay I argue that the issue of gains from trade is based on mainstream economic theories which have limited empirical validity and face theoretical challenges. Moreover, the mainstream comparative advantage views dubiously treat industrial policy and trade policy as separate, with de-emphasis on industrial policy. However, this overlooks the dynamics of comparative advantage and how it is created and maintained. In this regard, what is more important is the kind of industrial rather than simply instituting industrial policy. Despite the importance of industrial policy, institutions still matter.

Comparative advantage theory is the thesis that countries stand to gain from free trade because they have an inherent comparative advantage which creates the incentive to specialise in order to maximising the gains from free. Comparative advantage is a result of different costs of producing various commodities that countries can trade in. The comparative advantage does not arise from the absolute costs of production alone; opportunity costs have an influence on comparative advantage too. For instance, if we consider a hypothetical case in international trading of cars and maize, South Africa would have a comparative advantage 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 comparative advantage. For example, assume South African and foreign costs of producing cars and maize are given by:

1 Corporate Strategy and Industrial Development Research Programme, University of the Witwatersrand, Johannesburg, South Africa and master’s fellow at the Public Affairs Research Institute and Economic Research Southern Africa.

Table 1: Comparative Advantage


South Africa

Foreign Country

Cost of Producing 3 Cars



Cost of Producing 100 kg of Maize



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 comparative advantage 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 comparative advantage 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 comparative advantage. Consequently, comparative advantage theory asserts that it would be advantageous for all countries to specialise according to their comparative advantage and trade freely (Schumacher, 2013). Thus opportunity costs of production result in comparative advantage which creates an incentive to specialise according to their comparative advantage 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 comparative advantage 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. Autarky is the state when a country is not trading with any other country. 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 comparative advantage theory (Schumacher, 2013).

With factor endowment the emphasis is on the relative abundance of certain factors of production which allows for comparative advantage. Similarly to comparative advantage, absolute abundance in specific factors of production does not guarantee a comparative advantage 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 factor endowment 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:

Table 2: Factor Endowment


South Africa

Foreign Country

Car Factories (Number)



Arable Land (Area)



Car Factories / Arable Land



From this, South Africa has a higher ratio of capital relative to labour. This means that South Africa has a comparative advantage 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 comparative advantage theory, even if a country is at an absolute disadvantage in its endowments it can have a comparative advantage 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 comparative advantage (Todaro, 1996). With free trade, countries have an incentive to specialise in producing commodities that they have comparative advantage in depending on their factor endowments.

In contrast to comparative advantage theory, there are losers and winners under the factor endowment theory. The winners are the owners of the relatively abundant factor of production and they win by far more than the losers, which are the owners of the scarce factor. This is because as demand for the abundant factor increases, the price of that factor increases and demand for the scarce drops which reduces its price. Therefore, this price and demand mechanism which distributes gains unevenly thereby selecting winners is said to lead to global factor price convergence (Schumacher, 2013).

Theoretical Challenges and Empirical Facts This means that global inequalities in factor endowments can be a source of comparative advantage (Leamer, 1995). More importantly it is argued that 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 comparative advantage 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). Therefore the empirical evidence is at odds with the theory here.

Besides empirical challenges, these theories take costs of inputs or factor endowments as statically given in each case without much consideration about what changes the costs of production or the relative factor endowments besides demand. However, in many cases comparative advantage is not simply given but produced through historical experiences such as colonialism or a history of engagement in certain economic activities (Amsden, 2001). And on the other hand the factor endowment theory says nothing about impact of actual trade in changing the relative factor endowments and how this affects trade – it’s

almost like a tacit assumption that trade occurs in final consumption products only. These conditions are what determine the relative gains from trade as well as the prospects from trade.

In many cases, a country’s factor endowments and comparative advantage 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 country’s exports and its imports. Deteriorating terms of trade is the situation where the price of a country’s 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 returns from specialisation if a county’s comparative advantage is in the production of commodities with deteriorating terms of trade. If a country has a comparative advantage 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, 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 comparative advantage 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 countries

export commodities that have low income elasticity of demand; they will not have constant returns to specialisation.

This highlights the fact that there are sectorial or comparative advantage specificities which impact on economy performance. For example, specialisation in industrial or manufactured commodities which have higher value added will impact the returns to specialisation. There are export-commodity-specific characteristics which determine the impact of growth from trade. And sectorial specificities such as the composition a sector impact on the ability for free trade to impact on economy performance e.g. in the case of foreign investment to serve the domestic economy trade liberalisation is unlikely to impact on performance of that sector

The outcomes described are practical and empirical facts about trade. Yet even deductively they are clearly counterfactual to the outcomes of the comparative and factor endowment 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 poorer or less industrialised 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). However, the neoliberal policy recommendation to specialise according to comparative advantage and liberalise is founded on the assumption that there are constant returns to specialisation and free trade, and as the empirical evidence and nature of traded commodities shows this is not always the case. This is the central point of contention between the Ricardian and Hecksher-Ohlin approaches when contrasted to Kaldorian approach.

Creating Comparative Advantage as Opposed to it Being ‘Given’ The Kaldorian approach is based on the idea that a country’s growth is closely correlated with the performance of its manufacturing sector, based on Verdoorn Laws of increasing returns to scale in manufacturing, which have a spill-over impact on other non- manufacturing sectors whose growth is closely related to manufacturing (Kaldor, 1957). In summary, the desired strategy for successful economic development is a one that involves conscious efforts to create Verdoorn effects in order to bring local industry’s productivity up to a level that would enable them to compete with earlier industrialisers such as Britain. Thus industrial policy and the role of the state in development become very important.

The Kaldorian approach is in support of interventionist trade and industrial policies. The idea is that the state can create comparative advantage in the economy through targeted policies to promote manufacturing growth since this sectors is seen as characterised by increase returns to scale. However, this view is balanced by assertions that the experience of manufacturing has imparted invaluable learning which late industrialisers have not acquired (Amsden, 2001). Therefore learning is also important which means that the state’s industrial policy should not be limited to industrial growth but also promote learning and up skilling.

In addition, the Hecksher-Ohlin model assumes that technology is freely transferrable and easily codifiable. However, this assumption overlooks the impact of patenting and

copyrighting in restricting access to technology. These restrictions on technology have even been instituted at the World Trade Organisation in the form of the Trade Related Aspects of Intellectual Property Rights and Trade-Related Investment Measures council which deliberate on issue surrounding access to technology and protection of technological intellectual property on at the global (Markus, 2000). This means that industrial policy needs to take this into account because the performance of manufacturing is heavily affected by access to technology (Amsden, 2001).

However, these are things which are often missing due to the impact of neoclassical economics in narrowing the conception of industrial policy and the assigned role of the state (Fine, 2011). Although the Kaldorian view and subsequent models based on it are in stark opposition to the Ricardian view in that it advocates for the role of the state in promoting manufacturing through industrial policy, the tenets of the Kaldorian view are still methodologically different from that of neoclassical economics from which the Ricardian and Hecksher-Ohlin views are based. This principle is methodological individualism has impacted on the conception of industrial policy as well as the role of the state.

The embedded assumption of Ricardian and Hecksher-Ohlin models is that the domestic and global economies of countries trading fit the assumption of perfect market. Efficient outcomes of markets depend on various assumptions about individual behaviour and the nature of market which depends on perfect information according to neoclassical economics (Varian, 2010). Criticisms of these neoclassical assumptions argue that informational asymmetries, missing or incomplete markets, and transaction costs mean that markets are no longer perfectly competitive which necessitates institutions such as the state in order to avoid inefficient outcomes of imperfect markets (Stiglitz, 2002; Stigler, 1961). The implication of this is that equilibrium can exist even if it is not efficient so markets do not always clear or that they simply won’t exist (Akerlof, 1970). This is therefore a critique of the neoclassical type of theorising which makes the neoclassic-type markets an ideal.

With regards to policy these criticism introduce a role for the state albeit a narrow role in matters pertaining to the economy and ensuring perfect functioning of markets. Therefore, the state has a role in reducing information asymmetries in order to allow for Pareto efficient outcomes or to allow for the existence of markets that would otherwise be non-existent (Stiglitz, 2002). The alternative is that the objective of the state is by default the reduction of transaction costs and aiding in the perfect functioning of markets. Nevertheless this common policy proposal is very different from that of neoclassical economics which asserts that the state would either be obsolete or even detrimental according to various strands of neoclassical economics (Pollin, 1998).Thus the role of the state has been reduced trade policy and co-ordination of investment. Moreover, industrial policy has been conceived narrowly as a way to assist market functioning (Black, 2001; Black & Roberts, 2008). This highlights to the fact that industrial policy has been narrowly conceived without any consideration about skills, labour markets and regulating finance which is an impact of neoliberalism (Fine, 2011). But what exactly is industrial policy?

Creating a Comparative Advantage: The Less Criticised Role of Industrial Policy Industrial policy can be defined as strategic policy targeting certain sectors, to pursue outcomes assumed to be beneficial for industry as a whole. These policies do not address every sector of the economy; instead they are focused on certain sectors perceived to be able to pull the entire industry (Zalk, 2013). Industrial policy therefore has a role to play development. Historically industrial policy is seen as having helped the newly industrialised countries (NICS) of East and South-East Asia emerge through manufacturing development underpinned by industrial and trade policies inspired by nationalism. But this was also related to tacit knowledge of production learning through experience in manufacturing (Amsden, 2001). Therefore, although current industrial policy ignores this aspect of industrialisation tacit learning is integral to the success of manufacturing. In addition, it’s been argued that beyond just the co-ordination of investment and trade policy intervention, reciprocal control mechanisms are integral to successful implementation of industrial policy and avoiding state failures (Amsden, 2001). This raises a question of what extent industrial performance depends on industrial policy.

Industrial policy is often seen as the only important variable to avoid market imperfections or correcting market imperfection. However, as already discussed the influence of neoliberalism has led to a limited conception of industrial policy and the role of the state. The integration of national economies into the global market has resulted in paradigmatic changes in the organisation of production however. Technological and competitive advantages have become predominantly maintained through specific use of productive resources at the firm-level and institutional arrangements at the sectorial-level of the economy as opposed to the static notion of comparative advantage (Albo, 2005, pp. 71- 72). This means that the role the state cannot be limited to aiding markets to function, or assist market recovery following a crisis, or the neoliberal economic emphasis on ‘getting prices right’ which overlooks the role of the state in ‘picking winners’ by getting the prices wrong (Fine, 2013, pp. 3-4; Amsden, 2001). In this regard, South African liberalisation and its impact have very specific outcomes which highlight the importance of having an expanded conception of industrial policy.

Varied Policy Outcomes: The Case of South Africa and Relevance of the Kind of Policies The policy environment has favoured neoliberal policies and market-orientated economics in South Africa. Government has embarked on a piecemeal removal of all regulatory restraints on international capital flows and trade which was intended to attract foreign investment (Vickers, 2002). The era of South African neoliberalisation began with the post- Apartheid government’s adoption of the Apartheid government’s debt and it was followed by the GEAR macroeconomic package which was an indigenised policy package similar to the transnational neoliberal package of the IMF (Satgar, 2012). Consequently, subsequent macroeconomic policies have utilised neoliberal economic tools which GEAR was instrumental in establishing.

The South African government’s commitment to trade liberalisation and global competitiveness pressures meant that many domestic firms had to restructure through “right-sizing” and “downsizing” which led to large-scale job losses (Satgar, 2012, p. 47). More importantly labour-intensive import-substitution industries suffered the most whilst export-led industries failed to create job due to a shift towards capital-intensity in order to retain competitiveness (Satgar, 2012). Thus transnational neoliberalism has succeeded

in restructuring the South African macro economy towards ‘getting prices right’ and establishing governance that protects the interest of global capital against risk as opposed to serving the interests of South Africa citizens. This failure of industrial policy highlights four challenges associated with industrial policy.

Firstly the rise of neoliberalism has negatively impacted industrial policy theoretically and in practice. This has lead to disappointing performance of ‘developmental states’ which did not have a manufacturing base in their economy (Fine, 2011). This is also associated with state officials misallocating resources, being driven by personal interest and inherent inefficiencies of the state. However, rent-seeking is not necessarily inimical development, as Mushtaq Khan (2006) has shown through his work on governance reforms in developing countries. Moreover, some governments like that of Indonesia have been able to fund development projects through clandestine means of monopolising rent-seeking in the state; making them able to control rent-seeking in the economy in a way that was consistent with the developmental agenda (MacIntyre, 2000).

Secondly, there has been a shift towards focusing on the outcomes of development and what development is meant to offer such as higher incomes. This deemphasises the process of how these outcomes are achieved. This often suggests that development should increase freedom of choice by focusing on education, but this overlooks the challenges of creating expectations through education and not meeting them through interventions to create jobs (Fine, 2013).

Thirdly, as already discussed there has been a rise in neoclassical industrial policies that focus on market failures and suggest various ways in which to deal with these so that the state can discover its competitive advantage. This has led to deficiencies related to the scope of intervention, the object of intervention as well as the role of the state as previously discussed. In addition this deemphasised the importance articulation between policies no policy is an island therefore it is important how policies relate with one another.

Therefore if the South African state wants to improve its effectiveness in promoting local investment it will have to take on the role of ‘picking winners’ by getting the prices wrong instead of having an ideological inclination towards neoliberal economic which emphasises the state’s role in aiding markets to function by ‘getting prices right’ (Fine, 2013, pp. 3-4; Amsden, 2001, p. 10). Also the state-administered incentives and actual activities of investment promotion need to engage with the underlying reasons for investment by transnational automotive firms. Furthermore, if the state wants to reduce state failure it will need to institutionalise efficient reciprocal control mechanisms for its local investment promotion (Amsden, 2001, p. 290). Moreover, given the dominance of neoliberalism, these are all necessary in order for the state to overcome its limited capacity to ‘discipline capital’ due to asymmetric bargaining power between the state and multinational corporation which limits its ability to increase local content, production and competitiveness.

More than Just the Kind of Industrial Policy: Institutions Matter Therefore, although industrial policy is important, the impacts of trade on industry performance do not only depend on state policy. This view assumes that only economics performance, political will and policy have an impact on development and growth. There

is less emphasis on state performance and the impact of internal state re-organisation that could improve performance of industry through mechanisms of reciprocal control. There is also less emphasis on institutional aspects of investment or industrial policy such as the interaction between the state and industry actors. Although the developmental state discourse offers a useful theoretical focus on the bureaucracy and elites in relation to development by offering prescriptions that emphasise importance of an embedded autonomous and technocratic bureaucracy (Evans, 2008); the discourse overlooks the current institutional contexts of ‘developmental states’ and due its restricted focus on developmental state successes the discourse cannot say much about analysing failures or attempts at being a ‘developmental state’ (Evans, 2008, p. 5; Fine, 2013, p. 9). Therefore the notion of a developmental state, although it fits within the Kaldorian view, needs to be taken with a pinch of salt due to these limitations.

Moreover, amongst other criticisms, the contention about the efficiency of the state has been limited to the dichotomy of the state and ‘the market’ without interrogating the nuanced variations that exist amongst state agencies and within the market which is made up of economic sectors, firms and labour (Fine, 2011). In conclusion, whether we say it’s the state which is more efficient or the other way around, it’s undoubtedly the case that the role of the state has been understood as guiding against market failure or assisting recovery from market failure. So the debate ought to transform into ways of acknowledging the need for state involvement and emphasise the need for innovations on how the state can reduce or avoid state failure and ways to make state intervention dynamic, responsive to changes and increase state capacity.

In this essay I have argued that the comparative advantage theories have limited empirical validity and face theoretical challenges due to some of the assumptions they take. Firstly it is not the case that all goods exhibit constant returns to scale, in addition a comparative advantage cannot be taken as statically given and that in fact industrial policy is central to creating a comparative advantage as well as determining the gains from trade. Moreover, the mainstream comparative advantage views dubiously treat industrial policy and trade policy as separate, with de-emphasis on industrial policy. This overlooks the dynamics of comparative advantage and how it is created and maintained. In this regard, what is more important is the kind of industrial rather than simply instituting industrial policy. Despite the importance of industrial policy, institutions still matter.

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