NEOCLASSICAL  TRADE  THEORY

First question:  What's an economy for?
In 1776, Adam Smith wrote that The Wealth of Nations depends upon the goods and services available to their citizens.  Under this view of political economy (generally referred to as a liberal economic view -- which has little to do with current-day labels of liberal and conservative), governments should organize themselves and their economic management to maximize the aggregate level of goods and services that their citizens can consume (now and in the future).

(This differs from alternative interpretations of how and why a government should manage a national economy, such as increasing the self-sufficiency of the country, or increasing the government's store of wealth, or maintaining a moderately even distribution of wealth among its citizens).

Second question:  How can we maximize this wealth?
We can maximize this wealth --  the goods and services available to the citizens of a country -- by

• putting all the productive resources of the country to work (in a sustainable fashion -- see note 5),
• using the resources of the country in the activities in which those resources are most productive,
• selling some of those products (the results of those activities) to other countries, and
• importing products of activities for which our country's resources are not so productive.

Third question:  What determines which activities are the most productive ones for a given country?
The particular mix of resources available in a country determine which products will be most efficiently produced there.  (Note:  we're assuming that different products require different proportions of resources, and that different places have different proportions of resources).

natural resources:  mineral and non-mineral resources;  land;  climate;  and people (things we studied on 17 May)
acquired resources:  skilled labor;  physical infrastructure;  financial capital (from savings or from external sources)

Fourth question:  What determines whether a given country should engage in trade?
If the opportunity costs for producing the same items are different among countries, then each country should specialize in the production for which its opportunity cost is lower than for other production.

Summary of basic trade theory (this is another one of the very, very important things to take from this course):
The basic principle of most modern trade theories is that the global system benefits from each region or country using its resources to produce what it can produce most effectively and efficiently -- with lower opportunity costs than it faces to produce anything else -- and exchanging some of this output for goods and services that other regions use their resources to produce.
As a result, the resources of every region are being used most productively.

Note that the possibility of system-wide gains from trade persists, even when a given country has an absolute advantage in the production of no product.

Specialization and trade should occur according to the relative opportunity costs of production in each country, measured in terms of the alternative production given up to produce a tradable good.  This is the principle of comparative advantage (see note 1).

 Example:

• The opportunity cost of tea in Sri Lanka is 1 unit wheat;  the opportunity cost of tea in the US is 1.25 units wheat.  Sri Lanka has comparative advantage in tea production, despite its absolute disadvantage in the production of each commodity.
• To test for comparative advantage in the production of commodity 1 in a 2X2 model:  for which country is the opportunity cost of commodity 1 smaller -- which is to say, which country has the smaller ratio of  (a) resources required for a unit of 1 to (b) the resources required for a unit of 2?
• 10/10 < 5/4, thus, the comparative advantage of Sri Lanka is commodity 1, tea.
• Although the US has an absolute advantage in the production of both tea and wheat, the US has a comparative advantage only in the production of wheat.  This is because its advantage in wheat is comparatively greater than its advantage in tea.
• The scenario sketched here tells us unambiguously that the two-country world would be better off if each country specializes (to some extent) and trades.  Some issues are not unambiguous from this scenario:
• The relative sizes of the two countries (measured by the amount of resources each has) and the system-wide demand for tea and wheat will determine whether either country should produce some of both products, while trading the product in which it has a comparative advantage.
• This simple scenario doesn't tell us how the two countries will divide the gains from trade.  That will depend on a number of relative characteristics.  If you're interested, refer to a fuller discussion of the gains from trade.

Fifth question:  What explains the differences in opportunity costs for producing the same product in different countries?

If we assume:

• mobile technology across countries,
• general preferences to use the best available methods,
• perfect competition in domestic factor markets (which should push the prices of factors to reflect their opportunity costs),
• input requirements that differ across different products, and
• immobility of factors across countries,

How can we measure "abundant" and "scarce"?  Imagine the ratio of (a) the price that a nation's labor market will pay for an additional unit of labor to (b) the price that that same nation's capital market will pay for an additional unit of capital.  Compare that ratio in two countries.  The country where the ratio is higher is labor-scarce and capital-abundant, compared to the other country.

Sixth question:  What are the (theoretical) results of specialization and trade according to comparative advantage?

The basic result is that production should occur where the factors intensively used in that production are abundant.  Thus, abundant factors around the world are paid more than if there were no trade.  Most importantly, resources (factors) are being used to produce what they can produce at lowest opportunity cost:  world output can be higher than without trade.

Note that with national (or regional) specialization and trade according to comparative advantage, the demand for, and price paid to, a nation's (or region's) abundant factor(s) is increased -- and, as a result, producers may substitute other factors.  This is clearly related to our study of spatial interaction, in which we noted that if one region has an abundance of some factor relative to other regions (e.g., asparagus in Central Washington), establishing interaction with other regions (e.g., metropolitan Seattle) will increase the price of the abundant factor in its origin region -- because there's now more effective demand for the factor.  What are the abundant factors in the US?  As the US trades more with the rest of the world, what US factors should find their prices increasing?  What possibilities are there for substitution away from these factors?

Analogously, the price paid to a nation's (or region's) scarce factor(s) is reduced, because some of the products that intensively use those factors will be imported.  Producers in that nation may begin to use a higher proportion of the scarce factor than before trade.  What are the scarce factors in the US?  As the US trades more with the rest of the world, what US factors should find their prices falling?  What possibilities are there for substitution toward these factors?
 

COMPETITIVE   ADVANTAGE
A country's competitive advantage might be defined as those sectors in which companies based in a given country have profitable worldwide markets. The theory of factor proportions can be made more complex, to reflect the complex ways in which companies develop competitive advantages based on their home countries.  Economist and business scholar Michael Porter has done this through a long, empirical investigation (see note 3), and came up with a "diamond" of four national characteristics that seem to influence the sectors in which companies based in those countries have worldwide competitive advantages.

 1) availability and quality of factors (labor by type, infrastructure, resources)
  - basic (inherited) versus advanced (created)
  - generalized (infrastructural) versus specialized (industry)
  - role of [selective] factor disadvantages?  (esp. when they presage worldwide situations)

 2) size and nature of demand
  - both size and rate of growth, to encourage investment
  - sophisticated or demanding domestic markets may push companies to improve the quality of products, which will make them even more competitive internationally (see note 4)

 3) presence and quality of supplier and supporting (including service) industries

 4) nature and rules of competition

Quality factors, pace-setting demand, good supplier networks, and sufficient competition to keep firms' attention are all
obvious ways in which the national [or local] environment can assist the development of competitive advantage.  However,
competitive advantage can be found in less obvious ways, as in an unusual factor or sales market that leads a firm to
specialize in particular product attributes that leads to a specialized advantage worldwide.

Note, however, that improved competitiveness on the part of industries in any trading country -- not just "our" country -- will increase global productivity, the rate of technological advance, and the productivity with which global resources are used.