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SUBJECT: INTERNATIONAL BUSINESS TRADE AND THEORY

EXTENSIONS OF THE RICARDIAN MODEL

Let us explore the effect of relaxing three of the assumptions identified above in the simple comparative advantage model. Below we relax the assumptions that resources move freely from the production of one good to another within a country, that there are constant returns to scale, and that trade does not change a country's stock of resources of the efficiency with which those resources are entitled.

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Immobile Resources

In our simple comparative model of Ghana and South Korea, we assumed that producers (farmers) could easily convert land from production of cocoa to rice, vice versa. While this assumption may hold for some agricultural products, resources do not always shift quite easily from producing one good to another. A certain amount of friction is involved. For example, embracing free trade regime for an advanced economy such as the united states often implies that the country will produce less of some labor intensive goods, such as textiles, and more of some knowledge - intensive goods, such as computer software or biotechnology products. Although the country as a whole will gain from such a shift, textile producers will lose. A textile worker in South Carolina is probably not qualified to write software for Microsoft. Thus, the shift to free trade may mean that she becomes unemployed or has to accept another less attractive job, such as working at fast food restaurant.

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Resources do not always move easily from one economic activity to another. The process creates friction and human suffering too. While the theory predicts that the benefits of free trade outweigh the costs by a significant margin, this is of cold comfort to the one who bear the costs. Accordingly, political opposition to the adoption of a free trade regime typically comes from those whose jobs are most at risk. In the United States, for example, textile workers and their unions have long opposed the move toward free trade precisely because this group has much to lose from free trade. Governments often ease the transition toward free trade by helping to retrain those who lose their jobs as a result. The pain caused by the movement toward a free trade regime is a short term phenomenon, while the gains from trade once the transition has been made are both significant and enduring.

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Diminishing Returns

The simple comparative advantage model developed above assumes constant returns to specialization. By consent returns specialization we mean the units of resources required to produce a good (cocoa or rice) are assumed to remain constant no matter where one is on a country's production possibility frontier (PPF). Thus, we assumed that it always took Ghana 10 units of resources to produce one ton of cocoa. However, it is more realistic to assume diminishing returns to specialization. Diminishing returns to specialization occurs when more units of resources are required to produce each additional unit. While 10 units of resources may be sufficient to increase Ghana's output of cocoa from 12 tons to 13 tons, 11 units of resources may be needed to increase output from 13 to 14 tons, 12 units of resources to increase output from 14 tons to 15 tons, and so on. Diminishing returns implies a convex PPF for Ghana (see figure 6.3), rather than the straight line depicted in figure 6.2.

It is more realistic to assume diminishing returns for two reasons. First, not all resources are of the same quality. As a country tries to increase its output of a certain good, it is increasingly likely to draw on more marginal resources whose productivity is not as great as those initially employed. The result is that it requires ever more resources to produce an equal increase in output. For example, some land is more productive that other land. As Ghana tries to expand its output of cocoa, it might have utilize increasingly marginal land that is less fertile than the land it originally used. As yields per acre decline, Ghana must use more land to produce one ton of cocoa.

A second reason for diminishing returns is that different goods use resources in different proportions. For example, imagine the growing cocoa uses more land and less labor than growing rice, and that Ghana tries to transfer resources from rice production to cocoa production. The rice industry will release proportionately too much labor and too little land for efficient cocoa production. To absorb the additional resources of labor and land, the cocoa industry will have to shift toward more labor - intensive methods of production. The effect is that the efficiency with which the cocoa industry uses labor will decline, and returns will diminish.

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Diminishing returns show that it is not feasible for a company to specialize to the degree suggested by the simple Ricardian model outlined earlier. Diminishing returns to specialization suggest that the gains from specialization are likely to be exhausted before specialization is complete. However, the theory predicts that it is worthwhile to specialize until that point where the resulting gains from trade are overweighed by diminishing returns. Thus, the basic conclusion that unrestricted free trade is beneficial still holds although because of diminishing returns, the gains may not be as great as suggested in the constant returns case.

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DYNAMIC EFFECTS AND ECONOMIC GROWTH

The simple comparative advantage model assumed that trade does not change a country's stock of resources or the efficiency with which it utilizes those resources. This static assumptions makes no allowances for the dynamic changes that might result from trade. If we relax this assumption, it becomes apparent that opening an economy to trade is likely to generate dynamic gains of two sorts. First, free trade might increase country's stock of resources as increase supplies and capital from abroad become available for use the country. For example, this has been occurring in Eastern Europe since the early 1990s, with many Western businesses investing significant capital in the former communist countries.

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Second, free trade might also increase the efficiency with which a country uses its resources. Gains in the efficiency of resource utilization could arise from a number of factors. For example, economies of large-scale production might become available as trade expands the size of the total market available to domestic firms. Trade might make better technology from abroad available to domestic firm; better technology can increase labor productivity at the productivity of land. (The so-called green revolution had this effect on agricultural outputs in developing countries.) Also opening an economy to foreign competition might stimulate domestic producers to look for ways to increase their efficiency. Again, this phenomenon has arguably been occurring in the once protected markets of Eastern Europe, where many former state monopolies have had to increase the efficiency of their operations to survive in the competitive world market.

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Dynamic gains in both the stock of country's resources and the efficiency with which resources are utilized will cause a country's PPF to shift outward. This is illustrated in Figure 6.4, where the shift from PPF, to PPF results from the dynamic gains that arise from free trade. As a consequence of this outward shift the country is Figure 6.4 can produce more of both goods than it did before introduction of free trade. The theory suggested that opening an economy to free trade not only results in static gains of the type discussed earlier, but also results in dynamic gains that stimulate economic growth. If this is so, then one might think that the case for free trade becomes stronger still, and in general it does. However, as noted above, in a recent article one of the leading economic theorists of the twentieth century, Paul Samuelson, argued that in some circumstances, the dynamic gains can lead to an outcome that is not so beneficial.

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The Samuelson Critique

Paul Samuelson's critique looks at what happens when a rich country the united States-enters into a free trade agreement with a poor country - China that rapidly improves its productivity after the introduction of a free trade regime (i.e., there is a dynamic gain in the efficiency with which resources used in the poor country) Samuelson's model suggests that in such cases, the lower prices that US consumers pays for good imported from China following the introduction of a free trade regime may not be enough to produce gain for the U.S economy if the dynamic effect of free trade is to lower real wage rates in the United States. As he stated in a New York Times interview, "Being able to purchase groceries 20 percent cheaper at Wal-Mart (due to international trade) does not necessarily make up for the wage losses (in America).

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Samuelson goes on to note that he is particularly concerned about the ability to offshore service jobs the traditionally were not internationally mobile, such as software debugging, call center jobs, accounting jobs and even medical diagnosisof MRI scans (see the accompanying Country Focus for details). Recent advances in communications technology have made this possible, effectively expanding the labor market for these jobs to include educated people in places such as India, the Philippines, and China. When coupled with rapid advances in the productivity of foreign labor due to better education, the effect on middle-class wages in the United States, according to Samuelson, may be similar to mass inward migration into the country: It will lower the market clearing wage rate, perhaps by enough to outweigh the positive benefits of international trade.

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Having said this, it should be noted that Samuelson concedes that free trade has historically benefited rich countries (as data discussed below seems to confirm). Moreover, he notes that introducing protectionist measures (e.g., trade barriers) to guard against the theoretical possibility that free trade may harm the United States in the future may produce a situation that is worse than the disease they are trying to prevent. To quote Samuelson: "Free trade may turn out pragmatically to be still best for each region in comparison to lobbyist-induced tariffs and quotas which involve both a perversion of democracy and non-subtle deadweight distortion losses."

Part 3 The Global"Trade and livesummit FIGURE 6.4 The Influence of Free Trade on the PPF PPF2 PPF1 Cocoa O Rice