A2: Evaluating Comparative Advantage Theory

Remember Comparative advantage theory is great for explaining how trade is an engine for growth by allowing countries to specialise and trade at a mutually beneficial exchange rate they can operate outside their PPF. In many ways it provides the foundation for trade liberalisation, the creation of the EU and single currency and the removal of trade barriers by the World Trade Organisation. It has allowed consumers more choice and greater consumer surplus and provided firms with the ability to source cheaper suppliers. The latter effect has created a world economy that until the credit crunch was able to lower cost push inflation, deliver target inflation and lower interest rates as a result.

However it does have its flaws: 

1.How significant is trade for macroeconomic performance?

2. Are transport costs close to zero, given rising oil prices?

3. Are currencies persistently over valued (strong pound 97-07 witnessed further decline of UK manufacturing whilst German manufacturing expanded) or under-valued (China's currency fixed low) - thus preventing mutually beneficial exchange rates, especially given frequent  speculative attacks.

4. Global imbalances - USA and UK trade deficit records compared to Germany and China's large trade surpluses does not provide evidence of win-win trade scenarios.

5. Can we identify an economy's comparative advantage, especially in a fast changing world - did the IMF/World Bank get it wrong in recommending many LEDC specialise in cash crops.

6 The theory works if we assume full employment - given a world recession, especially in UK/EU, this presents a problem and perhaps explains the resurgence of countries using protectionist measures.

7 Is competitive advantage thoery more relevant - looking at price and quality.

In addition economicsonline.co.uk offers the the following arguments and provides a good summary of the theory - click here: http://www.economicsonline.co.uk/Global_economics/Comparative_advantage.html

Criticisms

However, the principle of comparative advantage can be criticised in a several ways:

1. It may overstate the benefits of specialisation by ignoring a number of costs. These costs include transport costs and any external costs associated with trade, such as air and sea pollution.
2. The theory also assumes perfect mobility of factors without any diminishing returns. The reality may be very different. Output from factor inputs is likely to be subject to diminishing returns. This will make the PPF for each country non-linear and bowed outwards. 
3. If this is the case, complete specialisation might not generate the level of benefits that would be derived from linear PPFs. In other words, there is an increasing opportunity cost associated with increasing specialisation. For example, it may be that the maximum output of cars produced by country A is only 20 million (compared with 30), and the maximum output of trucks produced by country B might only be 16 million instead of 21 million. Hence, the combined output from trade might only be 46 million units (instead of the 51 million units initially predicted).
4. Complete specialisation might create structural unemployment as some workers cannot transfer from one sector to another.
5. Relative prices and exchange rates are not taken into account in the simple theory of comparative advantage. For example if the price of X rises relative to Y, the benefit of increasing output of X increases.
6. Comparative advantage is not a static concept - it may change over time. For example, nonrenewable resources can slowly run out, increasing the costs of production, and reducing the gains from trade.
7. Many countries strive for food security, meaning that even if they should specialise in non-food products, they still prefer to keep a minimum level of food production.
8. Finally, the principle of comparative advantage is derived from a simple two good/two country model. The real world is far more complex, with countries exporting and importing many different goods and services.
9. However, the principle of comparative advantage clearly does ‘shape’ the pattern of world trade, although most countries do try to spread their risks by diversifying into a range of goods and services, even when they do not have a clear comparative advantage.