Comparative Advantage and the Gains from International Trade

Comparative Advantage and the Gains from International Trade

Comparative advantage is described as the capability of a country to generate a service or a good at a reduced opportunity cost than the other countries. Most countries specialize in the production of goods or economic activities that make them have a comparative advantage. In most circumstances countries engaging in business benefits from comparative advantages of each other. The use of Production Possibility Frontier can illustrate the benefits that the two countries get from each other.  Countries can find absolute advantages in production due to the natural endowment of the country. For instance, Saudi Arabia is pretty endowed with oil reservoirs, and it’s just a matter of hole drilling to extract oil. Other countries may find this simple process carried out by Saudi Arabia very expensive due to the kinds of technology and labor required to accomplish the production needs.  However, the USA harbors fertile farmlands hence making the growth of Corn very cheap (Magdoff, Fred, and Brian Tokar). Natural endowment in every country is dependent on the climate and the geographical location of the country.  When a country feels that it has a product that other countries would need and can produce it at a lower cost, then each state is guaranteed to benefit from the trade.  Most of the trading activities occurring internationally operate because of specializing in comparative advantage. The paper provides a detailed analysis of Comparative Advantage and Gains of trade between the USA and Saudi Arabia in Corn and oil products respectively.

The USA is endowed with productive farmland for Corn thus has a comparative advantage of corn production while Saudi Arabia has a comparative advantage on the production of oil due to the vast reservoirs of oil. In this Comparative Advantage and Gains analysis of international trade between Saudi Arabia and the USA, two products oil and corn which are highly produced by these two countries is used. These products are homogenous; therefore consumers cannot differentiate oil or corn from either of the countries (Tyner, Wallace E., Farzad Taheripour, Qianlai Zhuang, Dileep Birur, and Uris Baldos).  The consumers in both countries need these two goods. The assumption is that labor hours are the only resource found in the two countries.   Because of the endowment of oil resources, Saudi Arabia is capable of generating oil with lower resources, and on the other hand, the USA can use reduced resources in the production of Corn. This can be expressed in the number of hours that the two countries utilize to produce a unit of each product.  The table below shows the analysis.

 

From table one above the absolute advantage of oil production is in Saudi Arabia since the country only uses an hour to generate one barrel of oil while the USA takes two hours. However, the USA has got absolute advantage in cone production.

For an elaborate analysis, each country is given a time period of 100 hours to work. This is illustrated in Table two.  It is supported by a tool known as Production Possibility Frontier (PPF) in graph form in figure 1 below. The graph shows the maximum amount that each of the two countries can generate provided the limited resources which in this case are the workers and the technology level.

 

 

In figure 1 (a) (PPF), Maximum of 100 oil barrels can be generated by Saudi Arabia with Zero corn at point A. consequently at point B it is capable of producing 25 corn bushels and zero oil.  Point C shows the quantity the country can produce if it takes to a combination of oil and corn. At this point, the state have decided to manufacture  60 oil barrels sidelining 40 working hours to generate ten corn bushels (Magdoff, Fred, and Brian Tokar).  In figure 1 (b). At point A, the USA can yield a value of 50 oil barrels with zero corn production. At point B, the country can generate 100 corn bushels with no oil. Given the technology level and resources that the USA has, it can produce very little of both products at point C’.

From the logical point of reasoning, both the USA and Saudi Arabia requires oil for better livelihood. Before any trade occurred between the two countries, they generated and consumed at C or C’. For that case prior to trade, Saudi Arabia needs 60 worker hours to manufacture oil that it will consume without trade, meaning that it will be producing and consuming oil amounting to 60 barrels. With this, it will still have 40 working hours remaining and as shown in Table 1 that they can produce a bushel of corn using four hours they will be capable of producing 10 bushels of corn to consume. The USA at point C’ they will allocate 40 working hours to produce 20 oil barrels to consume without or before the trade while using the remaining 60 to generate 60 bushels of corn. Production before the trade is shown in table 3.

 

The PPF slope production indicates the opportunity cost of generating corn as compared to oil. It shows that when the USA uses all its resources before the trade, it can yield 100 corn bushels or 50 oil barrels. This means that the opportunity cost of generating a barrel of oil corresponds to two bushels of corn, making a slope of ½.  This implies that a surge of oil by one barrel in the USA results to a reduction of two corn bushels. On the other hand, when Saudi Arabia employs all its resources, it generates oil barrels amounting to 100 or 25 corn bushels (Bowen, Harry P., Abraham Hollander, and Jean-Marie Viaene). This implies that the opportunity cost of manufacturing a barrel of oil leads to a reduction of ¼ corn bushels that could have been produced. Therefore, Saudi uses the least amount of resources to produce oil while the USA uses the least resources to produce corn.  The PPF line to show that the opportunity cost remains constant. If a marginal unit of labor is shifted from corn production to oil production, then the result is that there will be a steady increase in the oil quantity with a decrease in the amount of corn produced. All these are illustrated in table 4 below.

 

Because Saudi Arabia uses the least amount of resources to produce a unit barrel of oil, then its comparative advantage is in the production of oil. On the contrary, the USA uses minimal resources to generate one bushel of corn; therefore its comparative advantage lies in the production of corn. From this example, symmetry exists between absolute and comparative advantage. Absolute advantage in this arises because Saudi Arabia requires a low number of worker hours to generate a unit of oil. On the other hand, it needs to give up very few in the production of oil as compared to production of other resources.

Gains from the International Trade

The gains from international trade come after two countries have realized the comparative advantage of the goods to trade in. Before the trade, Saudi Arabia generates/consumes a total of sixty barrels of oil and ten corn bushels (Jasimuddin, Sajjad M). While the USA manufactures and consumes 60 bushels of corn and 20 barrels of oil. Looking at the current products generation levels, if the USA decides to trade a volume of corn lower than 60 bushels to Saudi and in exchange receive more than 20 barrels of oil, the country will gain from the trade.

Consequently with this trade country will consume a high amount of both oil and corn than the country consumed before trade and specialization.  Likewise, if Saudi Arabia decides to trade given amount of oil below 60 barrels and in exchange receive a volume of corn bushels more than 10, it will consume and contain more of both corn and fat than it had before trade and specialization. This is indicated in Table 5 below.

 

The underlying principle of why international trade benefits both the parties are engrossed in the opportunity cost concept (Polachek, Solomon W.) If Saudi wishes to increase the domestic corn production without engaging in worlds international trade,  then according to its opportunity cost it must lose four of its oil barrels to gain an extra corn bushel. If Saudi found a way of getting an extra bushel of corn by giving out less than four oil barrels, it would find the trade better off. Similarly, in this trade, the USA is also going to gain a corresponding amount that it gives out to Saudi Arabia. This is because it will get exactly or more than what corresponds the export. For instance, if it gives out 100 corn bushels, then it will receive 50 oil barrels from the ratio. Therefore, any country that specializes entirely in the respective comparative advantage gains from the trade making the summation of its global output to increase (Hindley, Brian, and Alasdair Smith). To gain maximally from the comparative advantage, each participating country should strive to maintain 100%specialization. In general, specialization in the comparative advantage increases production of the entire world. Therefore, due to the comparative advantages and specialization, the USA and Saudi Arabia have had gains from international trade. The table below shows the quantity produced after specialization on the two products of trade between the USA and Saudi Arabia.

 

With partial specialization, the countries will still gain from the trade due to comparative advantage, but not as when the specialization is 100%. Consider a case when the international trade between the two countries when the US decides to export 20 corn bushels to Saudi Arabia to exchange it with 20 barrels of oil. Gains from oil trade to the USA can only go up by getting less quantity of corn from Saudi Arabia. This is elaborated in figure two.

 

Figure 2. Production Possibilities Frontier in Saudi Arabia

From figure two, starting from point C, reducing oil production from Saudi Arabia by 20% and trade it with 20 bushels of corn from the USA to get to point D. it can be noticed that the trading price of 20 bushels of corn and 20 oil barrels is higher than the opportunity cost of the country (Hindley, Brian, and Alasdair Smith). Therefore even without 100% specialization, Saudi Arabia is still benefitting from the trade. Indeed both the two country’s consumption rate increases after specialization and trade are effected concurrently.

The comparative advantage of the two countries was measured by use of Factor Flows Measurement method ( Balassa, Bela.) In this method, the factors of measurement of the comparative advantage are the export and import which are pegged on the production and consumption ratios of the two countries. As indicated in table 5, after specialization, the USA will export not more than 60 bushels of corn in exchange of at least 20 oil barrels from Saudi Arabia. On the other hand, by use of hourly production ratios, Saudi Arabia has to export 60 barrels of oil to get 10 bushels of corn making the country to gain from this trade. From the Factor flows measurement, it is right to say that the two countries are enjoying comparative advantage thus gains. Because the two countries also gain from 100% specialization, their consumption rate is also going to increase than before without straining.

The comparison of the actual dollar balances of trade in corn and oil between the USA and Saudi Arabia is as follows. In 2014 the USA exported bushels of corn worth 18,716.9 million dollars to Saudi Arabia while they imported barrels of oil worth a total of 47, 041.3 million dollars from Saudi Arabia resulting to a dollar deficit balance of 28, 324.4 million dollars. In 2015 the US exported corn bushels worth $ 19,791.6 million to Saudi while importing bushels of oil worth $ 22, 0883.2 million from Saudi Arabia. This resulted in a dollar balance deficit of $ 2,291.6 million. In 2016 the USA exported to Saudi Arabia bushels of corn worth $ 17,999.5 million while they imported from Saudi Arabia oil barrels amounting to $ 16, 923.6 (Cordesman, Anthony H. Bahrain, Oman, Qatar, and the UAE ). During this year they had a dollar balance surplus of $ 1, 075.9 million. In the year 2017, the USA exported corn bushels totaling to $ 16,348.0 million to Saudi Arabia while importing barrels of oil amounting to $ 18,880.5 from Saudi Arabia amounting to a deficit balance of $ 2,532.5 million. Finally, in 2018, the USA exported to Saudi Arabia bushels of corn worth $ 12, 503.9 million while importing a total of $ 22,028.1 million worth barrels of oil. This generated a dollar balance deficit of $ 9,524.2 million. From the data of trade in Corn and oil between the USA and Saudi Arabia, except for 2016 the USA has been trading in dollar balance deficits up to the last year 2018 (Goodwin, Neva, Jonathan M. Harris, Julie A. Nelson, Brian Roach, and Mariano Torras). Therefore, based on this trade relationship the USA has got trade deficits.

In conclusion, specializing in comparative advantage leads to gains when two countries get an opportunity to trade with each other.  From the analysis, it is evident that international trade between the USA and Saudi Arabia has been enhanced by specializing in comparative advantage.  Before countries engage in trade, they must have an absolute advantage in the production of a given commodity. After which each must analyze the opportunity cost and specialize in the production of the commodity in question, needed by another country for exchange.  If the two countries decide to engage in trade, the comparative advantage specialization makes them gain. In this case both the USA and Saudi Arabia with absolute advantage, opportunity cost and specialization in production of corn and oil respectively enjoy the comparative advantage. Therefore, countries should specialize in comparative advantage to gain from trade and consequently increase global production.

 
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