Mod-01 Lec-20 Ricardian economics and more

Let us go back before talking about Ricardo’s
theory of trade let us go back to smith,it all begins with him, and the strongest case
against mercantilism is smith’s case for free trade. Do you recall what smith’s idea
was on trade? Smith was veryaware that as long as there is unrestrictedfree trade across
countries, efficiency levels inboth countries or all the countries involved in trade would
grow,because the force of division oflabor and specialization and growth and expansion
would occur everywhere so, free trade was universally good. The idea which smith used in advocating free
trade was that there was an advantage every country had; in the sense that its labor could
work better in certain trades than other trades.So, each country could specialize increasingly
in those areaswhereas labor would be more productive.And eventually every country would
be involved the labor of every country would be involved in most productive possible way
and therefore, it was good for everybody.This idea was known as the idea of absolute advantage
in trade theories, have you studiedtheory of trade sometime in your courses?
Little bit. What did you do you have some idea can you
recall. The corporative advantage we studied.
You studied very nice so, are you aware that there was a theory of absolute advantage which
preceded it. heard of that.
Right. We do not
So, what is comparative advantages? It is two countries or two people if they
trade between each other and producing and trading what good atthen,even if one country
has absolute advantage over both the products they can stillmaximize theirbenefit or utility.
So, basicallyif two countrieseach country hasanadvantage in a particular product high
higher product can achieve higher productivity than the other country in a particular product.So,
that advantage over the other countries is called the competitive advantage.
Competitive or comparative? Sorry comparative advantage andso, henceif
both countriesproduce thata comparative advantage in trade then both are better off.
That is right, butbefore this comparative advantage theory came which was Ricardo’s
came smith’s idea of absolute advantage.And Prasoon was telling me just now about even
if you had absolute advantage you still have comparative, tell me about it.
Ifthere are two countries a and b, if a hasabsolute advantage over and if there are there are
two goods in the eco economy.And if a has advantage over producing these two goods a
has greater productivity higher productivity for these two goods. Evenhad then a can like
a will still want to tradethat good whichhas mean if I mean I am confused.
I think we can give numerical example.Would like somebody, would like to write on the
black board? Sir I can explainif a country has absolute
advantage over two goods a and b. But…
That is absolute advantage. Butif even if has an absolute advantage over
two goods a and b, butit has a higher productivity for good a than good b. Then it to be better
for himfor it is to trade good a for good b from other country.But that is absolute
advantage.Buteven when it has high productivity for both goodswith respect to the other country.Still
it will better for that countrytrade in that good which.
Which it has not comparative advantage. No, he is he is explaining absolute advantage.
Are you? No,I am steering that even if absolute advantage
over two goods in two goods. What is absolute advantage?
You can producewith the given resource; you can produce more than the othercountry.
Unless put it like thisthere are two goods cloth and wine, country a and b, country a
workers produce cloth more efficiently, country b workers produce wine more efficiently.So,
you can say one has absolute advantagein cloth another has absolute advantage in wine so,
one would trade wine for cloth another would trade cloth for wine. I am not talking of
comparative advantage I am saying this is absolute advantage know.So, when a counties
workers are better at both for instance if a country is workers are both more productive
with respect to both cloth and wine, then country has a has absolute advantage in both
industries and so, there will be no trade. There will be
No, I am saying according to the principle of absolute advantageright.So, the principle
ofabsolute advantage rules out trade a workers are more productive in both industries in
one country than in the other country There is a little bit of a myopia here,which is
about Ricardo’s potter. The myopia is not with respect tothe understanding that the
workers might be more efficient in both products in one country they might be. In both wine
and cloth a country might be having higher labor productivity than the other country
absolutely that is not problem. Butwhat is important is the productivitydifferences of
the labor in the two industries give you two domestic rates of exchange between the two
products. Suppose a bolt of cloth or a bale of cloth
takes five days to produce so, five men days will produce one bale of cloth. Suppose a
barrel of wine in the same country takes eight men days of work right so,eight men days is
costlier than five men days right. So, how would you determine the rate of exchange between
wine and cloth in this country?Wineone barrel of wine equals how much of cloth? I will repeat.Laborers
take five men days to make a unit of cloth and eight men days to make one unit of wine
so,what is the rate of exchange between cloth and wine has determined by the labor effort
which is the only cost? they produce five by eight unit of
Right so, five by eight ishow much?About 60 percent or 0.6 units.So,0.6 units of cloth
equals one unit of wine that is a rate of exchange. Now, irrespective of how much productive
the workers in the other country are if their domestic rate of exchange is such that you
can get wine for less cloth. For instance if in the other country you can get one unit
of wine for 0.5 units of cloth this cloth is cheaper there, yes you will buy cloth from
there. So, here whether you will buy cloth from the other country or not, is not determined
by whether in absolute terms their laborers are more productive in cloths than you or
more productive in wine than you, no. The understanding is thatdomestically speaking
the different rates of productivity of labor in two industries will give you a domestic
rates of exchange between the two products right. And if you can get the product from
abroad at a price which is lower than its domestic price, you will import it. Or conversely,
if you can get the price for a product higher than what you get domestically in exchange
then, you will export it so,this is comparative advantage. So,what is the distinction between
absolute and comparative advantage will somebody tell me now?Ashwati I just said it I wish
youIam just asking, if you can paraphrase me or summaries me whatever who can do it?Krishna
I will take some time. Take some time,Prasoon.
Absolute advantage rules outexchange between two countries likecountry has advantage over
both the goods.While comparative advantage takes into account the compares the two goods
compare compares the goods like. And it allows the country to produce more
of the goods in which it hasbetter productivity in which it has higher productivity and to
tread off that good with.No way it is much simpler than that,the advantage when you talk
of absolute advantage as nothing to do with the domestic prices of the two goods. The
advantage when you talk of comparative advantage has everything to do with the domestic prices
that is all,that is what I wanted you to tell me.
Ricardo’s proposition is more common sense proposition; the implication of Ricardo’s
comparative advantage is simply this that you can say well.This is cheaper I will buy
it cheaper if it is cheaper abroad cheaper abroad I will buy it from there it is cheaper
than in my country as simple is that. So, it is basically you know the domestic price
compare to international or the foreign price that is makes the difference.And as trade
opens up as a country, where is a domestic price of a product starts exporting itto the
other country it is domestic price starts rising.And the other country as it starts
importing the cheaper product it is domestics price starts falling.
Eventually, trade goes on as long as each country findsthere is some advantage in exporting
or importing eventually the whole thing stops when the two domestic prices are both equal
at the international price.Is it not so,that is when trade stops and that is the limit
to trade the difference here is in Ricardo it is not just some nominal price that is
talked about. Butthe productivity of labor that is been talked about as a measure of
price no. So, what do we mean when we say price increases and price falls if we are
talking about price in terms of productivity of labor?Do you understand my question, so,
how do you? Do that,shall I repeat my question;my question
is, when you are talk nominal price or something you say it is cheaper there I am buying it
from there.So, as long as you buying it from there as he keeps selling it to his price
keeps on going up and as you keep buying from him your price keeps on coming down.Tellat
one point the two prices are the same so, he say this is five rupeesit is to be ten
rupees now it is come down to five rupees I am better off.Now, this is as long as nominal
pricesareunder consideration. Suppose instead of nominal prices you have prices in terms
of labor effort, then how will the two prices equal because there is no money nominal price
involved. production that that is that can be achieved
by additional unit of labor. I think you are on the right track, what is
it called the amount of production that can be achievedby an additional unit of labor?
Marginal product of a labor. Marginal product of a labor.
Absolutely marginal product is it not itso, what you are saying some kind of equivalence
of marginal products might happen, how. Let us see one industry one country wheredomestic
price of cotton is lower than the domestic price of cotton in the other country. In other
words the exchange value as determined by productivity ratios you find that cottonis
costlier in one country, cotton is cheaper in other country.So, the country with cheaper
cotton starts exporting and the country with cheap costlier starts importing no. So, what
happens here?What happens is in the country where the is being imported the domestic cotton
industry is slowly starts giving up workers to the other industry right.
So, as it starts giving up laborers to other industry, then gradually the rate domestic
rate of exchange between the two industries will change isit not. So, laborers are moving
in this countrya less productive trade to a more productive trade because of trade.
So, gradually what is happening is the domestic rate of exchange in the two countries will
become the same.It might not be nominal price is just the rate of exchange relative prices
as measured by labor productivity is that sensible Krishna.So, whether you look at in
terms ofnominal price or in terms of productivity in due its relative prices the effect of trade
is equivalence of domestic prices with international prices that is it.Whereas such a thing might
not happened in the case of smith because domestic prices do not feature there are no
relative prices featuring there. ButRicardo’s theory a works under restrictive
assumptions, one of the assumptionsof Ricardian theory is that labor is homogenous in both
countries.In sense that no labor is not homogenous sorry labor is not homogenous as I saidlabor
cannot migrate from one country to another mobility of labor is prohibited by assumption.And
the states of technology in the two countryremain constant. So, that the given differences in
labor productivity continue to stay because if technology changes half way through trade
negotiations the whole thing might turn topsyturvy. The third assumption of course, is that labor
is the one factor of production; capital is not takeninto consideration as a serious factor
of production in the Rcardian model. So, we have threevery solid assumptions onwhichthis
is based, one is productivity differences in the two countries as determined by technology,
remain constant and unchanging which is the same as saying technology is unchanging. And the second assumption is that just because
somebody is textile worker is very efficient I cannot just import that worker into my country
labor is not mobile. And third assumption of course, is that there is no interventions
by the state know there are no taxes, there are no subsidies, which distort the rates
of exchange between the two countries.There are no transportation costs because you might
have comparative advantage in terms of domestic rates of exchangegiven bydomestic productivity.You
have high transport costs across the space; your export prices will be much higher than
or import prices or that matter higher than domestic exchange rates and so, it might not
be feasible. The other assumption is when all negotiations
going on the state of demand remain constant suppose you have decided thattextilesfrom
Ceylon are much cheaper than textiles from India. You decided to import textiles from
Ceylon as you have taken this decision suddenly everybody in India’s starts losing interest
in clothes, everybody becomes a lover of what is that they do not want clothes anymore.
So,the key assumptionis that the demand the state of demand remains constant in the two
countries well trade is going on.Now, these are all very strict assumptions, subject to
these strict assumptions you can say that comparative advantage it leads to free trade
and free trade leads to prosperity. Ricardian theory of trade was very strongly
influential through the nineteenth century, but in the twentiethcentury we have a more
expensive, more inclusive theory of trade which isHatcher hollentheory of trade. Two
sweetsHatcher and hollenwrote about these things simultaneously and the Hatcher hollentheory
of trade replace Ricardian theory of trade almost completely As I said theHatcher hollentheorem theory
of trade is also knownHatcher hollentheorem is more it more inclusive.And more expansive
in the sense thatitdoes not restricted cell through one factor of production labor it
includes both labor and capital. And in a generalized form it can include any number
of factories production, factors of production. The basic illustrations of Hatcher hollentheorem
happen with two factors of production capital and labor.So,it ismore expansive, more inclusive
of a larger number of situationsHatcher hollentheorem also permits a greater variety of application
of the idea of the comparative advantage. It
is notlabor productivity differences alone in factHatcher hollentheorem says productivity
differences across country can change over time, butwhat cannot change is endowment of
factors of production. How much labor you have how much capital you have that endowment
does not change. Whereas you might have so much of laborize,so, much of capitalize productivity
change in six months time with technology changing. So,Hatcher hollentheorem emphasizes
the resource endowments rather than productivity of labor as a source of advantage. So, a country
which has abundance of any factor of productionsee capital will have a comparative advantage
in exporting that product which use more capital or which is capital intensive right.
So, more generally a country will have comparative advantage in the export of that commoditywhich
is intensive in the use of the abundant factor of production in that country.Now, you can
see this is a different cup of tea all together as compare to Ricardo, much less restrictive.And
in a general form you can have this theorem applying any number of factors of productions.
Why not just two, why not six, seven as long as long as put them in ananalyzable form.The
advent ofHatcher hollentheorem made international theory, international trade theory even more
extensively analyzed and made it much deeper in its capacity to interpret economic situations.
By the 1960s the belief in any idea of comparative advantage started declining in the world.
It was found that trade occur due to a number of reasons not necessarily comparative advantage
either of Ricardo orHatcher hollenin type. In other words the fundamental assumption
of Ricardo that there should be comparative advantage for you to trade;and then with comparative
advantage free trade grows across the world and brings prosperity to everybody.Hatcher
hollentheorem was an extension of this idea whereas, the other theories which came up
alternative theories of trade which came up. Which question whether the idea of comparative
advantage had he meaning at all, had any relevance at all, they brought about other explanations.Whichexplain
things, which explain why trade happens without necessarily making it free trade and more
efficient trade. One such idea was the product cycle theoryand
the product cycle theory stresses back to And the serietells you the trade happens not
because the country has the comparative advantage in x y z etcetera. Trade happens because it
is a newly patented product and somebody has monopoly rights the manufacture that under
intellectual property rights.Any manufactures it others cannot manufacture it so, he sells
in to them. So, product cycle theoryis a nice way of explaining how a new product comes
into world market and how it expands and how it is gets starts getting manufacture all
over the world. Now, the cycle of the product is like this,a
new product is invented, a new technology is invented,anintellectual property comes
into existence. The owner of that intellectual propertythe company concerned or the organization
concerned, capitalizes on this on the monopoly basis manufacturing and selling it first domestically
where the market is,because it is easier to canvass something in your own market than
in a foreign market.And you are protected from foreigners producing in any way because
your of your I P. So, the first phaseimmediately after acquisition of intellectual property
rights, the products starts getting manufacture domestically for domestic market. And as this
grows foreigners here about this product and they wanted in their country too so, next
phase. In phase two you start exporting this productwhether
export of this product you move from domestic to foreign markets as a source of revenue.
Not that you give up domestic market, butmore and more foreign markets are buying your products
it becomes more and more exported product phase two. Phase three the foreign demand
for this product might be might have become so, high that you start thinking whether it
is cheaper to keep exporting it to that country.Or simply cheaper toset up a plant in the other
country and make it there in other words at this point in time you do not export the product
anymore. Butyou export capital and technology in order that you set a production facility
abroad in phase three. In phase four your intellectual property has
expired you no long have the patent 20 years a past, seven years a past whatever at that
time the productions of product becomes prolific. Because nobody is preventedfrom making it
anymore there is a massive spurt of this product all over the world. In phase five what happens
is this big company which set up foreign branches all over the world it finds foreign market
competition to high. So, eitherdiversifies the foreign production into some other product
or simply closes down and focuses on domestic market. This is the product cycle theory ofworld
would you like write this down. It seems no similarity of greater destruction.
It is, is it not it is, butwhat is important in the product cycle theory is that it does
not talk of comparative advantage, it does not talk of free trade, it actually talks
of trade under monopolistic conditions. And in fact the postHatcher hollentheories of
trade there are so, many of them they are all talking of how tradecomes about under
different conditions. And in none of these conditions you have to have comparative advantage.
The other theory of trade which becamepopular after Marxist started writing about it, is
the theory of imperialism. The theory of imperialismI think it was written in 1917 or 18Lenin wrote
a little pamphlet called imperialism the final stage of development of capitalism.
The argument here is like this, finance and capital become the source of growth in all
developed countries in the best.Gradually they also become the source of trading between
the other parts of the world and these countries.And eventually they also become the source of
export of capital to these other countries exploit their raw materialsand then creates
semi finish products sent back to the parent country.So, the industrialization of developed
countries is funded by financial institutions from the developed countries,which set up
subsidiary units in under developed countriesto create semi finished or partially finished
goods, which can be finished and completed in developed countries.
So, under this trade happens because of the power of capital in developed countries to
exploit the resource of under developed countries. The theory of imperialism is a very central
part ofMarxist economics. You cannot have the development of any part of the world as
a capitalist country without imperialism according to Marxist thinking, would you like to write
this down. By 1960’sAmerican research scholarship in
development of industries organization of industries unfolded new knowledge.And that
knowledge was that modern capitalist systems do not work on the basis of profit maximization
whatever. This came out in a classic work by BainHarvard professor I think 1960 he wrote
a book called barriers entry in American industry.Now, what he wrote wasthat in a study of I do not
recall how many industries he studied, butquite an extensive study of industries across the
U S. He found that maximization of profit was not the number or not even the top priority
consideration in these industries. The principles concerned of these industries
were to create barriers to entry within the industry by different firms.In other words
the world is market share; holding on to market share an expanding market share is the concern.
And different strategies used in this direction become the portfolio of strategies in different
firms, from this point of view then capitalism is predatory.And the international version
of Baintype of hypothesis is found in the writings of Koogmanwhose theories of state
trade are based mostly on entry barrier strategies.An industry could a firm could create barriers
to entry in a number of ways,the first thing is getting an I P intellectual property, getting
a patentensures that nobody can enter this trade for x number of years.
And gives you sufficient groundto build a massive market share and make otherintellectual
patterns which will expand the market share.The second strategy is creating a very high sunkcost
type of technology, are you familiar with sunk cost tell me what it is?
Infrastructure cost that is not recovered fixed costare notrecovered.
Well not so much whether they recoverable or not, but it is just like they are incurred
andthey are recoverable in such a long time that it virtually decides the fate of technology
in that industry.Petro chemicals is one example,oil refiningis another example, fertilizer is
another, power generation is another, these are all industries, these are all technology
industries incorporating very high sunk cost.One advantage of having technology with high sunk
cost is that you make it virtually impossible for anybody else to be able to afford this
technology. You can have only a few companies were doing big time petroleum refinery you
can you can a few companies which are into big time petrochemicals.
So, the decision to adopt the technology involving high sunk cost itself is a barrier this is
a second strategy used by many corporate to create barriers. In a situation where your
demand is unpredictable in the long run and a the same time you can recover your sunk
cost only over the long run. The whole economics of the viability of your industry becomes
questionableif there has been competition.So, the idea is to preempt competition creating
very high sunk costs a technology with very high sunk costs. So that you virtually a monopolist
so, this is the second strategy used by many firms opting for entry barrier strategies.
The third aspect of entry barrier strategy is very well known advertising,advertising
not so much in the positive sense of propagating the positive qualities of your productthe
others. Butto create a space in the minds of the public which is your space so, you
create market shares by creating mind shares heavyadvertising costs towards the Zen therefore,
fairly common.So, whenBain found all these things is started asking the question, how
significant is the profit maximization objective of the firm, he did not know? He certainly
knew that firms wanted to do a lot of other things. Second how efficient the such an industrial
structure I mean your theory tells you that the motive of profit maximization gives you
efficiency. Butyour motivation is entry barriers your
tendency to become more and more monopolistic and monopolistically competitivewhich means
you becomes more and more inefficient.So, entry barrier strategies and globally practiced
across global investments with then regulate global trade make global trade very inefficient.At
the same time it does not matter whether the global trade is inefficient or not. Because
for the players in the global market, what is important is market share so, this is called
the industrial organization approach.The industrial organization approach to trade merely tells
you that you do not need to have comparative advantage, you do not need to become efficient
there are number of other reasonswhy trade happens such as entry barrier.
It is pointed outthat one of the best examples of this kind ofinternational economic activity
was the attempt by Enron tobuild power generation in west coast of India.The whole idea was
to make sure that nobody else picked up that project and eventually when it became totally
non viable it cost wide was abandoned.So, a large number of investments happens across
the world by gigantic corporations to ensure that there are no rivals in the trade across
the world so, this is the industrial organization approach. Finally, there are large number
of political factors which involve countries in trade or which prevent countries from getting
involved in trade. So, political economy is a very important
factor, for a large number of political and economic factors of to be traded off against
each other in making trade decisions.Then the process is not a rational process, the
process is not rational decision making process there are so many objectives you have in the
political economic portfolio.That some of these objectives might be mutually contradictory,
some of these might be conflicting so, you cannot decide on any one particular objective
and decide not sets way other objective.So, in this decision making process in trade invariably
involves a compromise, a compromise activity which is not efficient in the sense of choosing
any one which is the best. Butwhich is efficient in the sense of making
sure that as many criteria are possible are satisfied this approach is called the bounded
rationality approachgoes back to that very great organizational psychologist Albert Symon,who
is probably one of the few people to get a noble prize in economics through the route
of psychology.So, in the bounded rationality approach what you are saying is decision making
in international relations, in international trade is a very complex political economic
process. Where you are always trading offone against another in the among the ingradience
of the decision making process and in this way you are constantly striking compromises
between objectives. So,you end up in rational, butin a limited
or a bounded way because you are always compromising so, this approach is called the bounded rationality
approach. The idea of bounded rationality of course, as I said goes back to the work
of Albert Symon in the 1940’s, when you were studying the behavior ofAmerican organizations.
Well we have come to the end of the Saturdays class and see you next week have a nice weekend.

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