Question

4. Suppose a capital abundant country, such as Italy, enters into free trade with a natural resource rich country, such as India.

(i) Explain the form of trade, such as, who exports what and imports what, using the concept of comparative advantage in trade theory. Identify each country’s comparative advantage and disadvantage.

(ii) Does trade create winners and losers within each country? Explain how.

Answer 1

The Ricardian model of comparative advantage is the most basic model of international trade and is used to explain how the differences between countries resources give rise to trade and why is it mutually beneficial. The theory of comparative advantage explains that each country specializes in producing goods in which it has comparative advantage i.e. it produces a good if the opportunity cost of producing that good in terms of other goods is lower in that country than its counterparts. This trade is mutually beneficial if each country engages in export of goods in which it has comparative advantage.

In case of Indo-Italian bilateral trade, Italy is India’s fifth largest trade partner in EU. Italy which is capital abundant country mainly exports Machinery for textile, garment industries, vehicles etc. Along with this, it exports tools for metal shaping, chemical products, organic basic products etc. Italy’s counterpart i.e. India on the other hand exports in the area of raw natural resources like iron, steel and ferro alloys, chemical refined petroleum products, tanned leather, plants of beverage production etc. Each country has mutual benefit as they export goods in which they have comparative advantage. Italy engages in the trade of capital rich products like machinery whereas India trades in primary products being resource rich country.

Ricardo’s model explains that gains from trade depends on comparative advantage rather than absolute advantage. It is also true that comparative advantage of an industry depends not only on its relative productivity but also on relative wage rate between the trading partners. For instance, India has low productivity in extracting natural resources as compared to Italy but its productive disadvantage in capital and machinery is even greater, thus it pays low wages to have comparative advantage in primary products over Italy.

Argument rises as trade based on low wage is unfair and it generates domestic winners and losers. This is also called pauper labour argument. The fallacy here lies in the idea that trade is only good if one receives high wage however, the trade based on low wage or high productivity is not in question but what is actually cheaper in terms of labour i.e. to trade capital for primary goods or produce capital itself. Even though, domestic workers are at loss but one can’t say it’s the exploitation unless there’s an alternative. There is gap when it comes to whose pockets are getting filled but denying the opportunity to trade altogether reduces the purchasing power even further. Thus, to maintain free trade, government must try to protect domestic workers and producers by providing them opportunity of growth than following strict protectionism policy.