PNW Agricultural Trade: Comparative Advantage and Competitiveness are Fundamental
Keywords: trade, competitiveness, arbitrage
The concepts of comparative advantage and competitiveness are important foundations for understanding the importance of international trade in Pacific Northwest agriculture. These concepts illuminate the underlying factors responsible for current trade patterns. The potential for ongoing trade negotiations to alter established world trade patterns can be more readily understood by thinking in terms of comparative and competitive advantage.
Comparative advantage and competitiveness are related, but are often mistakenly exchanged for one another. Comparative advantage explains how trade benefits nations through more efficient use of the world's resource base when that trade is totally unrestricted. Competitive advantage defines trading patterns as they exist in the real world including all the barriers to free trade ignored by comparative advantage. These concepts were originally applied to trade among nations, however trade between U.S. states or even trade among individuals in a family may be explained by applying these same principles.
A World Without Trade
To begin a discussion of comparative advantage it is useful to imagine a world where trade does not exist and each country must be self sufficient in producing all commodities. In this imaginary world without trade, prices of commodities in each country are determined by the availability of the factors of production (land, labor, and capital inputs) and consumer demand. Prices of the same commodity under self sufficient conditions would vary substantially among countries even if consumer demand was the same in each of those countries. This price variation is due to the variable quantity and quality of productive factors such as land and climate, and the presence of skilled labor more suitable for production of certain products than others.
Due to these resource variations some goods may be produced only at very high cost, or perhaps not at all, in some nations. For example, the production of oranges in Canada could only be accomplished under greenhouse conditions resulting in extremely high unit production costs while oranges are produced in California at relatively low cost due to the immovable factors of climate, water and land favorable for orange production.
Free Trade Among Nations
Now consider a world where trade among nations is possible while maintaining the previous assumption of immovable productive resources. Consumers will compare prices of locally produced commodities with the prices of the same commodities produced in other nations. Consumers will choose to purchase identical commodities at the lowest price regardless of where produced. As trade proceeds among nations, commodity prices rise in those nations which had relatively low prices in the absence of trade while prices fall in nations with relatively high pre-trade prices.
Arbitrage Between Nations
The price adjustment is accomplished through the process of arbitrage as practiced by traders who buy goods in nations with low prices and in turn sell the goods in nations with higher prices. For example, suppose a produce trader can purchase oranges in California, transport them to Canada and sell them for a price which yields him a profit while undercutting the price of our hypothetical hothouse oranges produced in Canada. This new competition in the international orange market will cause Canadian orange producers to lower their prices in order to compete with the added supply of California oranges while the added demand for oranges in California allows producers there to increase prices. The arbitrage process leads to a set of equilibrium prices for all commodities in the trading nations. The set of prices for the same product in all nations will vary by no more than the cost of transporting one unit of a good from the low cost nation to the high priced nation.
Gains Through Trade
The key to an appreciation of comparative advantage lies in its explanation of gains from trade even if one nation can produce all commodities at lower cost than every other nations. The gains arise through increased supplies of all goods when each nation makes more intensive use of the its abundant factors in the production of commodities for which the resources are best suited.
This can be illustrated by expanding our earlier example to include milk and oranges produced in both California and Canada. Let's assume that California can produce both commodities more cheaply than Canada but that its cost difference is largest in orange production. Does California gain by trading with Canada under these assumptions?
Yes, by the law of comparative advantage gains are available to both nations through specialization and trade. As California shifts resources from milk production to orange production, gains arise because the resources shifted to orange production yield enough additional oranges that when traded with Canada they return more milk than was given up to produce them in the first place. Similarly, the resources freed from producing oranges in Canada yield enough extra milk so that when traded for oranges more oranges are available in Canada than were produced before trade was initiated.
Trade results in each nation specializing in the good produced with comparative efficiency. This results in trading bundles of goods which embody abundantly available, immovable factors of production in exchange for goods embodying relatively scarce factors of production. Gains arise by specializing and trading because the relatively abundant factors of production are used more intensively in both nations.
Comparative Advantage Alone Isn't Enough
Comparative advantage in production of agricultural commodities is slow to change over time since it is based upon immovable factors such as climate and land, and location relative to markets. The world as we observe it has always had many governmental policies in all nations which distort the trade patterns which would prevail if trade were solely determined by comparative advantage in an unfettered fashion. Tariffs, exchange rate policies, interest rates, and whole sets of technical restrictions alter the assumptions of trade based on pure comparative advantage.
Competitive Advantage Encompasses More Factors
our world, trade is complicated by many variations in policies and marketing
practices that violate conditions necessary for trade based solely on comparative
advantage. Competitive advantage is a term which more properly describes trade
patterns when all these additional factors are considered. Competitive advantage
characterizes trade patterns resulting from comparative advantage coupled with
policy effects, product quality differences and industry marketing skills.
Trade shares are frequently used to compare competitive advantage among regions or nations. If a region is expanding its share of trade in a given product then its is said to be gaining competitiveness in world markets. Market shares can be changed by manipulating the many competitive factors in control of governments, commodity groups and managers of industry.
Comparative advantage is fundamental to understanding international trade. It must be kept in mind, however, that world trade patterns are not solely the result of the narrowly defined conditions necessary for comparative advantage. Instead, existing and future trade patterns are determined by competitive advantage outcomes which are based on all policy and industry forces with influence on trade in addition to the law of comparative advantage.
Thomas Worley is a member of the Western Extension Marketing Committee and is an Extension Economist at Washington State University.
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