Trade Theories:

In economics one examines Adam Smith's idea of absolute advantage and David Ricardo's idea of comparative advantage.

Ricardo said that in the case of two countries, even if that country were to have an absolute advantage in the production of a range of commodities, still each country should specialize in that commodity in which it has the greatest comparative advantage. Naturally, specialization leads to trade.

Absolute Advantage of US over UK in wheat and UK over US in cloth:










Economics analyze the numbers in the cells of the above table to ask what happens after specialization and then use this argument to support the idea of "Gains from trade?"

Ricardo: Concept of comparative advantage










Ricardo's notion says that a country should specialize in that commodity in which it has a comparative advantage. This became the heart of international trade theory, and countries came to be associated with particular crops: cocoa in Ghana, tea in Sri Lanka, peanuts in Gambia, and tobacco in Malawi. Such countries subscribed to the tenets of Ricardo's theory, specializing in the production of commodities in which they had a comparative advantage. But please take some time to consider how it is that these countries came to be producing these goods in the first place. There is no original logic that says Ghana should grow cocoa and that Sri Lanka should grow tea. We would need to retrace colonial history in order to find out how these crops came to be grown in the first place when they were put in place by colonial authorities...

Consider the following topics and questions that arise:

1. What is the role of "primary commodities" in the export economies of Third World countries?

2. What are terms of trade? What are deteriorating terms of trade?

Why have terms-of-trade deteriorated for countries exporting primary commodities?

What is the relation of trade to the social construction of scarcity?

Why is the record of the contributions of trade to the production and consumption of basic goods not a good one?

3. Role of fluctuating prices.

So you have a situation of countries depending on exports for their economic well-being; most of the exports consists of two or three primary commodities; these commodities have experienced short-term price fluctuations and long-term deteriorating terms-of- trace. More of a country's resources--land, labor, capital, and so on have to be devoted simply to stay in place. Terms of Trade: The terms of trade describe global swapping ratios. For example, to say that the terms of trade have declined between 1960 and 1990 means that a country's purchasing power has decreased, and the total value of their exports is not worth as much today as it was previously. This has a large impact on nutrition since producers usually try to produce more to compensate for diminishing profits or value. If farmers in developing countries produce more primary commodities (cocoa, peanuts, tea, tobacco) there is less land, resources, and labor left to cultivate food. It is this which results in more hunger.

Nevertheless, there are some caveats to the concept terms of trade as:

Add to this the implications of the questions about the disarticulated economy:

What is a disarticulated economy? How does this relate to the wage bill?

What is the contradiction of the wage bill?

What does it mean to say that Third World countries do not experience a contradiction of the wage bill? What are the implications of that for production and consumption of basic goods?

What is the relationship of all this to the ultimate question--why poor countries are poor?

Criticism of trade theory by Latin American Economists:

By the 1950s there was much debate about free trade and the inequity it created between countries. A group of Latin American economists responded to this debate with Structuralism. This kind of structuralism was the idea that individual countries should produce all of their goods, and encouraged the use of tariffs and taxes to put up barriers to foreign trade. It criticized the sole production of primary commodities, while emphasizing the importance of industrialization and import substitution. This policy was implemented in many Third World countries, but did not successfully address economic inequities. There were several reasons for the failure of this policy:

For this reason, more and more people went back to ideas of free trade in the 1980s. By the 1990s the World Bank was espousing the merits of free trade, and many efforts have been made to liberalize the economies of Third World countries which engaged in import substitution. The result has been that many Third World countries are producing primary commodities to the exclusion of other exports, becoming non-diversified in their agricultural realms. This is summarized below:

Export Economics: Disarticulated Economies

Contradiction of the Wage Bill

Imagine a simple model economy divided into firms and households and consider the production and consumption relations between the two. Households supply labor to firms, and firms in turn pay wages to households. This is a production relation. Define the sum total of wages going to the households as "The Wage Bill." Firms supply goods to households, for which households pay the firms. This is a consumption relation.

Wages are a cost of production to an individual firm. Any rational firm will try to lower wages, because wages are costs. Now if all firms lowered costs, the total wage bill will go down. That will reduce the capacity of the households to consume. That in turn will reduce the total income going back to the firms which will affect their future prosperity adversely. Thus the individual interests of a firm does not coincide with the collective interests of all firms. This is called the contradiction of the wage bill. What is the contradiction here, precisely? The description given above holds because for the most part the households consume the products manufactured by the firms. The households are not only the suppliers of labor but also the consumers of the products made by the firms. An economy with such a balanced relationship between households and firms is called an "articulated economy".

This simple model provides a description of an economically developed economy such as the U.S. Here there are several mechanisms in place to prevent the total wage bill from shrinking too low. For example, there are: legislated minimum wages, unemployment compensation, welfare benefits, social security, and tax rebates.

The balance between firms and households breaks down in Third World export economies (look again at the Circular Flow diagram at the beginning of this essay, at the top). Consider a country where exports constitute a large part of the GNP and the export economy depends on one or two commodities, for example, tea and rubber exports in Sri Lanka. The workers in tea and rubber plantations are not in the market to consume the products of these plantations. The prosperity of the plantation owners does not depend on rising living standards of their workers because their markets are overseas. So plantation and mine owners can reduce wages to a subsistence level without affecting their own prosperity. In other words the contradiction of the wage bill that we saw in the U.S. is not present in countries like Uganda, Honduras, and Sri Lanka. These economies are said to be "disarticulated" because a balanced relationship between firms and households does not exist (meaning not internally connected).

Next let us consider how trade functions in the disarticulated export economy.

Consider the model appearing in the figure a few paragraphs above.

The box "productive resources" refer to things such as land, labor, capital, and infrastructure of a nation. The box "mass economy" refers to the economy of peasants (small scale farmers), workers, and unemployed who demand basic commodities like rice, bread, fuel, bicycles, and so on. We are going to assess the capacity of our export economy to provide these basic minimum goods. Note that Third World elite have a comparatively higher standard of living in contrast to the majority of the population in developing nations. Their living standards require imports such as automobiles, TVs, VCRs and so on. They have the capability to import these (see box titled, "imports") foreign goods because of the income they receive from export goods (see box titled, "exports"). There is a very tight relationship between export income and capacity to pay for imports In elementary economics there is a formula that states: Revenue = Price X Quantity. When price falls, to maintain revenue we have to increase the quantity produced. History tells us that export incomes have fallen over the years through "deteriorating terms of trade." Exporters have compensated for falling prices by increasing quantities that are exported to the World Economy. But increasing quantities exported requires expanding inputs such as land, labor, and fertilizers.

Expanding exports is usually seen as a good thing because it means higher economic growth and development. But expanding exports in a disarticulated economy has two adverse consequences on the poor people in the mass economy. First, in a disarticulated economy higher exports need not mean increased wages for the workers. Second, expanding exports absorb more productive resources such as land, capital, labor, fertilizer, and so on that could otherwise go into improving living conditions in the mass economy. So increased trade does not automatically guarantee that the poor will be better off. In fact, the opposite can and does occur.

Circular Flow & Disarticulated Third World Economies

December 12, 2005