Unit 4 Macro: Focus on India - Comparative Advantage

The concept of comparative advantage was possibly first introduced by David Ricardo in 1817. Comparative advantage exists when a country has a ‘margin of superiority’ in production i.e. where the marginal cost of production is lower.

• Countries will usually specialise in and export products, which use intensively the factors inputs, which they are most abundantly endowed. • If each country specializes where they have an advantage, then total output can be increased leading to an improvement in allocative efficiency and welfare.

The dynamic Asian economies including China have focused their resources in exporting low-cost manufactured goods which take advantage of much lower unit labour costs.

In most developed countries, the comparative advantage is shifting towards specialising in producing and exporting high-value and high-technology manufactured goods and high-knowledge services. Many developing countries are looking to do the same including India.

Data from Timetric.

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Merchandise trade (% of GDP), India from Timetric

India has become more of an open economy over recent years as the chart above demonstrates

Revealed comparative advantage for India is shown through in her export and trade balance data for example in business services such as IT outsourcing, film, green energy, pharmaceuticals and gems, iron ore. Trade in services as a share of her national income has increased five-fold since the mid 1970s.

Data from Timetric.

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Trade in services (% of GDP), India from Timetric

But the common perception of India as an economy increasingly dependent on exports of services needs to be dispelled. The chart below provides some compelling counter-evidence

Data from Timetric.

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High-technology exports (% of manufactured exports), India from Timetric

What Determines Comparative Advantage?

1. The quantity and quality of factors of production available

2. Investment in research & development which can drive innovation and invention

3. Fluctuations in the real exchange rate, which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers.

4. Import controls such as tariffs, export subsidies and quotas – and other forms of protectionism – these can be used to create an artificial comparative advantage for a country’s domestic producers.

5. The non-price competitiveness of producers - covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support.

Comparative advantage is often a self-reinforcing process

1. Entrepreneurs in a country develop a new comparative advantage in a product either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets

2. Rising demand and output encourages the exploitation of economies of scale; higher profits can be reinvested in the business to fund further product development, marketing and a
wider distribution network. Skilled labour is attracted into the industry and so on

3. The expansion of an industry leads to external economies of scale.