This is “Factors of Production”, section 6.3 from the book Beginning Economic Analysis (v. 1.0).
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Production possibilities frontiers provide the basis for a rudimentary theory of international trade. To understand the theory, it is first necessary to consider that there are fixed and mobile factors. Factors of productionInputs to the production process. is jargon for inputs to the production process. Labor is generally considered a fixed factor because most countries don’t have borders that are wide open to immigration, although of course some labor moves across international borders. Temperature, weather, and land are also fixed—Canada is a high-cost citrus grower because of its weather. There are other endowments that could be exported but are expensive to export because of transportation costs, including water and coal. Hydropower—electricity generated from the movement of water—is cheap and abundant in the Pacific Northwest; and, as a result, a lot of aluminum is smelted there because aluminum smelting requires lots of electricity. Electricity can be transported, but only with losses (higher costs), which gives other regions a disadvantage in the smelting of aluminum. Capital is generally considered a mobile factor because plants can be built anywhere, although investment is easier in some environments than in others. For example, reliable electricity and other inputs are necessary for most factories. Moreover, comparative advantage may arise from the presence of a functioning legal system, the enforcement of contracts, and the absence of bribery. This is because enforcement of contracts increase the return on investment by increasing the probability that the economic return to investment isn’t taken by others.
Fixed factors of productionFactors that are not readily moved and thus give particular regions a comparative advantage in the production of some kinds of goods and not in others. are factors that are not readily moved and thus give particular regions a comparative advantage in the production of some kinds of goods and not in others. Europe, the United States, and Japan have a relative abundance of highly skilled labor and have a comparative advantage in goods requiring high skills like computers, automobiles, and electronics. Taiwan, South Korea, Singapore, and Hong Kong have increased the available labor skills and now manufacture more complicated goods like DVDs, computer parts, and the like. Mexico has a relative abundance of middle-level skills, and a large number of assembly plants operate there, as well as clothing and shoe manufacturers. Lower-skilled Chinese workers manufacture the majority of the world’s toys. The skill levels of China are rising rapidly.
The basic model of international trade, called Ricardian theoryTheory that suggests nations, responding to price incentives, will specialize in the production of goods in which they have a comparative advantage, and purchase the goods in which they have a comparative disadvantage., was first described by David Ricardo (1772–1823). It suggests that nations, responding to price incentives, will specialize in the production of goods in which they have a comparative advantage, and purchase the goods in which they have a comparative disadvantage. In Ricardo’s description, England has a comparative advantage of manufacturing cloth and Portugal similarly in producing wine, leading to gains from trade from specialization.
The Ricardian theory suggests that the United States, Canada, Australia, and Argentina should export agricultural goods, especially grains that require a large land area for the value generated (they do). It suggests that complex technical goods should be produced in developed nations (they are) and that simpler products and natural resources should be exported by the lesser-developed nations (they are). It also suggests that there should be more trade between developed and underdeveloped nations than between developed and other developed nations. The theory falters on this prediction—the vast majority of trade is between developed nations. There is no consensus for the reasons for this, and politics plays a role—the North American Free Trade Act (NAFTA) vastly increased the volume of trade between the United States and Mexico, for example, suggesting that trade barriers may account for some of the lack of trade between the developed and the underdeveloped world. Trade barriers don’t account for the volume of trade between similar nations, which the theory suggests should be unnecessary. Developed nations sell each other such products as mustard, tires, and cell phones, exchanging distinct varieties of goods they all produce.