Analysis of the relevance of Ricardian comparative ...



University of Warwick

Research essay

Analysis of the relevance of Ricardian comparative advantage theory in explaining “Delocalization” of production.

Eugenio Di Pasquale

10/05/2006

Analysis of the relevance of Ricardian comparative advantage theory in explaining “Delocalization” of production.

Abstract: The aim of this pare is to give an overview over the relevance of the Ricardian comparative advantages in explaining the delocalization of production today. The new international order, the end of the control over finance by the states and mass production are some of the main change from the nineteen economic century framework. Ricardo’s theory was based on a state-centric reality; now a day, the economy is following a globalization trend which deeply weaken the role of the state, while multinational companies acquired influence. This unbalance of power compared to Ricardo’s reality weakens the theory’s utility. Besides, comparative advantages do not contemplate an important negative externality, the environmental problems deriving from the delocalization of production: the transportation pollution and the low environmental legislation, which is often exploited by the “delocalizers”. While once, in Ricardo’s theory, workers, consumers, states and enterprises could enjoying mutual benefit, today those subject are frequently fighting one against each other.

“Throughout the history of capitalism, the institutionalized expression of economic and political life has typically attained its highest and clearest articulation in the national economy and the sovereign state, respectively. Over the last couple of centuries, indeed, the relationship between the two has commonly been so strong and organic in its nature that it tends to pass for a self-evident if not necessary condition. An important consequence of this notion of national economy and the state as integrated social entities is that international system has often been understood as a disorderly field of competition in which a finite number of these phenomena interact holistically with one another rather like billiard balls in constant motion (Waltz, 1979)”.

The theory of the comparative advantage was born in this environment in the nineteenth century. In economics, the theory of comparative advantage explains why it can be beneficial for two countries to trade, even though one of them may be able to produce every kind of item more cheaply than the other. What matters is not the absolute cost of production, but rather the ratio between how easily the two countries can produce different kinds of things. Comparative advantage may be compared to absolute advantage. When one entity (be it a company or a country) is able to produce more efficiently than another entity it has an absolute advantage: that is, assuming equal inputs, the entity with an absolute advantage will have a greater output. Comparative advantage was first described by Robert Torrens in 1815 in an essay on the corn trade. He concluded that it was to England's advantage to trade various goods with Poland in return for corn, even though it might be possible to produce that corn more cheaply in England than Poland. However, the theory is usually attributed to David Ricardo, who explained it in greater detail in his 1817 book The Principles of Political Economy and Taxation in an example involving England and Portugal. In Portugal it is possible to produce both wine and cloth with less work than it takes in England. However, the relative costs of producing those two goods are different in the two countries. In England it is very hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore, while it is cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth. Conversely, England benefits from this trade because its cost for producing cloth has not changed but it can now get wine at closer to the cost of cloth.

The concept of national economy, however, is under considerable pressure at the present time in light of the fast-moving changes that have been occurring world-wide in structures of economic and political interaction. More particularly, there is a need of reconceptualization of the economic and political geography of the modern world, with one of the main ingredients being an effort to come to terms with the widening mismatch between the sovereign state as the definite territorial unit and the realities of modern economic system whose ever-extending and ramifying tentacles now reach out across the world. This intensifying geographic polymorphism of the economic order is presently driving forward a corresponding transformation of the political order such that of the sovereignty of the state is beginning to disintegrate at significant points of contact with the economic (Scott: 9-23). Many things had changed since the Ricardian time. Our period and our economy are marked by some phenomena and their consequences.

After World War II, there was a big change in the international relations: the decline of war among the developed states and even the creation of a security community among them. This element involves a change in outlooks and even value among the general population, elites and national leaders. This situation represents a truly revolutionary change in world politics; so, the concept of security threat has changed in nature to some extent (Jervis, 1998: 985, 991). Economy now is the arena where developed countries fight their conflicts, give rewards and punishments to each other. “The nature of the economic environment has already substantially changed […] the nature of competitive games between states is not what it was. Instead of competing for territory (because land was the prime of wealth, and therefore wealth and political power for the state could be achieved through control over territory), states are now engaged increasingly in a different competitive game: they are competing for world market shares as the surest means of greater wealth and therefore, greater economic security (Strange, 1987: 564)”.

Therefore, especially after Bretton Woods, finance is a key issue. Finance means credit, the control of credit is important because, trough it, purchasing power can be acquired without either working or trading for it, but it is acquired in the last resort on the basis of reputation on the borrower’s side in confidence on the lender’s. The power to create credit implies the power to allow or deny other people the possibility of spending today and paying back tomorrow, the power to let them exercise purchasing power and thus influence markets for production, and also the power to manage or mismanage the currency in which credit is denominated, thus effecting rates of exchange with credit denominated in other currency. Governments do not yet abdicate their role as monetary managers, even if they do not always succeed in achieving the goals they set themselves (Strange, 1988: 88-9).

The end of Bretton woods meant that States were not able to control finance and that capital flow and floating rates were allowed. The “financial revolution” of the 1970s was a major development in the postwar international economy. Removal of capital controls by leading economies and the consequent freedom of capital movement resulted in increased integration of national capital markets and the creation of a global financial system. Emergence of an international financial market has greatly facilitated efficient use of the world’s scarce capital resources. On the other hand, international capital flows have increased the instability of the international economy (Gilpin, 2000). Since the end of the Bretton Woods agreements, the international financial structure has proceed fast away from nationally-centered credit system towards a single system of integrated financial markets. Instead of a series of national financial system linked by few operators buying and selling credit across the exchanges, we now have a global system, in which national markets, physically separate, function as if they were all in the same place. The balance has shifted from financial structure which was predominantly state-based with some transnational links, to a predominantly global system in which some residual local differences in markets, institutions and regulation persist.

The world economy controls events, but not the macro-economics of the nation-state. Consequently, developments in the international financial structure have had a decisive influence of how wealth creating activities are divided among nations. Twenty years ago, many of the smaller economies were more or less cut off from the world market economy. Today there are virtually none, apart from extreme cases. Yet, though most developing countries have created ties to the international system for sovereign borrowing and for accommodating the demand of the World Bank for the adaptation of more “outward-looking” policy (Stopford and Strange, 1991:41).

Firms can enjoy a huge and growing amount of credit. Finance is the facet which has risen in importance in the last quarter of the century more rapidly than any other and has come to be of a decisive importance in international economic relations and in the competition of corporate enterprises. Credit can be created; it does not have to be accumulated. Therefore, whoever can gain the confidence of others in their ability to create credit will control a capitalist economy. So large have the financial requirements in industry and even agriculture that it could only be financed through the creation of credit (Strange, 1988: 30).

Finance is necessary for the development of new technology; there has been an escalation of capital cost of most technological innovations in a time huge technological change. Thanks to the liberalization of international finance, the “old difficulties” of raising money for investment in off-shore operation and moving it across the exchanged vanished. Aspiring or already global firms were no longer stuck with national capital markets, and could raise found wherever they cost the least. Restrictions on a broad spectrum on investment decision have been lifted. This has facilitated a rapid transnationalisation of corporate production strategies and a commensurate increase in intra-firm and intra-industry trade, developments again associated with rapid technological change. Firms could fragment production process and locate activities closer to market or whatever production costs most advantageous, spurring a rapid transformation of international division of labor. From a system of national economy with a few international firms, the global political economy has become a system of ever more intense cooperation and thus ever more rapid adaptation of the states and firms to the realities of the new “triangular diplomacy” state-state, firm-firm, and state-firm (Strange, 1994). Freeing the international financial structure allowed the production restructure: the accelerating pace of technological change has enhanced the capacity of successful producer to supply the market with new products and/or make them with new materials or new processes. At the same time, product and process lifetime s have shortened, sometimes dramatically. Meanwhile, the costs of the firm of investment in research and development and, therefore, innovation have risen. The result is that all sort of firms that were until recently comfortably ensconced in their home markets have been forced, whether they like it or not, to seek additional markets abroad to gain the profits necessary to amortize their investments in time to stay up with the competition when the next technological advance come along (Strange, 1994: 104).

However, as we can see from the different amount of value involved (more than a trillion of US dollars compared with some hundred billions), there has been “a fundamental shift toward an autonomous global financial market in which financial activity is largely divorced from the requirements of trade, that is, the exchange of goods and services (Held and others, 2003: 221)” and, therefore, production. Trade and finance provoke different problems: in trade problems appear when keeping the trading system open, and in finance, they arise when keeping the financial-system controlled.

The multinational company (MNC[1]) is a key feature of this globalized financial world. Multinational firm refers to a firm with production and /or distribution facilities in two or more countries. With this type of global environment, MNEs can realize economies of scale and build dispersed production networks. They are able to produce and sell goods and products across nation borders, often within their own international networks or in close alliance with partner firms (Rugman: 6).

Some data: by 1997, 54,000 parent MNCs controlled 449,000 foreign affiliate around the world representing an overall investment valued at 3.4$ trillion. The world’s 200 largest corporations now account for more than 25% of all global economic activity. US MNCs earn twice as much in revenue from manufacturing operation abroad as from exports. One-third of all world trade takes place on an intrafirm basis. Among the 200 companies mentioned, 62 are based in Japan, 53 in the United States and 23 in Germany (the so called “triad” area); only 2 are headquartered in developing countries (Lairson and Skidmore: 347-9). Most FDI is intra-regional, rather than inter-regional, in 1996 the triad made 57.3% of world exports and 56.5% of import (Rugman: 2 and chap. 7).

Besides, TNCs “think regional and act local”, as Ohmae (1996[2]) argued that MNCs today are not centrally controlled, nor are they fully decentralized. Instead, they are a complex mixtures of organizational structures in which pressure of economic globalization is consistently offset by the need of national responsiveness on a regional basis. Multinational are more a web of firms rather than a vertical structured enterprise, a flexible framework which permits them to adjust in order to maximize the environmental benefits instead of fighting against host conditions (Sethi: 2002).

States have become increasingly compelled to liberalize because of competitive deregulation pressures resulting from the mobility of capital. The threat of shifting production from one country to another causes countries to compete against each other. This has produced the phenomenon of competitive deregulation between states as any attempt to maintain their attractiveness to investors and to sustain global competitiveness. This often led to a situation in which wages, working conditions, and environmental standards became depressed with severe consequences on life standards and human rights.

In addition, the cooperation with multinationals is increasingly a necessity also for developed countries to achieve economic, politic and social goals. States must try to find a balance between attracting and encouraging investment while still maintaining a range of social goals and promotion of the so-called national interest (O’Brian and Williams: 191).

Many economists accept the equivalency that the international transfer of factors of production (capital, technology etc.) through FDI produces consequences for the real world equivalent to those from the international flow of goods, this means trade and investments are perfect substitute for one another. However, MNCs are not the merely substitute for trade. Multinational enterprises engage strategic behavior; an MNC decision whether to export a product from its own market or to invest it abroad in order to service a foreign market will strongly affect the location of economic activities and the rates of economic growth around the world. For example, IBM manufactures in a number of countries, so as to maintain good political relations with host government rather than for strictly economic reasons. It is clear that multinational companies desire not only to earn immediate profits, but also to change and influence the rules or regimes governing trade and intentional competition in order to improve their long-term position (Gilpin, 2001: 279-81).

In parallel also production had its major developments. The benefit of the division of labor boosted productivity thanks to the application of modern factory management techniques. Frederick Taylor influenced the field so much that they even named a form of production for him, “Taylorism”. Taylorism refers to the practice of scientific management. Similar to Smith, Taylor advocated the braking down of production into individual tasks. Kay to Taylorism was management control over time. The primary characteristic of Taylorism as such can be described in terms of a bipartite division of the mass production labor force into a group of unskilled and semi-skilled blue collar workers, assigned to routine jobs defined by the minute technical division of labor that was made possible by the moving assembly line; and a cadre of highly skilled white-collar workers (managers, professionals, engineers etc.) responsible for the overall organization of production process so as to reduce the discretionary decision making power of blue-collar workers on the factory floor to the minimum.

The resulted was that workers were increasingly deskilled as they fit into the factory system. Workers could be substituted into a series of simplified tasks. Henry Ford applied Taylorism into his car factory, from there the term “Fordism”. He standardized car models so that they could made more quickly and cheaply. The working conditions in Ford’s factories were very difficult, but the wage was high; it was designed to attract workers and also offered the possibility that workers might one day be able to afford the products they were producing. It opened the door to mass consumption to go along with mass production.

Mass consumption was achieved by redistributing income from the wealthy to a broader base of citizens through programs such as progressive taxation, old age benefits, public health care and education, and unemployment insurance. Organized labor played a role in the system as it negotiated wage increase for its member as productivity in the economy increased.

However, during the 1970s, the fordist system came under increasing pressure. Over the 1970s and early 1980s, mass production was being pushed from center-stage in the major capitalist countries, burgeoning new sectors, often marked by drastically new forms of production organization, were moving into the economic vacuum that was being created. The leading edges of capitalist development were now being increasingly identified with booming sectors such as high-technology manufacturing, consumer oriented industries making everything from clothing to high performance cars to films and television programs and resolutely focused on niche markets and personal and business services (Scott: 21).

Fordism faced both saturating markets and mounting challenge from Japanese (soon to be joined in the competitive race by the newly industrializing countries) manufacturer methods called flexible specialization, lean production or toyotaism. This method emphasized a form of production that was more flexible than fordism, for example, the just-in-time inventory system which allowed the company to avoid the stockpile parts, they would order them and receive them just-in-time for production. Workers were encouraged to work in teams, learn a variety of skills and abandon traditional union structures in favor of work team or company unions. These developments permitted radical shifts in output configurations, away from the standardization that was the rule under fordist mass production, and toward more customized, differentiated, and rapidly changing product designs. The new products were often the carriers of a rising new technological paradigm involving flexible forms of production based on electronic technologies and resurgence of de-routinized work practices requiring high level of human handicraft and discretionary performances.

At the same time, the rise of Thatcherism in Britain and of Reaganomics in the United States marked a decisive break with Keynesian welfare statism as an overarching system of political arrangements. In its place, a neo-conservative political agenda was set in motion with its central objective firmly directed to the withdrawal of the central government from heavy handed economic management.

Today we a have a mixture of production methods in the global economy. Many automobile manufactures have moved to Japanese production method and more flexible specialization. However, the mass-production factory system is alive and well in many old industries such as textiles and some newer service industries. For example, call centers where workers are closely monitored and follow particular scripts operate on a rigid factory model (O’Brian and Williams: 200-206).

Finance, multinational companies and mass production are different face of the same phenomenon, they are complementary one to each other for the globalization of the economy; the huge steps in telecommunication technology, cheap transportation and the dramatic world population increase are the remaining side of the framework of the globalization of economy. States lost part of their sovereignty, in Susan Strange opinion, they just give it away in favor of the market, as we can see through taxation fro example. The explanation on MNCs is linked also to the transfer price, in other words how to avoid taxation. “Ability to tax is central to the state capacity as ordinarily conceived, since states that cannot levy effective taxes will have only limited capacity to do anything else (unless they can find workable substitute for taxation such as military conscription). Hence, tax capacity provides a – perhaps the – key test on state capacity (Hood: 213)”. Intra-firm trade can be used to evade taxation easily: consider a company in an industrialized country exporting semi-finished goods to a developing country, where they are finished and sold; imagine that the government of the industrial country decide to cut taxes, while the other government increases taxes to found development. The transfer price can be used by the company to determine the level of profit of each branch. By increasing the transfer price and declaring more of its profits for each branch. By increasing the transfer price and declaring more of its profits in low-tax industrial country, the company can avoid its global tax bill increasing. Than each government would find the effect on tax revenue is the opposite of its intentions (Baylis and Smith: 430).

According to scholars, finance is close to be an objective global reality; freedom of goods movement is more a regional phenomenon than a global one, however even trade barriers are weakening and are more and more friable to the market economy. On the contrary, labor is still under state control; in China (one fifth of the world population) it is also difficult to be allowed to move from region to region (Rampini: 123).

Ricardo’s comparative advantages contemplate originally two states trading which were producing different goods inside their borders by companies whose ownership belong to a citizen of the same state. This means that the benefit of the free trade were shared among the owners of the trading companies, the people who were enjoying a better division of labor as workers and better goods as consumers and the state which was gaining direct and indirect revenues from a good economic activities.

Today this had changed. From one side the currency policy deeply influence the system. As far as the gold standard was the kingpin of the structure, the competition was only among goods, while today states like China are using subsidies to keep false low exchange rate in order to help exports. Besides, its population, like the Indian one, is so significant that is hard to imagine the need of a different country which specialize itself in a production China is not already able or will not soon be able to provide by its own people. Indeed, China’s productions are gaining positions in the world market of goods; nevertheless, there are still some Ricardian realities related to services, “Chinese people do not trust their banks services, which are not as qualitatively good as the European or the American ones, therefore they invest in foreign, mainly American, financial tools (Lorenzo Bini Smaghi[3]).

However, as far as we are talking about global economy and transnational companies it is hard to use comparative advantages today because it not clear who are the owners, where the production takes place and who is gaining benefits from this economic operation. Recent studies (Sethi) shows that multinationals are more and more dislodged from their home countries. On the other hand Rugman shows clearly that MNCs are concentrated into the so called “triad” (North America, Western Europe and Japan), and, therefore, also their ownership, while the production is delocalized elsewhere through portfolio or foreign direct investments. It sure the companies are acting in favor of themselves, however, delocalizing they are usually able to pay a smaller amount of taxes and there are people loosing jobs at home. On the other side, as O’Brian and Williams underlined it is not possible to say if and how those investments abroad give benefit to the host country, it is necessary to value each situation one by one.

Nonetheless, during the nineties all the major developing nations, the one which had the benefit of FDI, like the East Asian tigers, suffered from the crash of their economies due to an overload of foreign investment quickly withdrew with serious consequences all over the world.

Coming back to Ricardo’s pure theory, comparative advantages are based on seven assumptions: only two countries, lack of technological innovations, free market, perfect capital mobility within the state borders, constant cost of production, and the theory of labor value. The first two hypothesis are easy to eliminate (Salvatore: 47); but the last one implies the homogeneity of labor, which does not fit with our reality, so it was modify in 1936 by Habeler with the theory of cost-opportunity. However, it was hardly criticized after the collapse of many developing economy which were linked to few goods. Those goods were often replaced by new technological tools; therefore, they were not useful any more. It became clear that the diversification of economic outcome maybe the best solution against economic crisis.

The new trend of delocalization was made possible by the free capital flow, which allowed the enterprises to invest abroad, but the comparative advantages offered were the beginning of a race to the bottom among the developing countries which is still going on giving benefits to the TNCs, but it is not clear if and how it is giving advantages to the host countries. Delocalized activities are the one which need a large amount of labor. The cheap labor cost is the gain or where certain actions which are illegal in the home country, in the host country are legal. Besides, MNEs are also trying to circumvent minimum health and safety requirements and to reap the benefits working with a largely non-unionized workforce; and from the perspective of workers in advanced industrial countries, the shift of labor-intensive production overseas altered the economic structure causing economic and social decay in the wake of high level of unemployment (O’Brian: 195). On the other hand where the capital has a major importance there is no reason to do it somewhere else.

Another weakness of the Ricardian analysis, especially in explaining the delocalization of production, is the complete lack of the environmental issue. Apparently, during Ricardo’s life this was not a central issue, unfortunately it is now a day. Environmental problems, even more the financial one, are global. The delocalization of production has two serious side effects: first, the transportation cost of mass production does not value the environmental damage it produces; second, MNCs often delocalize their production in countries which have a small environmental legislation in order to cut also the expense related. For example, they are able to use old technologies which are illegal in their home country, which are mainly concentrated in the “triad”, where the environmental laws are quiet demanding and quickly enforced. This means either the govern will use its resources, which comes mainly from his people taxation, because, as it was showed before, corporate taxation in developing countries is a sensible topic, to help the damaged environment, or the people will suffer for it. In both cases the population will bear the burden.

The globalization of production has altered the attitude of the governments, shifted the bargaining power between states and MNCs, and also transformed the nature of the state. States have become increasingly compelled to liberalize because of the competitive deregulation pressure resulting from the mobility of capital. Boundaries are shifting as resources are linked with indistinct borders, while industries shift and react to changed circumstances and new technologies. The threat of shifting production from one country to another causes countries to compete against each other. This has produced the phenomenon of comparative deregulation between states as they attempt to maintain their attractiveness to investors and to sustain global competitiveness. The competitive process between states can lead to a situation in which wages, working condition and environmental standards become depressed.

The globalization of production and internationalization of finance has enhanced the capacity of the capital managers to evade jurisdiction of what is often perceived as hostile economic management. Therefore, states must be increasingly sensitive to the regulatory policy of their neighbors, since they are now effectively competing for the right to regulate investment. Further, this new competitive dynamic is propelling states to accommodate the preferences of market actors and to actively court international investors by introducing more liberal regulatory standards. States will be able to influence this process and regulating foreign direct investments by assigning or delegating to supranational institutions some of their power to authority. The development of offshore markets is another instrument that has eroded national financial barriers. These changes provide investors with prospect for minimal level of taxation and regulation, thereby allowing for the unconstrained movement of financial resources. These resources have also been critical in providing a wider source of founding for MNCs engaged in the process of globalizing their business (O’Brian and Williams: cap. VI).

Ricardian comparative advantages were a powerful tool for the reality of the nineteenth century. They were related to a state-centric framework of economic relations. Today, the economic organization’s trend is toward a globalized one, states’ grip on economy is weakened, new actors, multinational enterprises, acquired power in the international order thanks to the new international relations, mass production and to the free flow of capital. TNEs could expand themselves selling and producing all over the world.

The end of the state-centric economic system and the new problems linked with the enormous growth of human population, like the environmental one, were not contemplated in the comparative advantages theory. Therefore, its suppositions of mutual benefits do not work as well as it did. The delocalization of production is a critic point to the massive profits TNCs made and are making, it allowed to cut the expenses from high-wage industrial countries to low-wage developing economies; but it is not clear how much those countries could benefit for these activities, a large literature suggest it was a damage more than a benefit, other propose an opposite view, O’Brian and William propose a case-to-case discussion. Hence, the immediate multiple benefits are a controversial issue which often does not count all the externalities involved. Besides, the incredible growth of human population, unimaginable at the time, gives further doubts on the efficiency of the comparative advantages today.

However, there are still comparative advantages, but they are related only to one economic subject. For example, a multinational will have a comparative advantage to delocalize its production from its home country to the developing country which has the lowest taxes while likely it will be not such an advantage for the workers in the two countries.

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[1] I will use transnational company (TNC) and multinational enterprise (MNE) as synonym of MNC

[2] In Rugman: 53

[3] Italian rapresentor in the European Centra Bank, Tg2 Dossier 9/4/2006

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