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The Kaldorian-Ricardian Impasse

Written by Siyaduma Biniza


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The issue of the impact of trade to economic growth and development is highly contested.
Although there is some agreement that under very specific conditions, trade liberalisation
can lead to growth there is little consensus regarding those conditions and the empirical
evidence is inconclusive. Therefore the relation is still an empirical issue and some argue
that the inconclusiveness of empirical evidence results from ineffective liberalisation or
the methodological and theoretical problems of the comparative advantage theory that
underpins trade liberalisation. The idea that trade liberalisation can lead to economic
growth is at the centre of the Ricardian approach to trade and development which is
based on comparative advantage. In more contemporary economics comparative
advantage is underpinned by the Hecksher-Ohlin Model. The Ricardian and Hecksher-Ohlin
approaches are respectively based on the theory of comparative advantage and factor
endowment theory. Comparative advantage and factor endowments theories of
international trade share the same normative prescription; that free trade is a maximally
efficient and mutually-beneficial policy for trade.
In this essay I argue that the issue of gains from trade is based on mainstream economic
theories which have limited empirical validity and face theoretical challenges. Moreover,
the mainstream comparative advantage views dubiously treat industrial policy and trade
policy as separate, with de-emphasis on industrial policy. However, this overlooks the
dynamics of comparative advantage and how it is created and maintained. In this regard,
what is more important is the kind of industrial rather than simply instituting industrial
policy. Despite the importance of industrial policy, institutions still matter.
Comparative advantage theory is the thesis that countries stand to gain from free trade
because they have an inherent comparative advantage which creates the incentive to
specialise in order to maximising the gains from free. Comparative advantage is a result of
different costs of producing various commodities that countries can trade in. The
comparative advantage does not arise from the absolute costs of production alone;
opportunity costs have an influence on comparative advantage too. For instance, if we
consider a hypothetical case in international trading of cars and maize, South Africa would
have a comparative advantage against a foreign country even if South Africa has an
absolute disadvantage in producing either of these commodities. This is because the
countries have different opportunity cost of producing these commodities which allows
South Africa to have comparative advantage. For example, assume South African and
foreign costs of producing cars and maize are given by:


1
Corporate Strategy and Industrial Development Research Programme, University of the
Witwatersrand, Johannesburg, South Africa and masters fellow at the Public Affairs
Research Institute and Economic Research Southern Africa.


siyadumab@pari.org.za | siyaduma.biniza@students.wits.ac.za Scribd | Linkedin
Table 1: Comparative Advantage

South Africa Foreign Country
Cost of Producing 3 Cars 5 3
Cost of Producing 100 kg of Maize 10 1
From the table above, the opportunity cost of producing 3 cars in South Africa is 50 kg of
maize since that is the amount of maize that could have been produced. Similarly the
opportunity cost of 3 cars is 300 kg of maize in the foreign country. Therefore South Africa
has a comparative advantage in producing cars because it has lower opportunity costs
related to specialising in the production of cars as opposed to maize; conversely the
foreign country has a comparative advantage in producing maize. The lesson to be learned
from this illustrative example is that even if countries are at an absolute disadvantage
they can still gain from specialisation and free trade because of their comparative
advantage. Consequently, comparative advantage theory asserts that it would be
advantageous for all countries to specialise according to their comparative advantage and
trade freely (Schumacher, 2013). Thus opportunity costs of production result in
comparative advantage which creates an incentive to specialise according to their
comparative advantage and trade freely because everyone stands to gain if that occurs.
But what do countries gain from free trade?
The theory only acknowledges the higher output and consumption related to specialised
free trade as the only benefits (Schumacher, 2013). If there is free trade between the
countries in the example above, and each specialised according to their comparative
advantage, the overall output would be higher than the autarkic state. In the autarkic
state there can only be a total 200 kg of maize and 6 cars produced. But if each country
specialised according to its comparative advantage there would be a total of 9 cars and
400 kg of maize. Also, with free trade and specialisation there would higher consumption
than the autarkic state. Under autarky each country would have 100kg and 3 cars. Autarky
is the state when a country is not trading with any other country. But with free trade and
specialisation the countries would trade commodities and possible have a higher share of
each commodity for its consumers. So each country would gain in that its consumer would
have higher consumption and there would be a high total output than under autarky.
These are the only gains from free trade according to the comparative advantage theory
(Schumacher, 2013).
With factor endowment the emphasis is on the relative abundance of certain factors of
production which allows for comparative advantage. Similarly to comparative advantage,
absolute abundance in specific factors of production does not guarantee a comparative
advantage since the production of specific commodities requires relative more, or less, of
a certain factor. So it is the relative abundance, or scarcity, of factor that matters. The
central thesis of factor endowment theory is that countries will specialise and trade
commodities that make relatively intensive use of their relatively abundant and cheap
factor of production; and import those commodities that make relatively intensive use of
their relatively scarce factor of production (Todaro, 1996; Schumacher, 2013). From
example, we can assume that the relevant factors to producing cars and maize are car
factories and arable land and that South Africa and the foreign country have the following
endowments:
Table 2: Factor Endowment
South Africa Foreign Country
Car Factories (Number) 3 10
Arable Land (Area) 4 25
Car Factories / Arable Land 3/4 2/5
From this, South Africa has a higher ratio of capital relative to labour. This means that
South Africa has a comparative advantage in production of commodities that are more car
factory intensive because it has a higher car factor-arable land ratio; and it would import
commodities that are arable land intensive. Similar to the case of comparative advantage
theory, even if a country is at an absolute disadvantage in its endowments it can have a
comparative advantage by specialising in producing commodities that use its relatively
more abundant factor. Therefore, because production of commodities can be
characterised according to relative factor intensity, free trade is beneficial to all because
countries have unique endowments of factors and ratios which allows for comparative
advantage (Todaro, 1996). With free trade, countries have an incentive to specialise in
producing commodities that they have comparative advantage in depending on their factor
endowments.
In contrast to comparative advantage theory, there are losers and winners under the
factor endowment theory. The winners are the owners of the relatively abundant factor of
production and they win by far more than the losers, which are the owners of the scarce
factor. This is because as demand for the abundant factor increases, the price of that
factor increases and demand for the scarce drops which reduces its price. Therefore, this
price and demand mechanism which distributes gains unevenly thereby selecting winners
is said to lead to global factor price convergence (Schumacher, 2013).
Theoretical Challenges and Empirical Facts
This means that global inequalities in factor endowments can be a source of comparative
advantage (Leamer, 1995). More importantly it is argued that free trade will lead to factor
price convergence through price and demand mechanisms. As demand for the abundant
factor increases, the price of that factor increases and demand for the scarce drops which
reduces its price allowing countries to overcome absolute disadvantages of their factor
endowments. Therefore free trade will lead to mutual benefit for trading partners with
unequal factor endowments because their comparative advantage will lead to high output
and consumption; and there would be a global convergence in factor prices (Leamer,
1995) which allows for income convergence in the world. But there is significant global
divergence and growing income inequality even though there is a strong political and
ideological push towards trade liberalisation (Deraniyagala & Fine, 2001; Pritchett, 1997).
Therefore the empirical evidence is at odds with the theory here.
Besides empirical challenges, these theories take costs of inputs or factor endowments as
statically given in each case without much consideration about what changes the costs of
production or the relative factor endowments besides demand. However, in many cases
comparative advantage is not simply given but produced through historical experiences
such as colonialism or a history of engagement in certain economic activities (Amsden,
2001). And on the other hand the factor endowment theory says nothing about impact of
actual trade in changing the relative factor endowments and how this affects trade its
almost like a tacit assumption that trade occurs in final consumption products only. These
conditions are what determine the relative gains from trade as well as the prospects from
trade.
In many cases, a countrys factor endowments and comparative advantage are a
consequence of historic factors. This is definitely the case in many post-colonial African
countries. Since colonialism was largely motivated by economic-driven exploitation of raw
materials to catalyse the expansion of capitalism and the European industrialism; most of
the African colonies were forced to grow one or two cash crops which resulted in
neglecting food production and import-substitution (Boahen, 1987). This is not to say that
the African countries specialised in growing cash crops because they had a relative
abundance in the relevant factor. In addition, the monetary policies in the colonies meant
that the colonies were deeply entrenched in an economic imperialism which encouraged
all expatriate companies and banks to repatriate surplus capital to metropolitan states
instead of reinvesting in the colonies (Boahen, 1987). This means that the gains that could
have led to some convergence between the African countries and metropolitan state were
negated by historic factors; even if there was free trade between the colony and
metropolis. These objections point to the dubious separate treatment of trade and
industrial policy in the free trade discourse (Deraniyagala & Fine, 2001) which overlooks
significant practical facts about international trade surrounding historical facts that
determine the gains from trade.
Furthermore, export-commodity-specific factors such as the terms of trade, price and
income elasticity of demand for the exported commodity significantly determine the gains
from trade. Terms of trade is described by the relative prices of a countrys exports and
its imports. Deteriorating terms of trade is the situation where the price of a countrys
exports is decreasing relative to the price of its imports which means that the country
needs to increase the volume of its exports in order to balance its trade (Todaro, 1996).
Therefore, free trade may lead to diminishing returns from specialisation if a countys
comparative advantage is in the production of commodities with deteriorating terms of
trade. If a country has a comparative advantage or is relatively abundantly endowed with
a factor used in the production of commodities with volatile prices; the country could face
uncertain foreign exchange earnings from its exports which can affect its balance of trade
(Todaro, 1996). This could possibly also lead to sovereign debt or currency crisis if the
country cannot balance its trade and payments; or if a country has to repeatedly revalue
its currency in order to realise its exports. In other words it matters what a country
specialises in and what it exports because of the export-commodity-specific.
There is sufficient empirical evidence showing that there is a lower income elasticity of
demand for primary commodities, that predominantly poor countries have a comparative
advantage in (Todaro, 1996). That is to say, as incomes rise in a foreign country, there is
diminishingly increased demand for the export commodities from poor countries which has
a negative impact on the gains from specialisation. In other words, countries may reap
marginally less increases in consumption if their commodities have lower income elasticity
of demand than their imports. Moreover, if poor countries have a comparative advantage
or they specialise in commodities with deteriorating terms of trade and lower income
elasticity of demand, they will realise diminishing returns to specialisation. So if countries
export commodities that have low income elasticity of demand; they will not have
constant returns to specialisation.
This highlights the fact that there are sectorial or comparative advantage specificities
which impact on economy performance. For example, specialisation in industrial or
manufactured commodities which have higher value added will impact the returns to
specialisation. There are export-commodity-specific characteristics which determine the
impact of growth from trade. And sectorial specificities such as the composition a sector
impact on the ability for free trade to impact on economy performance e.g. in the case
of foreign investment to serve the domestic economy trade liberalisation is unlikely to
impact on performance of that sector
The outcomes described are practical and empirical facts about trade. Yet even
deductively they are clearly counterfactual to the outcomes of the comparative and factor
endowment theory. This means that the policy recommendations that arise from these
theories cannot be asserted as always conducive to mutual benefit as the theory suggests;
more especially in relation to the economic growth and developmental outcomes of poorer
or less industrialised countries. Both theories lead to neoliberal policy recommendations
which emphasise the importance of trade liberalisation as a requirement for development
and economic growth but none of the empirical evidence conclusively supports this
conclusion (Deraniyagala & Fine, 2001; Rodriguez & Rodrik, 2000). However, the
neoliberal policy recommendation to specialise according to comparative advantage and
liberalise is founded on the assumption that there are constant returns to specialisation
and free trade, and as the empirical evidence and nature of traded commodities shows
this is not always the case. This is the central point of contention between the Ricardian
and Hecksher-Ohlin approaches when contrasted to Kaldorian approach.
Creating Comparative Advantage as Opposed to it Being Given
The Kaldorian approach is based on the idea that a countrys growth is closely correlated
with the performance of its manufacturing sector, based on Verdoorn Laws of increasing
returns to scale in manufacturing, which have a spill-over impact on other non-
manufacturing sectors whose growth is closely related to manufacturing (Kaldor, 1957). In
summary, the desired strategy for successful economic development is a one that involves
conscious efforts to create Verdoorn effects in order to bring local industrys productivity
up to a level that would enable them to compete with earlier industrialisers such as
Britain. Thus industrial policy and the role of the state in development become very
important.
The Kaldorian approach is in support of interventionist trade and industrial policies. The
idea is that the state can create comparative advantage in the economy through targeted
policies to promote manufacturing growth since this sectors is seen as characterised by
increase returns to scale. However, this view is balanced by assertions that the experience
of manufacturing has imparted invaluable learning which late industrialisers have not
acquired (Amsden, 2001). Therefore learning is also important which means that the
states industrial policy should not be limited to industrial growth but also promote
learning and up skilling.
In addition, the Hecksher-Ohlin model assumes that technology is freely transferrable and
easily codifiable. However, this assumption overlooks the impact of patenting and
copyrighting in restricting access to technology. These restrictions on technology have
even been instituted at the World Trade Organisation in the form of the Trade Related
Aspects of Intellectual Property Rights and Trade-Related Investment Measures council
which deliberate on issue surrounding access to technology and protection of technological
intellectual property on at the global (Markus, 2000). This means that industrial policy
needs to take this into account because the performance of manufacturing is heavily
affected by access to technology (Amsden, 2001).
However, these are things which are often missing due to the impact of neoclassical
economics in narrowing the conception of industrial policy and the assigned role of the
state (Fine, 2011). Although the Kaldorian view and subsequent models based on it are in
stark opposition to the Ricardian view in that it advocates for the role of the state in
promoting manufacturing through industrial policy, the tenets of the Kaldorian view are
still methodologically different from that of neoclassical economics from which the
Ricardian and Hecksher-Ohlin views are based. This principle is methodological
individualism has impacted on the conception of industrial policy as well as the role of the
state.
The embedded assumption of Ricardian and Hecksher-Ohlin models is that the domestic
and global economies of countries trading fit the assumption of perfect market. Efficient
outcomes of markets depend on various assumptions about individual behaviour and the
nature of market which depends on perfect information according to neoclassical
economics (Varian, 2010). Criticisms of these neoclassical assumptions argue that
informational asymmetries, missing or incomplete markets, and transaction costs mean
that markets are no longer perfectly competitive which necessitates institutions such as
the state in order to avoid inefficient outcomes of imperfect markets (Stiglitz, 2002;
Stigler, 1961). The implication of this is that equilibrium can exist even if it is not efficient
so markets do not always clear or that they simply wont exist (Akerlof, 1970). This is
therefore a critique of the neoclassical type of theorising which makes the neoclassic-type
markets an ideal.
With regards to policy these criticism introduce a role for the state albeit a narrow role in
matters pertaining to the economy and ensuring perfect functioning of markets.
Therefore, the state has a role in reducing information asymmetries in order to allow for
Pareto efficient outcomes or to allow for the existence of markets that would otherwise
be non-existent (Stiglitz, 2002). The alternative is that the objective of the state is by
default the reduction of transaction costs and aiding in the perfect functioning of markets.
Nevertheless this common policy proposal is very different from that of neoclassical
economics which asserts that the state would either be obsolete or even detrimental
according to various strands of neoclassical economics (Pollin, 1998).Thus the role of the
state has been reduced trade policy and co-ordination of investment. Moreover, industrial
policy has been conceived narrowly as a way to assist market functioning (Black, 2001;
Black & Roberts, 2008). This highlights to the fact that industrial policy has been narrowly
conceived without any consideration about skills, labour markets and regulating finance
which is an impact of neoliberalism (Fine, 2011). But what exactly is industrial policy?


Creating a Comparative Advantage: The Less Criticised Role of Industrial Policy
Industrial policy can be defined as strategic policy targeting certain sectors, to pursue
outcomes assumed to be beneficial for industry as a whole. These policies do not address
every sector of the economy; instead they are focused on certain sectors perceived to be
able to pull the entire industry (Zalk, 2013). Industrial policy therefore has a role to play
development. Historically industrial policy is seen as having helped the newly
industrialised countries (NICS) of East and South-East Asia emerge through manufacturing
development underpinned by industrial and trade policies inspired by nationalism. But this
was also related to tacit knowledge of production learning through experience in
manufacturing (Amsden, 2001). Therefore, although current industrial policy ignores this
aspect of industrialisation tacit learning is integral to the success of manufacturing. In
addition, its been argued that beyond just the co-ordination of investment and trade
policy intervention, reciprocal control mechanisms are integral to successful
implementation of industrial policy and avoiding state failures (Amsden, 2001). This raises
a question of what extent industrial performance depends on industrial policy.
Industrial policy is often seen as the only important variable to avoid market imperfections
or correcting market imperfection. However, as already discussed the influence of
neoliberalism has led to a limited conception of industrial policy and the role of the state.
The integration of national economies into the global market has resulted in paradigmatic
changes in the organisation of production however. Technological and competitive
advantages have become predominantly maintained through specific use of productive
resources at the firm-level and institutional arrangements at the sectorial-level of the
economy as opposed to the static notion of comparative advantage (Albo, 2005, pp. 71-
72). This means that the role the state cannot be limited to aiding markets to function, or
assist market recovery following a crisis, or the neoliberal economic emphasis on getting
prices right which overlooks the role of the state in picking winners by getting the
prices wrong (Fine, 2013, pp. 3-4; Amsden, 2001). In this regard, South African
liberalisation and its impact have very specific outcomes which highlight the importance
of having an expanded conception of industrial policy.
Varied Policy Outcomes: The Case of South Africa and Relevance of the Kind of Policies
The policy environment has favoured neoliberal policies and market-orientated economics
in South Africa. Government has embarked on a piecemeal removal of all regulatory
restraints on international capital flows and trade which was intended to attract foreign
investment (Vickers, 2002). The era of South African neoliberalisation began with the post-
Apartheid governments adoption of the Apartheid governments debt and it was followed
by the GEAR macroeconomic package which was an indigenised policy package similar to
the transnational neoliberal package of the IMF (Satgar, 2012). Consequently, subsequent
macroeconomic policies have utilised neoliberal economic tools which GEAR was
instrumental in establishing.
The South African governments commitment to trade liberalisation and global
competitiveness pressures meant that many domestic firms had to restructure through
right-sizing and downsizing which led to large-scale job losses (Satgar, 2012, p. 47).
More importantly labour-intensive import-substitution industries suffered the most whilst
export-led industries failed to create job due to a shift towards capital-intensity in order
to retain competitiveness (Satgar, 2012). Thus transnational neoliberalism has succeeded
in restructuring the South African macro economy towards getting prices right and
establishing governance that protects the interest of global capital against risk as opposed
to serving the interests of South Africa citizens. This failure of industrial policy highlights
four challenges associated with industrial policy.
Firstly the rise of neoliberalism has negatively impacted industrial policy theoretically and
in practice. This has lead to disappointing performance of developmental states which
did not have a manufacturing base in their economy (Fine, 2011). This is also associated
with state officials misallocating resources, being driven by personal interest and inherent
inefficiencies of the state. However, rent-seeking is not necessarily inimical development,
as Mushtaq Khan (2006) has shown through his work on governance reforms in developing
countries. Moreover, some governments like that of Indonesia have been able to fund
development projects through clandestine means of monopolising rent-seeking in the
state; making them able to control rent-seeking in the economy in a way that was
consistent with the developmental agenda (MacIntyre, 2000).
Secondly, there has been a shift towards focusing on the outcomes of development and
what development is meant to offer such as higher incomes. This deemphasises the
process of how these outcomes are achieved. This often suggests that development should
increase freedom of choice by focusing on education, but this overlooks the challenges of
creating expectations through education and not meeting them through interventions to
create jobs (Fine, 2013).
Thirdly, as already discussed there has been a rise in neoclassical industrial policies that
focus on market failures and suggest various ways in which to deal with these so that the
state can discover its competitive advantage. This has led to deficiencies related to the
scope of intervention, the object of intervention as well as the role of the state as
previously discussed. In addition this deemphasised the importance articulation between
policies no policy is an island therefore it is important how policies relate with one
another.
Therefore if the South African state wants to improve its effectiveness in promoting local
investment it will have to take on the role of picking winners by getting the prices wrong
instead of having an ideological inclination towards neoliberal economic which emphasises
the states role in aiding markets to function by getting prices right (Fine, 2013, pp. 3-4;
Amsden, 2001, p. 10). Also the state-administered incentives and actual activities of
investment promotion need to engage with the underlying reasons for investment by
transnational automotive firms. Furthermore, if the state wants to reduce state failure it
will need to institutionalise efficient reciprocal control mechanisms for its local
investment promotion (Amsden, 2001, p. 290). Moreover, given the dominance of
neoliberalism, these are all necessary in order for the state to overcome its limited
capacity to discipline capital due to asymmetric bargaining power between the state and
multinational corporation which limits its ability to increase local content, production and
competitiveness.
More than Just the Kind of Industrial Policy: Institutions Matter
Therefore, although industrial policy is important, the impacts of trade on industry
performance do not only depend on state policy. This view assumes that only economics
performance, political will and policy have an impact on development and growth. There
is less emphasis on state performance and the impact of internal state re-organisation that
could improve performance of industry through mechanisms of reciprocal control. There is
also less emphasis on institutional aspects of investment or industrial policy such as the
interaction between the state and industry actors. Although the developmental state
discourse offers a useful theoretical focus on the bureaucracy and elites in relation to
development by offering prescriptions that emphasise importance of an embedded
autonomous and technocratic bureaucracy (Evans, 2008); the discourse overlooks the
current institutional contexts of developmental states and due its restricted focus on
developmental state successes the discourse cannot say much about analysing failures or
attempts at being a developmental state (Evans, 2008, p. 5; Fine, 2013, p. 9). Therefore
the notion of a developmental state, although it fits within the Kaldorian view, needs to
be taken with a pinch of salt due to these limitations.
Moreover, amongst other criticisms, the contention about the efficiency of the state has
been limited to the dichotomy of the state and the market without interrogating the
nuanced variations that exist amongst state agencies and within the market which is made
up of economic sectors, firms and labour (Fine, 2011). In conclusion, whether we say its
the state which is more efficient or the other way around, its undoubtedly the case that
the role of the state has been understood as guiding against market failure or assisting
recovery from market failure. So the debate ought to transform into ways of
acknowledging the need for state involvement and emphasise the need for innovations on
how the state can reduce or avoid state failure and ways to make state intervention
dynamic, responsive to changes and increase state capacity.
In this essay I have argued that the comparative advantage theories have limited empirical
validity and face theoretical challenges due to some of the assumptions they take. Firstly
it is not the case that all goods exhibit constant returns to scale, in addition a comparative
advantage cannot be taken as statically given and that in fact industrial policy is central
to creating a comparative advantage as well as determining the gains from trade.
Moreover, the mainstream comparative advantage views dubiously treat industrial policy
and trade policy as separate, with de-emphasis on industrial policy. This overlooks the
dynamics of comparative advantage and how it is created and maintained. In this regard,
what is more important is the kind of industrial rather than simply instituting industrial
policy. Despite the importance of industrial policy, institutions still matter.








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