The Kaldorian-Ricardian Impasse Written by Siyaduma Biniza 1

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 master’s 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 – it’s

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 country’s 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 country’s exports and

its imports. Deteriorating terms of trade is the situation where the price of a country’s

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 county’s

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 country’s 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 industry’s 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

state’s 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 won’t 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, it’s 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 government’s adoption of the Apartheid government’s 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 government’s 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 state’s 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 it’s

the state which is more efficient or the other way around, it’s 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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