linking comparative advantage, supply management and - atrium

Environmental Externalities: Lessons from an Integrative Economic
Approach
by
for the degree of
Guelph, Ontario, Canada
ECONOMIC APPROACH
University of Guelph, 2011 Dr. Glenn Fox
Applying the concept of comparative advantage in the allocation of production
has been required but ignored in Canadian supply-managed agriculture. There seems to
be a lack of consensus among economists on how comparative advantage is to be
observed and applied in this context. It is also not clear whether the recent changes in the
environmental pressures from agriculture across Canada might have contributed to
changes in the patterns of comparative advantage in primary dairy production. Linking
the concept of individual comparative advantage with the concept of the market as an
information discovery process through comprehensive microeconomic general
equilibrium modeling, deductive reasoning, and statistical analysis of recent industry data
has shown (1) that changes in individual comparative advantage in supply-managed
industries are expressed through quota exchange and revealed through quota prices, and
(2) that environmental externalities may change the patterns of comparative advantage.
The current provincial quota prices, as the appropriate indicators of comparative
advantage, suggest that more quota should be allocated to British Columbia and Alberta.
iii
ACKNOWLEDGEMENTS
This thesis is an outcome of the wholehearted support I received from many
people. My advisor, Professor Glenn Fox, provided the optimal combination of structure,
spontaneity, technical expertise, and friendly atmosphere that made my work an
exceptional intellectual experience. The members of the advisory committee, Professor
Karl Meilke, Professor John Cranfield, and Professor Michael Hoy, have greatly
contributed to improving the quality of the thesis through rigorous constructive criticism.
Throughout the project, I received invaluable feedback from Professor Alfons Weersink,
Professor Danny Le Roy, Professor Bruno Larue, and Professor Philip Paarlberg. I am
also grateful to the external examiner, Professor Peter Boettke, for his encouraging
review and for providing additional insights and suggesting avenues for future research.
My research effort would probably not bear much fruit without being complemented by
the unconditional support of my family, friends, and colleagues. Likewise, I am grateful
to the Canadian Dairy Commission, Toronto Milk Producers, and the Ontario Ministry of
Agriculture, Food and Rural Affairs for their financial contributions to this project.
iv
Introduction into the Problem of Implementing the Principle of Comparative
Advantage in Supply-Managed Industries ...................................................... 1
1.1 Supply Management and Comparative Advantage .............................................. 1
1.1.1 Comparative Advantage and Canadian Dairy Policy ............................................... 5
1.1.2 Sources of Comparative Advantage ......................................................................... 6
1.1.3 Environmental Externalities and Comparative Advantage ...................................... 7
1.2 Economic Problem ............................................................................................. 12
1.5 Chapter Outlines ................................................................................................ 18
for the Interpretation and Application of the Concept of Comparative
Advantage ...................................................................................................... 21
2.4 Other Issues with Input Homogeneity ................................................................ 37
2.5 The Importance of not Ignoring Heterogeneity.................................................. 38
2.6 Conclusion .......................................................................................................... 39
Comparative Advantage—From an Individual to the Economy ................... 41
3.1 Introduction ........................................................................................................ 41
3.2.1 Self-sufficiency ...................................................................................................... 45
3.3.1 A Discrete Distribution of Individual Production Possibilities .............................. 54
3.3.2 Examples of Hypothetical Markets ........................................................................ 61
3.3.3 A Continuous Distribution of Individual Production Possibilities......................... 73
3.3.4 Differences in Autarky Prices ................................................................................ 75
3.3.5 Non-identical Preferences between Populations .................................................... 79
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3.3.7 Supply Restrictions ................................................................................................ 86
Chapter 4
4.1 Introduction ........................................................................................................ 99
4.3 Environmental Externalities and Comparative Advantage in Aggregate Models
101
4.4 The Model ......................................................................................................... 107
4.4.1 The Scenarios ........................................................................................................ 109
4.4.2 Scenario 1: Known Polluting Attribute, Global Emissions, and Absent Legal
Liability................................................................................................................. 111
4.4.3 Scenario 2: Known Product Emission Attribute, Local Emissions, and Absent
Legal Liability ...................................................................................................... 131
4.4.4 Scenario 3: Unknown Product Emission Attribute, Global Emissions and Absent
Legal Liability ...................................................................................................... 132
4.4.5 Scenario 4: Unknown Product Emission Attribute, Local Emissions, and Absent
Legal Liability ...................................................................................................... 134
4.4.6 Scenario 5: Known Product Emission Attribute, Global Pollution and Present Legal
Liability................................................................................................................. 134
4.4.7 Scenario 6: Known Product Emission Attribute, Local Emissions, and Present
Legal Liability ...................................................................................................... 135
4.4.8 Scenario 7: Unknown Product Emission Attribute, Global Emissions, and Present
Legal Liability ...................................................................................................... 135
4.4.9 Scenario 8: Unknown Product Emission Attribute, Local Emissions and Present
Legal Liability ...................................................................................................... 135
4.6.7 Changes in the Spatial Patterns of Comparative Advantage ................................ 162
4.7 Discussion of Results ........................................................................................ 165
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Industries: Why Markets and Why Quota Markets? ................................... 171
5.1 Introduction ...................................................................................................... 171
5.2 The Question of Implementing Comparative Advantage within a Society ....... 172
5.3 Changes in Comparative Advantage and Quota Exchange ............................. 177
5.3.1 Restrictions on Quota Exchange and Comparative Advantage ........................... 183
5.3.2 Quota Exchange as an Information Discovery Mechanism ................................. 184
5.4 Conclusion ........................................................................................................ 186
Canadian Dairy Industry .............................................................................. 188
6.1 Introduction ...................................................................................................... 188
6.2 Recent Changes in the Patterns of Production in the Canadian Dairy Industry
189
6.3 Factors Contributing to Changes in Patterns of Production ........................... 193
6.4 Recently Suggested Indicators of Provincial Comparative advantage ............ 208
6.5 Quota Prices and Comparative Advantage ...................................................... 227
6.5.1 Additional Considerations.................................................................................... 228
6.7 Using Quota Prices as Indicators of Comparative Advantage ........................ 233
6.7.1 Accounting for Interprovincial Differences in Administered Milk Prices ........... 233
6.7.2 Accounting for a Quota Price Ceiling .................................................................. 234
6.7.3 Allocating Over-Base Quota ................................................................................ 235
6.7.4 Data ...................................................................................................................... 239
6.8 Discussion and Conclusion .............................................................................. 252
Chapter 7
7.1 Conclusions ...................................................................................................... 255
References .................................................................................................... 263
Table 3.1. Specialization and exchange pattern in a hypothetical 3-individual economy
at the food price of 1.7 ........................................................................... 52
at the food price of 1.06 ......................................................................... 63
with heterogeneous preferences at the food price of 1.136 ................... 67
Table 3.4A Specialization and exchange pattern in a hypothetical 15-individual economy
at the food price of 1.33 ......................................................................... 70
Table 3.4B Specialization and exchange pattern in a hypothetical 15-individual economy
at the food price of 1.33. (cont’d) .......................................................... 71
Table 4. 1. Combinations of attributes defining the eight assessed scenarios ............... 110
Table 4.2. A hypothetical distribution of production possibilities in clothing, non-
polluting food and polluting food for 24 individuals ................................... 138
Table 4.3. Summary of utility function forms and parameters for the eight assessed
scenarios ...................................................................................................... 139
Table 4.4. Market outcome in Scenario 1 under the prices of polluting and non-
polluting food of 0.86 and 1.31 , respectively ......................... 141
Table 4.5. Indifference prices of polluting and non-polluting food as specialization
decision criteria in Scenario 1 ..................................................................... 143
Table 4.6. Market outcome in Scenario 2 under the price of food of 1.08 ........... 150
Table 4.7. Market outcome in Scenario 3 under the price of food of 1.08 ........... 154
Table 4.8. Market outcome in Scenario 4 under the price of food of 1.08 .......... 157
Table 4.9. Market Outcome in Scenarios 5, 6, 7, and 8 under the price of food of 1.40
............................................................................................................... 160
Table 4.10. Summary of outcomes in the eight assessed scenarios ................................ 167
Table 6.1. Summary statistics for county-level dairy cow population density, human
population density, cash crop area, farm cash receipts, and per person
income in Canada for 1996 and 2006 .......................................................... 197
viii
Table 6.2. Estimated effects of selected explanatory variables on the 1996 – 2006
change in the dairy cow population density................................................. 202
Table 6.3. Livestock and human population densities in Canada by province, 1996 and
2006 .............................................................................................................. 205
Table 6.4. Yearly weighted average per standard hectolitre gross farm gate nominal and
real milk prices by province for dairy years 2003-2004 to 2010-2011 ....... 241
Table 6.5. A comparison of the CDIC calculated average producer per standard
hectolitre milk prices and prices calculated by the author using available
provincial component prices ........................................................................ 244
Table 6.6. Levies paid by farmers to provincial milk marketing boards in 2010
(estimates based on most recent available data) ......................................... 245
Table 6.7. Average nominal and real milk production quota prices in Canada by
province for dairy years 2001-2002 through 2010-2011 2 ($/kg of
butterfat/year) .............................................................................................. 247
Table 6.8. Provincial over-base quota allocations for 2010-2011 calculated using the
Quota Price Ratio Method, the Quota Price Difference Ratio Method, the
Revealed Output Advantage Index, and the actual 2010-2011 allocation .. 250
FIGURES
Figure 1.1. A comparison of human population densities (2007) and livestock units per
square kilometre of agricultural land (2004) across the E.U., U.S., New
Zealand, Australia, and Canada. ..................................................................... 9
Figure 1.2. Human and livestock (hogs, dairy and beef cattle) population densities in
1981, 1986, 1991, 1996, 2001 and 2006 in Canada by province .................. 11
Figure 2.1. A graphical representation of the Heckscher-Ohlin model adapted from
Stolper and Samuelson (1941) ....................................................................... 30
Figure 3.1. Individual decision to specialize and trade depending on the exchange ratio
........................................................................................................................ 48
Figure 3.2. Market equilibrium in a three-individual economy ....................................... 51
Figure 3.3. Aggregate excess supply and demand for food in a 12-individual economy . 65
Figure 3.4. Aggregate excess supply and demand for food in a 15-individual economy . 72
ix
Figure 3.5. Increases in productivity resulting from acquisition of specific inputs after
specialization ................................................................................................. 82
Figure 3.6. Supply management, individual consumption bundles and preference ......... 88
Figure 4.1. Categorizing specialization decisions by comparing the slope of individual
Production Possibilities Frontiers with the market prices of polluting and
non-polluting food ........................................................................................ 122
Figure 4.2. Demand and supply schedules for food for the 24 hypothetical individuals in
Scenario 1 .................................................................................................... 147
Scenario 2 .................................................................................................... 152
Scenario 3 .................................................................................................... 155
Scenario 4 .................................................................................................... 158
Scenarios 5, 6, 7, and 8 ................................................................................ 161
Figure 4.7. Spatial distribution of production in the eight assessed scenarios .............. 163
Figure 5.1. Individual specialization and consumption decisions in a two-good model of
exchange....................................................................................................... 179
Figure 5.2 Changes in individual production possibilities and quota exchange in a two-
good model of exchange ............................................................................... 181
Figure 6.1. Top 15 census divisions by percent share in the provincial dairy herd in
Ontario in 1991 and 2006 ............................................................................ 190
Quebec in 1991 and 2006 ............................................................................ 192
Alberta in 1991 and 2006............................................................................. 194
Figure 6.4. Milk quota by province, 1998 – 2010, and provincial percentage shares of
national dairy cow population in 1993 and 2006 ........................................ 207
Figure 6.5. CPI levels across Canadian provinces in 2010 (2002=100) ....................... 212
x
Figure 6.6. The effect of differences in preferences and provincial quota levels on the
potential trade patterns between two provinces with identical production
possibilities and the same number of egg consumers. ................................. 217
Figure 6.7. A potential increase in transportation distance resulting from a decision to
reallocate production to the province with a lower average freight cost. ... 220
Figure 6.8. The effect of production function assumptions on marginal input productivity
as a measure of comparative advantage ...................................................... 226
APPENDICES
Appendix 3.1: Deriving individual demand for food and clothing for an individual
specializing in food ................................................................................. 93
Appendix 3.2: Deriving individual demand for food and clothing for an individual
specializing in clothing ........................................................................... 94
Appendix 3.3: Demonstrating the existence of equilibrium for a general case of convex
preferences .............................................................................................. 96
Comparative Advantage in Supply-Managed Industries
1.1 Supply Management and Comparative Advantage
Production and marketing of milk, eggs and poultry in Canada are administered
under a system commonly known as supply management. Katz et al. (2009) express
concerns that this system has reduced the flexibility of reallocation of production in
response to market demand and to the underlying changes in productivity. The Farm
Products Agencies Act (2011 [1985]) stipulates that one of the legal mandates for the
operation of the Canadian supply-managed industries is to include the principle of
comparative advantage in allocating additional quota to provinces. Thus, if the spatial
patterns of comparative advantage are changing over time, the supply management
authorities need to take these changes into account when allocating additional quota to
provinces.
In general, there may be many factors contributing to changes in comparative
advantage. For example, Rothbard (1996 [1962]) identifies quality and quantity of nature
given factors of production and the skill of the producer as important factors. In
aggregate models, such as those built upon the model developed by Stolper and
Samuelsson (1941), an exogenous technological change or a change in aggregate factor
endowments may affect the pattern of comparative advantage. Recently, Copeland and
Taylor (1995, 2004) have identified environmental externalities as another factor that
could potentially change aggregate patterns of comparative advantage.
2
While the issue of observing and implementing comparative advantage in
Canadian supply-managed industries has stirred up quite a bit of debate among
agricultural economists, not much progress has been made in finding the common
ground for applying this mandate. The current debate on the appropriate mechanism of
implementing comparative advantage in the Canadian egg production includes several
recent studies by Doyon (2007), Larue and Gervais (2008), Katz et al., (2008), Bruneau
and Schmitz (2008), Mussell et al. (2008), and Meilke (2009).
To compound the problem, there seems to be differing views among economists
both on the theoretical nature of the concept of comparative advantage as well as on what
the most suitable institutional framework for putting this theoretical concept into practice
would be. Most of the contemporary literature, including Stolper and Samuelson (1941),
Samuelson (1953), Rybczynski (1955), Jones (1957), Vanek (1968), Bhagwati (1972),
Horiba (1974), Mussa (1978), Melvin (1985), Chen (1992), Bernard (2006), and many
others, applies the concept primarily at the aggregate national level where micro-
economic qualitative features of individuals play a tertiary role. While the existence of
the market is sometimes implicitly assumed, it is linked with the assumptions of
complete information and homogeneity of factors of production. Other times, entire
economies are represented as singular, uniform, optimizing units.
Some economists, like Mises (1996 [1949]); Hayek, 1945; Rothbard (2009
[1962]), Buchanan (1969), Kirzner (1979), Barnett (1992), and Boettke (1997),
underscore the principles of methodological individualism and the subjective theory of
value. These authors put priority on the qualitative features of individual human actors as
the underlying principles governing the operation of the market process. This is a process
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changing knowledge of a multitude of individual producers, consumers and
entrepreneurs. This process, according to the above authors, is expressed through market
competition as an information discovery mechanism where market prices play a crucial
role in reflecting the subjective, unobservable and heterogeneous characteristics of a
multitude of individuals.
While the implications of these differing conceptualizations of the market have
been assessed at the level of an economy by the economists examining the possibility of
central planning in the second half of the 20 th
century, Boettke (1997) stresses that more
recent literature seems to have omitted these issues, particularly when it comes to
legislative interventions in the market process at a smaller scale. The recent difficulties
in putting into practice the concept of comparative advantage using legislative
mechanisms in the context of egg production in Canada may be an indication of a similar
omission.
These attempts to politically implement the principle of comparative advantage
seem not to have found a common ground on what the most appropriate source of
information for such implementation would be. Doyon (2007) suggests a number of
potential indicators of comparative advantage in the Canadian egg industry, including
partial productivity measures, farm size, enterprise budget data, farm cash receipts,
transportation costs, inflation rates and input prices. Meilke (2009) generally disagrees
with most of the suggested indicators on the basis that they are either theoretically
inconsistent or empirically biased. Instead, Meilke suggests production quota prices as
the primary indicator. Gervais and Larue (2009), while pointing out that quota prices are
4
worth considering, express reservations as to whether this indicator would be
theoretically consistent with the concept of comparative advantage.
Katz et al. (2008) suggest an index called the Relative Output Advantage (ROA)
as a potential measure of aggregate, provincial comparative advantage in the poultry and
egg industries. This index is based on the percentage share of agricultural production in
the total economy (in terms of total dollar outlays) for each province. Sarker (2008) and
Mussell et al. (2009) doubt the validity of this procedure and argue that provincial
comparative advantage in agriculture does not necessarily imply comparative advantage
in all agricultural industries. Schmitz and Bruneau (2009) defend the Katz et al. (2008)
approach as being imperfect but still the best alternative because other alternatives such
as comparing quota prices or prices from a similar industry are practically infeasible due
unavailability or unreliability of data. Gervais and Larue (2009) disagree and propose an
indicator called the Domestic Resource Cost as potentially a better alternative.
The above attempts rest on the theoretical framework built upon the Stopler and
Samuelson‘s (1941) aggregate interpretation of the concept of comparative advantage. It
is unclear how this theory takes into account the insights of the authors focusing on
market as the process of materialization of unobservable individual heterogeneity. This
lack of clarity may have implications for the Canadian dairy industry, as its current
institutional framework is built upon the Farm Products Agencies Act (2009 [1985]),
which invokes some method of observing a material reflection of the concept of
comparative advantage and including this information in provincial production
allocations.
5
1.1.1 Comparative Advantage and Canadian Dairy Policy
The Canadian milk supply management system constitutes of a legal framework
by which the price and volume of milk produced in each province are determined each
year and potentially adjusted on a monthly basis. The price is determined based on the
Cost of Production (COP) formula and the quantity of milk to be produced in each
province is estimated to meet the provincial expected demand for fluid and industrial
milk at the COP price. This estimated volume is set as the provincial quota, which is
maintained by a system of permits issued to each individual milk producer. To maintain
the pre-planned market share of the producers in each province, the quota system is
coupled with restrictions on import of dairy products.
According to the Canadian Dairy Commission (2011), supply management in
primary milk production was instituted to address the unstable markets, uncertain
supplies and highly variable producer and processor revenues that were common in the
1950s and 1960s. The initial quota allocations were determined based on the historical
production volumes. The Farm Products Agencies Act (2011 [1985]) established the
legal basis for the operation of the Canadian Dairy Commission (CDC), a federal agency
that governs the operation of milk supply management. The body responsible for
estimating quota allocation among provinces is the Canadian Milk Supply Management
Committee (CMSMC). Each province has a team representing its interests in the
CMSMC. The decisions are made unanimously, where each province gets one vote.
Section 23 of the Farm Products Agencies Act (2011 [1985]) states that in
allocating additional quotas for anticipated growth of market demand, an agency shall
consider the principle of comparative advantage of production. However, the Act does
6
not refer to a particular definition of comparative advantage or details on the methods of
observation or procedure by which the principle would be considered. This section of the
Act seems to have been ignored up until the recent research focusing on the egg industry.
Taking into account the current debate about the implementation of this mandate, it
would be useful to provide a comprehensive assessment of the treatment, understanding,
and interpretation of the principle of comparative advantage in the economic literature to
determine whether and how this concept can be put into practice within supply-managed
industries.
Given the experience in the egg industry, the Canadian Milk Supply Management
Committee could face similar challenges in assessing any potential changes in the spatial
patterns of comparative advantage in dairying in Canada since the introduction of supply
management in the 1970‘s. Gaining more information on these changes would be
valuable for more informed public policy implementation. In addition, changes in the
underlying patterns of comparative advantage may have implications for supply-
managed industries in the event of supply and/or trade liberalization. However,
regardless of the future trade policy, if the legal mandate for considering comparative
advantage in inter-provincial quota allocation still remains, there is space for research in
finding ways to best address this mandate.
1.1.2 Sources of Comparative Advantage
In the broadest sense, any difference between two economic agents can be a
source of comparative advantage (i.e. differences in skills or preferences). The principle
of comparative advantage, or as Mises (1996 [1949]) calls it—the law of association—
allows individuals to exploit their differences for mutual benefit. Individuals can
7
specialize in what they do better relative to other individuals and exchange some of their
product for other goods or services, produced by other specialized individuals.
In aggregate models, opportunity costs are represented by the aggregate
Production Possibilities Frontier. Differences in the slope of the economy Production
Possibilities Frontier indicate differences in marginal factor productivity. In the original
model, Ricardo (1821) does not elaborate on the sources of differences in labour
productivity across countries. It is generally assumed by later economists that the sources
are climatic or technological differences across countries.
In the Heckscher-Ohlin model of international trade expounded by Stolper and
Samuelson (1941) and other later authors, differences in marginal factor productivity can
arise due to differences in national factor endowment ratios. Additionally, the optimal
point on the production possibilities frontier (as defined by the Heckscher-Ohlin model)
is determined by both production possibilities and preferences.
Pethig (1975) and Copeland and Taylor (2004) identify internalization of
environmental externalities through policy as one of the potential factors that can change
market outcomes such as prices and patterns of production and exchange at the aggregate
level. Within this approach, some countries may be better able to meet policy
requirements compared to others and thus reveal comparative advantage in certain
products. In this sense, policy setting may shape the type of comparative advantage that
will be expressed.
1.1.3 Environmental Externalities and Comparative Advantage
In Canada, the agricultural sector has been traditionally less subjected to
environmental standards and regulations compared to the manufacturing sectors.
8
However, in the last decades this trend is changing and there have been new
environmental legal acts concerning agriculture. Rajsic et al. (2011) document a number
of new standards regarding construction of livestock operations, manure management,
wildlife and biodiversity preservation, farming practices for protection of ground and
surface waters etc.
According to Copeland and Taylor (2004), a change in environmental policy
stringency is a joint result of a change in the aggregate demand for environmental quality
and changes in marginal abatement costs. These changes could result from an increased
production intensity, changes in human population density, and changes in income.
Rajsic et al. (Forthcoming 2012) assess the link between production intensity of
agriculture, population density, and costs of compliance with environmental standards in
the European Union, United States, New Zealand, and Canada and find that farmers in
densely populated countries with input-intensive agriculture often face higher
compliance costs. This, in turn, may affect the patterns of international exchange of
agricultural commodities when new environmental laws are introduced.
Figure 1.1 illustrates some of the country-level differences in human and
livestock population densities. The horizontal axis shows the number of persons per
square kilometre of agricultural land, while the vertical axis measures the number of
livestock units 1 per square kilometre of agricultural land. The countries closer to the
origin can be said to have a relatively lower potential for environmental externalities
because both measures are relatively low in these countries. For example, this diagram
1 Livestock Units are generally used as a measure of manure output calculated by multiplying the number
of animals by a livestock unit factor, based on size and manure production for the specific type of animal.
9
Figure 1.1. A comparison of human population densities (2007) and livestock units per square kilometre of agricultural land (2004)
across the E.U., U.S., New Zealand, Australia, and Canada.
Source: Food and Agriculture Organization (FAO) (2007)
Notes:
10
reveals that the amount of potential agricultural environmental externalities, measured by
the distance from the origin, is multiple times lower in Canada than in Malta,
Netherlands, Belgium, Cyprus, and many other European countries.
Canada itself is not a homogeneous country when it comes to measures of
potential environmental externalities. As Figure 1.2 shows, both human and livestock
population densities vary across Canadian provinces. Like in the previous Figure, points
further away from the origin indicate higher potential for agricultural environmental
externalities. In this context, environmental externalities are potentially high in Quebec
and Ontario relative to the Prairie Provinces.
In Ontario, Quebec, and Nova Scotia, there are more than 200 persons per km 2 of
agricultural land but less than 20 in Alberta, Manitoba and Saskatchewan. In addition,
Ontario has become the most densely populated province in 2006 compared to being
fourth on the list in 1981. With respect to the livestock (hogs, dairy and beef cattle)
population density, Quebec is the most densely populated, with about 160 animals per
square kilometre of agricultural land. It is followed by Ontario and Prince Edward Island.
It is also evident that the ranking of provinces in terms of livestock population density
has changed over time. This is the most noticeable for Manitoba, which became the
fourth most densely livestock populated province, compared to being the second last
in1981.
Given the observed differences and changes in environmental pressure from
agriculture, differences in the legal and political pressure on diary producers would not
be surprising. Table 1.1 compares manure management standards across Canadian
provinces in 2007. Differences across provinces exist in all categories: minimum
11
Figure 1.2. Human and livestock (hogs, dairy and beef cattle) population densities in 1981, 1986, 1991, 1996, 2001 and 2006 in
Canada by province
12
manure storage days for new and expanding facilities, minimum distance of manure
storage from watercourses, minimum distance of manure storage from wells for new and
expanding facilities, minimum separation distance of barns from other dwellings,
minimum distance of manure application from water bodies or wells, and minimum farm
size requiring a Nutrient Management Plan. Additional differences on the municipal
level are present as well. Judging by these inter-provincial differences in environmental
pressure, and taking into account the previous discussion of different interpretations of
comparative advantage, it stands to reason to assess the link between environmental
externalities, identifying and implementing comparative advantage and the market
process.
1.2 Economic Problem
The economic problem that this thesis addresses is composed of three interrelated
sub-problems: (1) the concept of comparative advantage has been required but ignored in
Canadian supply-managed agriculture; (2) there seems to be a lack of consensus among
economists on how this concept is to be observed and applied in supply-managed
industries, and (3) there are indications that recent changes in the environmental pressures
across Canada might have contributed to potential changes in the patterns of comparative
advantage in dairy production.
Since there seems to be differences in the understanding and interpretation of the
concept of comparative advantage both in the academic community and within the
Canadian supply management legal framework, a move toward a resolution of the
apparent conflict would contribute to a more articulated use of the concept within the
legal framework, particularly the Canadian Farm Products Agencies Act. Furthermore,
13
Table 1.1. Comparison of manure management standards across Canadian provinces in 2007 1
Minimum
spreading site size)
Alberta 270 30 100 350 and up 7 10
8 - 30
Saskatchewan Not specified Not specified Not specified 400 - 1600 10
Not specified 300 LU
400 and up 8 - 35 12
300 LU
Not specified Prohibited within
spreading site
New
Brunswick 210 Not specified Not specified 300 and up 300 and up Not specified
Nova Scotia 210 91.44 21
91.44 91.44 Not specified Not required
Prince Edward
Island 210
23 40 and up
or 30 27
Notes:
2. The reported value corresponds to distance from any watercourse.
3. The reported value corresponds to distance from a water source for domestic use.
4. The reported value corresponds to distance from the nearest neighbour.
5. The reported value corresponds to distance from churches, schools, restaurants, etc.
6. The reported value corresponds to distance from the urban boundary.
14
7. Minimum distance depends on animal species, facility size, degree of expansion (if expanding), manure system, and
encroachment.
9. Applies if manure is incorporated within 48 hours.
10. According to municipal regulations (case of Rural Municipality of the Lake of Rivers), minimum distance depends on the
number of animal units.
11. Minimum distance is regulated under municipal regulations (case of Rural Municipality of Hanover).
12. Minimum Distance depends on manure application method and presence of vegetative buffer strips.
13. Minimum distance is regulated under municipal by-laws based on the number of animal units, odour potential, base distances,
type of manure (solid or liquid), type of project, usage, etc.
14. The reported value corresponds to distance from a drilled well.
15. The reported value corresponds to distance from any other well.
16. The reported value corresponds to distance from a municipal well.
17. Minimum distance depends on the manure type, storage system, and type of livestock.
18. The reported value applies if the maximum sustained slope of the land is 25% or greater.
19. New and expanding livestock operations with less than 300 nutrient units must complete an approved certified Nutrient
Management Strategy and are subject to construction and sitting standards, and setbacks from wells and surface water. New
and expanding operations with greater than 300 nutrient units or those within 100 metres of a municipal well must have an
approved certified NMS as well as a certified Nutrient Management Plan.
20. The 30 m distance applies to construction of new facilities; the 300 m distance applies to storage on the ground.
21. The minimum distance standard was reported as 300 feet under municipal bylaws.
22. This value has a status of a guideline under Guidelines for Manure Management for Prince Edward Island.
23. Minimum distance depends on type of storage, soil type, depth to bedrock, etc.
24. Minimum distance is calculated according to a formula that takes into account facility size, type, animal type, etc.
25. Minimum distance depends on application method and water body type.
26. As reported under the Environmental Assessment Regulations.
27. As reported under the Environmental Guidelines/Stipulations.
15
more clarity in the area of the theory (or theories) of comparative advantage may
contribute to new insights about the interrelationships between comparative advantage
and environmental externalities.
Additionally, within the currently prevailing theory, environmental policy is
considered to be an emerging contributing factor that can shape comparative advantage at
the aggregate level. It is generally concluded that environmental policy can affect
patterns of inter-regional trade. Consequently the competitiveness of provincial dairy
industries might have changed in favour of some provinces. Thus, lack of knowledge of
the present spatial patterns of comparative advantage can contribute to less informed
policy decisions in the future (i.e. consequences of trade policy and/or supply
management changes for different provinces).
1.3 Economic Research Problem
The understanding and interpretation of the concept of comparative advantage
varies significantly among economists, while the understanding of those involved in the
Canadian supply management policy design is unclear at best. Thus, the application of
the concept in public policy is ambiguous for both conceptual and practical reasons.
While some economists apply the concept of comparative advantage predominantly to
aggregate models of national and regional economies, it is still not clear whether this
approach is consistent with the principles stressed by some scholars as the basic tenets of
neoclassical economics—methodological individualism and the subjective theory of
value. It is also not well understood what would be the implications of applying the
concept at an individual, micro-economic level.
16
Notwithstanding this conceptual dilemma, and assuming that the concept can be
applied to administrative decisions in the context of aggregate economies, it is not known
whether and in what way the pattern of comparative advantage in milk production across
Canadian provinces changed over the last several decades, since the introduction of
supply management. Additionally, it is not known whether environmental externalities
related to agriculture that came about in the last several decades played a role in this
potential change.
Answering these research questions would provide two kinds of information.
Firstly, there would be a theoretical contribution. The thesis would offer an integrated
assessment of the treatment of comparative advantage within economics, with special
emphasis on subjectivism and methodological individualism. This would result in more
complete understanding of the concept with more emphasis on the microeconomic
underpinnings of human choice. In addition, the thesis would integrate these new insights
with the theory of environmental externalities and comparative advantage.
Secondly, there will be an empirical contribution. The thesis will offer
information to both federal and provincial producer organizations about the advantages
and disadvantages of different approaches to observing and implementing comparative
advantage. This would contribute to meeting the current requirement of the supply
management legal framework. Next, the thesis will provide insight into the potential
changes in the patterns of comparative advantage in the Canadian dairy industry.
Together with the theoretical insights, this information can guide more informed support
or opposition of the Canadian public, its elected representatives and agricultural producer
organizations to different agricultural and environmental policy proposals.
17
1.4 Purpose and Objectives
The purpose of this study is to (1) assess the theoretical nature of the concept of
comparative advantage and its practical applicability in the Canadian supply management
legislation (2) identify and assess the theoretical link between individual heterogeneity,
comparative advantage, and environmental externalities. The intermediary steps in
achieving this purpose consist of the following objectives:
1. to assess the treatment, understanding, and interpretation of the concept of
comparative advantage in economic literature in order to define the scope for the
use of this concept in the Canadian supply management policy and law;
2. to provide an integrated framework of different interpretations based on the
principles of methodological individualism and subjectivism and apply this
framework to describing the relationship between individual heterogeneity,
environmental externalities, and observing comparative advantage in supply-
managed agriculture;
3. based on the above analysis, ultimately to determine the appropriate indicator of
spatial differences in the patterns of comparative advantage in a supply-managed
industry;
4. to assess potential changes in the spatial patterns of comparative advantage in the
Canadian dairy industry by using the selected indicator and to develop a
framework for incorporating these changes in the allocation of production quota
across provinces; and
18
5. to use the theoretical and empirical insights from the previous four objectives to
derive potential implications for the functioning of the Canadian supply
management system and policy.
1.5 Chapter Outlines
The next chapter provides a comparative assessment of the pivotal theoretical
literature on comparative advantage in the last two centuries. I compare and contrast the
conceptualization, interpretation and application of this economic principle in the works
of major contributors to the literature. This leads to identifying two general streams of
literature with subtle but potentially significant differences in how the principle has been
formally represented. Then, I assess how these differences in representation can shape
our understanding and interpretation of comparative advantage. Then I discuss some
implications of these differences for the practical implementation of comparative
advantage in society. Finally, I discuss the elements of the concept of comparative
advantage, such as the unobservable heterogeneity within an economy, that are too
important to be overlooked in the formal representation of the concept.
In Chapter 3, I take a formal step towards integrating individual heterogeneity
into a general equilibrium model of comparative advantage. In this context, production
and consumption decisions are made by individuals based on individual production
possibilities and preferences. The existence of separate industries is derived from
individual comparative advantage rather than assumed without reference to individual
specialization decisions. The purpose of this approach is to more explicitly present the
specific elements of knowledge needed to put the principle of comparative advantage into
practice. These elements fall into the category of what Hayek (1945) and Barnett (1992)
19
call the time- and place-specific knowledge dispersed among a multitude of individuals.
This approach provides a basis for illustrating and visualizing the link between individual
heterogeneity and the knowledge problem first explicitly deduced by Hayek (1945).
Next, I incorporate cross-boundary and within-boundary differences in preferences into
the model. Finally, I use this framework to analyze supply management.
Chapter 4 extends the model developed in Chapter 3 to incorporate environmental
externalities. The purpose of this chapter is to evaluate the consequences of relaxing the
producer homogeneity assumption in a general equilibrium model. I place special
emphasis on the role of incomplete information, spatial distribution of producers, and
legal liability in the process of internalization of externalities.
In chapter 5, I contrast the models developed in Chapter 3 and Chapter 4 to actual
markets to illustrate the practical implications of the fact that individual production
possibilities and preferences are not directly observable by anyone but the individual who
possesses them. I link these models to the literature that highlights the origin and
importance of market prices for the allocation of resources within a society. Next, this
chapter illustrates the mechanism by which quota exchange facilitates the implementation
of changes in individual comparative advantage in supply-managed industries.
Chapter 6 includes (1) an assessment of the potential changes in the spatial
patterns of comparative advantage in the Canadian dairy industry, (2) an assessment of
the previous attempts to measure comparative advantage in the egg industry in Canada
and (3) a description of practical means of implementing the principle of comparative
advantage by using provincial quota prices. Using recent market data, I present two
methods for using quota prices as a guideline for allocating quota to provinces.
20
Chapter 7 summarizes the major findings from the preceding six chapters. In
addition, it includes a summary of potential limitations and suggestions for further
research.
21
Implications for the Interpretation and Application of the Concept
of Comparative Advantage
2.1 Introduction
The principle of comparative advantage is one of the fundamental concepts that
underlie our understanding of the functioning of the market economy. However, there are
subtle but important differences in how this concept has been understood and applied by
different economists. At the root of these differences are, it seems, variations in the
economic language and method used.
Boettke (1997) noted that relying strictly on mathematical modeling of human
action often creates disconnect between the economic meaning of human action and the
mathematical formulation of that action. This disconnect, Boettke argues, has far
reaching implications for economic policy. Since implementing the economic principle of
comparative advantage is a question of economic policy, it is important to fully
understand the policy implications of different theoretical approaches.
The thesis of this chapter is that the emphasis on modeling using aggregate
variables has left out important aspects of the concept of comparative advantage.
Consequently this has weakened the logical basis for the existence of a market economy
in these models. More specifically, comparative advantage framed as a national or
regional attribute leaves out the process of individual decision-making based on
individual time- and place-specific knowledge. As Hayek (1945) noted, time- and place-
specific knowledge owned by an individual in society is not directly available to other
22
human beings, including the economic analyst. Nevertheless, some of this individual
knowledge is reflected in market prices through specialization and exchange. For
example, a potential producer can use market prices to indirectly compare his or her own
production possibilities with the production possibilities of the current marginal producer.
While some economists have maintained these principles attached tightly to the concept
of comparative advantage, some have marginalized or even completely ignored them
through the process of translation into models that employ aggregate variables. The next
section provides a review of selected works on comparative advantage since Adam Smith
with emphasis on the differences in economic method used and some of the implications
of these differences.
2.2 Division of Labour since Adam Smith
Although Block et al. (2007) point out earlier references to the concept of
comparative advantage and the resulting benefits from division of labour, Adam Smith is
the most well known today for highlighting the importance of this economic
phenomenon. Smith (1886 [1776], p. 3) writes:
The division of labour, however, so far as it can be introduced,
occasions, in every art, a proportionable increase of the productive
powers of labour. The separation of different trades and employments
from one another seems to have taken place in consequence of this
advantage. This separation, too, is generally called furthest in those
countries which enjoy the highest.
Even though he did not perform a deeper analysis of the principles underlying division of
labour, it is evident that Smith here applies this concept to individuals within a country
and concludes that individual specialization and exchange leads to an increase in total
productivity.
23
The next (chronologically) most quoted reference is Ricardo (1821, p. 141).
Compared to Smith, Ricardo was more precise in spelling out the analytical steps of the
increase in total productivity resulting from specialization. These analytics constitute
what is now called the principle of comparative advantage. However, Ricardo applies this
principle to whole countries rather than to individuals. He uses an example of Britain and
Portugal trading cloth and wine and concludes that even though both goods can be
produced with less labour in Portugal, it is still beneficial for Portugal to import cloth
from Britain:
because it would be advantageous to her [Portugal] rather to employ her
capital in the production of wine, for which she would obtain more cloth
from England, than she could produce by diverting a portion of her capital
from the cultivation of vines to the manufacture of cloth.
This anthropomorphism, where a country seems to make production and
consumption decisions as a single entity, might be seen by some as an acceptable
abstraction. However, it seems that this anthropomorphism also initiated a translation
process in which the importance of individual differences for the existence of a market
economy and the consequent exchange across country borders has been diminished and
often completely ignored. Some authors have linked their translation efforts to a
perceived link of the concept of comparative advantage to the labour theory of value that
both Smith and Ricardo supported.
Long after the refutation of the labour theory of value by Menger (1871), Ohlin
(1991 [1924]) and Haberler (1985 [1930]) express a concern that the concept of
comparative advantage itself is based on the labour theory of value. In the initial
development steps of what is now known as Heckscer-Ohlin trade theory, Ohlin (1991
[1924], p. 75) writes:
24
The classical theory of value has long ceased to be a satisfactory solution
to the problem of price determination. Nevertheless, it continues to form
the basis for the theory of international trade, even in contemporary
expositions. This is clearly an anomaly.
In addition, Ohlin (1924, [1991]) argued that the Ricardian model of international
exchange suffers from a serious inadequacy – inability to explain partial specialization of
countries. Ricardo, similar to Ohlin, implicitly assumed homogeneous inputs 2 . However,
Ricardo used a fixed proportions aggregate technology which, Ohlin argued, was due to
Ricardo‘s adherence to the labour theory of value 3 . Since capital and labour in the
Ricardian model are used in fixed proportions in production of all goods and at any level
of output, the marginal productivity of labour is constant at any aggregate level of
production for all goods. The opening of trade between two nations would, according to
this model, lead to complete specialization of nations. In reality, countries produce and
import some products at the same time. Thus, the strict application of the Ricardian
model could not explain partial specialization at the economy level nor the effect of
supply and demand for final products on market prices.
2 It needs to be said that Ohlin initially acknowledges the fact that intra-national markets are a consequence
of heterogeneity of inputs owned by different individuals but then argues that assuming homogeneity is a
useful abstraction. However, it is not obvious for what purpose this abstraction is useful other than for
creating an apparent conceptual difference between exchanges based on which side of the border the
participants in the exchange happen to be. This apparent difference was later cemented by Samuelson‘s
mathematical formulation of the H-O model.
Ohlin builds his argument on the claim that factors of production are less mobile across than within
country borders and that international trade in goods is a way of compensating for the inability to exchange
inputs between countries. However, in the world of heterogeneous inputs, as is the world we live in, even if
the exchange of all inputs was possible, and all inputs were perfectly mobile, exchange of inputs is not a
substitute for the exchange of outputs. Exchange of heterogeneous inputs only results in a different
distribution of property rights over these heterogeneous inputs. There is no reason why some individuals in
each country would not have a comparative advantage in one of the outputs compared to some individuals
in the other country. Thus, movement of goods across the border is possible in both directions even it the
case of two identical countries. 3 Assuming variable proportions technology would imply that the same product could be produced using
different quantities of labour, which would, within the context of the labour theory of value, imply different
value (and price) for every unit produced. This result is inconsistent with the labour theory of value.
25
Ohlin (1924, [1991]), following the initial idea of Heckscher ([1919], 1991),
suggested that this inconsistency could be overcome by assuming variable proportions
technology. He believed that this is what is needed to break away from Ricardo‘s labour
theory of value and bring the theory in line with the subjective theory of value.
Haberler (1985 [1930], p. 7) follows a similar line of thought as Ohlin:
The theory of comparative costs was developed on the basis of the labor
theory of value, and all theorists who accepted it have indeed assumed that
it rests also logically on the labor theory of value. For the authors who
reject the labor theory of value, the theory of comparative costs founders
on the cliffs as the former, that is, on the fact that there simply exist no
units of real cost, neither in the shape of days of labor nor in any other
shape.
However, two decades later, Mises (1996 [1949], p. 159) contrasts this perception and
stresses that the concept of comparative advantage (or cost) stems from productivity
differences:
The theorem of comparative cost is in no way connected with the value
theory of classical economics. It does not deal with value or with prices. It
is an analytic judgment…The law of comparative cost is as independent of
the classical theory of value as is the law of returns, which its reasoning
resembles. In both cases we can content ourselves with comparing only
physical input and physical output. With the law of returns we compare
the output of the same product. With the law of comparative costs we
compare the output of two different products. Such a comparison is
feasible because we assume that for the production of each of them, apart
from one specific factor, only non-specific factors of the same kind are
required.
Here, Mises notes that the concept itself deals with differences in relative productivities
between two economic actors that result from the differences in the specific factors, and
not with differences in the cost of production in any shape or form. As Rothbard (2009
[1962], p. 97) later elaborates, the specific factors may include physical or human
resources of a different quality while the nonspecific factor is time:
26
It is clear that conditions for exchange, and therefore increased
productivity for the participants, will occur where each party has a
superiority in productivity in regard to one of the goods exchanged—a
superiority that may be due either to better nature-given factors or to the
ability of the producer. If individuals abandon attempts to satisfy their
wants in isolation, and if each devotes his working time to that specialty in
which he excels, it is clear that total productivity for each of the products
is increased. If Crusoe can produce more berries per unit of time, and
Jackson can kill more game, it is clear that productivity in both lines is
increased if Crusoe devotes himself wholly to the production of berries
and Jackson to hunting game, after which they can exchange some of the
berries for some of the game.
Following Rothbard‘s description of individual comparative advantage, factors of
production or inputs can be defined as (1) time and (2) physical objects used in the
production of other physical objects intended for consumption or further use in
production. In reality, these physical objects (including the body of the individual
producer) are not homogeneous within a geographical area. They generally have differing
physical, chemical, bio-chemical or any other properties that make them more or less
suitable for different purposes and give rise to differences in productivity per unit of time
in different production processes across individuals.
If one recognizes the body of an individual producer as an input, differences in
individual productivity in assembling even identical non-living objects into different
outputs can be explained by the differences in the properties (or qualities) of one of the
inputs—the physical body of the producer, with all its external and internal attributes
(physical strength, dexterity, mental capabilities, etc.). These differences are in common
experience observed as differences in the skill of the producer, where one person can
perform the same task, using the same tools, more productively than another person.
It should, however, be noted that Rothbard ignores the possibility of increased
total productivity through specialization even if one of the parties is more productive in
27
both goods as long as there is a difference in relative productivities. For example, if
Crusoe is more productive per unit of time in both berries and game, total productivity
per unit of time could still be increased as long as Crusoe is not equally more productive
in both goods compared to Jackson. This is also the essence of Ricardo‘s argument but at
the aggregate level.
However, the difference between Mises‘s and Rothbard‘s representation and
application of the concept of comparative advantage and the representations by Ricardo
and Ohlin is in the understanding of the economic actor to whom these differences in
relative productivity and the subsequent decision to specialize and exchange are ascribed.
For Mises and other theorists applying methodological individualism, the economic actor
is an individual human being. But, for many economic modellers, the difference between
an individual and a country is often not obvious or of tertiary importance.
Those that followed the works of Ohlin, while seeking a way to separate the
concept of comparative advantage from the perceived tie to Ricardo‘s labour theory of
value, have still maintained the Ricardian tradition of expressing the concept in terms of
aggregate variables. Haberler (1985 [1930], p. 8) states:
Fortunately, however, it is possible to reformulate the theory in such a way
that its analytical value and all conclusions drawn from it are preserved,
rendering it at the same time entirely independent of the labor theory of
value. This may most readily be shown in a diagrammatic representation
of our theorem.
This was the introduction of the concept of a Production Possibilities Frontier
(PPF) into economics. One of the most common diagrammatic representations of national
comparative advantage based on Haberler‘s diagrammatic approach can be found in
Stolper and Samuelson‘s (1941) mathematical formulation of the Heckscher-Ohlin (H-O)
28
trade theory. This was, to my knowledge, the first derivation of a national PPF, output
and input prices by explicitly assuming a uniform technology and homogeneous inputs
within a country. This model is known today as the Heckscher-Ohlin model of
international trade. The model has retained this form up to date. I will use Stolper and
Samuelson‘s graphical representation to illustrate the basic components.
There are two goods, (wheat) and B (watches), two homogeneous inputs, capital
(C) and labour (L), and two countries (Country I and Country II). There is a limited
amount of each input in each country. Constant Returns to Scale (CRS) technology in
both countries is used in production of and B. The technologies do not differ between
countries but they do differ between and B. A is more capital-intensive and B is more
labour-intensive at given input prices. This means that, in order to produce one unit of A,
more labour per unit of capital is used at given factor prices compared to B. The two
goods are produced by two perfectly competitive industries (i.e. no transaction costs or
externalities, complete information, firms are price-takers, etc.). Inputs are perfectly
mobile across industries but immobile across country boundaries.
After stating these assumptions, Stolper and Samuelson then take the next step in
which they analyze the whole economy as a single entity. The logic is as follows: Since
inputs are homogeneous, they can be aggregated across firms and industries. Thus, the
production within a country can be characterized by a single, homogeneous production
function.
Figure 2.1 is an adaptation of the Stolper and Samuleson diagrammatical
representation of the H-O theory. Stolper and Samuelson use diagrams to represent the
economy of Country I, while noting that it is possible to avoid detailed consideration of
29
the second country. For completeness, I extend the logic of the model to show the
diagrammatic representation of the Production Possibilities Frontier for Country II. The
upper panel in the figure shows two production Edgeworth boxes for the two countries.
The box
represents Country
II. The labour to capital ratios in the two countries are represented by the slope of the
diagonals:
for Country II. Country I has a lower labour to
capital ratio compared to Country II. At the same time, Country I has a higher capital to
labour ratio compared to Country II, since this is just a reciprocal value of the labour to
capital ratio.
The locus of optimal production points in each country is defined by the contract
curves. For homogeneous production functions, each country‘s contract curve lies below
the diagonal connecting the two origins. The contract curve for Country I in Figure 2.1 is
the arch lying below the diagonal
. Similarly, the contract curve for Country II is
the arch
. In the output space, the contract curves for the two countries translate
into concave economy Production Possibilities Frontiers shown in the lower panel of
Figure 2.1.
Since both countries use the same technology, the isoquant represents the same
quantity of in both countries. The isoquants and represent quantities of in
Country I and Country II respectively for a given quantity of . The factor ratio along the
Country II contract curve is higher compared to Country I at any quantity of . This
means that the capital to labour ratio used in production of any quantity of in Country I
is higher compared to Country II. Since is the capital-intensive product, marginal input
level of . This implies that the Country I Production Possibilities Frontier is steeper than
30
Figure 2.1. A graphical representation of the Heckscher-Ohlin model adapted from
Stolper and Samuelson (1941)
31
that of Country II when is on the vertical axis. In other words, at any given level of ,
Country I has to give up less in order to increase its output of by one unit. This is
interpreted as a lower opportunity cost of in Country I compared to Country II. It is
said that the capital-abundant Country I has a comparative advantage in the capital-
intensive good, , while the labour-abundant Country II has a comparative advantage in
the labour-intensive good, .
In this model, preferences do not differ between the two countries. The autarky
price ratio is assumed to equal the marginal rate of substitution along the
Production Possibilities Frontier. Consequently, the difference in the price ratio between
the two countries is determined by the difference in aggregate endowments of
homogeneous factors.
There have been several theoretical refinements of the standard H-O model.
Stolper and Samuelson (1941) find that in a H-O model defined above, the factor price
ratio is equal to the output price ratio (i.e. Factor Price Equalization Theorem). Thus, in
trade equilibrium, real wages in two countries are equalized. In addition, Samuelson
(1953) showed that an increase in the price of a commodity will bring more than a
proportional increase in the price of the relatively intensive factor (i.e. Stolper-
Samuelson Theorem). Rybczynski (1955) demonstrates that an increase in the supply of a
factor will cause an increase in the supply of the output that uses that factor relatively
intensively and a decrease in the supply of the other output. In addition, there have been
several major extensions of the model.
Jones (1957, p. 6) extended the model from two to three commodities and found
that the general results would stay unchanged in the sense that
32
[o]rdering the commodities with respect to the capital-labor ratios
employed in production is to rank them in order of comparative advantage.
Demand conditions merely determine the dividing line between exports
and imports.
Bhagwati (1972) extended the model further to a multi-commodity case. Vanek
(1968), on the other hand, extended the number of factors from 2 to N. Vanek (1968) also
finds that if preferences are identical and homothetic, trade is a linear function of factor
endowments. Horiba (1974), introduced a multi-country case, while Mussa (1978)
examined dynamic adjustments in a two-sector case when transfer of capital from one
industry to the other requires use of resources. Chen (1992) developed a long run
dynamic H-O model with endogenous savings and endogenous labour supply and found
that initial factor endowments lead to continued trade in the long run.
For mathematical tractability, the homogeneity of inputs and uniform technology
within countries are maintained throughout this literature. These assumptions are seen as
useful abstractions, and not as omissions. When heterogeneity at the firm level within an
economy is introduced, it exists only as a special case in the generic Heckscher-Ohlin
model, as in Bernard et al. (2006), or the Ricardian aggregate model, as in Melvin (1985)
and Melitz (2003). These modifications are generally intended to explain two-way trade
between countries. This is the case when the same product is both imported and exported
from the same country. This situation cannot be explained using the traditional models
and thus some economists called upon firm heterogeneity within countries as an
explanation.
However, in these models heterogeneity within an economy is not seen as a
general requirement for the existence of a market. Similar to the general H-O model,
market prices in these models exist by assumption. For example, Bernard et al. (2006)
33
replace capital (C) and labour (L) from the standard H-O model with skilled labour (S)
and unskilled labour (L). The two outputs are produced by N firms with identical fixed
costs across firms within an industry. Firms differ in their input productivity. In this
model, the equilibrium price in industry i equals the marginal cost of firm j plus a
constant mark-up, :
is the unskilled labour wage;
is the parameter of the Cobb-Douglas cost function for industry i;
is the constant elasticity of substitution consumption function parameter;
and
is the productivity parameter for firm j; .
In equilibrium, the differences in the firm marginal cost stem from differences in firm
productivity. If we assume firm homogeneity, productivity parameter, , takes the same
value for all firms. Consequently all firms experience identical marginal cost, , and
equilibrium price is still derived using equation (2.1). Consequently, this model would
still produce market prices within each national economy, even if the firm or regional
heterogeneity is assumed away. In other words, the existence of the market price
variables is not contingent upon heterogeneity within an economy.
In contrast to the above literature, Mises (1996 [1949]), Rothbard (2009 [1962]),
and other authors putting emphasis on methodological individualism, used the concept of
34
comparative advantage in the context of interpersonal specialization and exchange. As I
will elaborate in the next section, they have maintained the link between individual
heterogeneity and the workings of the market economy. Both Mises and Rothbard state
that individuals may differ in terms of the quality of inputs they own or skills of
combining those inputs into final outputs. Consequently, there is a potential for increased
productivity leading to mutual benefits if some individuals specialize in some activities
while others specialize in some other activities and then exchange the surplus production
with each other. Here, Mises uses the term law of association to indicate that in a world
inhabited by people who differ from each other in a near-infinite number of ways;
possibilities for mutual gains from association are omnipresent. While generally accepted
in the microeconomic literature, like in Frank and Bernanke (2003) and in Mankiw
(2011), this reasoning is absent from traditional aggregate models built upon the
Ricardian climatic or the Heckscher-Ohlin factor-endowment models of national
comparative advantage based on differences in technologies and/or relative quantities of
aggregate inputs between countries.
2.3 Input Heterogeneity and the Market Economy
As argued by Stolper and Samuelson (1941) and Dornbusch et al. (1977), in
aggregate general equilibrium economy-level models, comparative advantage is
equivalent to a lower autarky price. The conclusion is that countries will export goods
for which they have a lower autarky price. Thus, the understanding of the meaning of the
concept of comparative advantage bears heavily on the meaning and function of market
prices.
35
Market prices are exchange ratios observed in an interpersonal exchange of goods
and services. For an exchange to occur, there need to be at least two individuals in an
economy. If there was only one individual in a country, he or she could not constitute a
market. All the exchanges that this individual would make would be intra-personal
exchanges. He or she might choose to devote more time to the production of clothing and
thus give up some of the food he or she might have produced instead. However, in this
situation there is no exchange ratio to be observed – there are no market prices to be
compared with the market prices in some other (hypothetically isolated) country.
In the mathematical language, the intra-personal exchange ratios (i.e., the
individual trade-offs when deciding between two actions) are the shadow prices or the
slope of the individual Production Possibilities Frontier, not market prices. Some
economists using the aggregate models of comparative advantage often ignore the
distinction between an individual and a country and treat them as equivalent economic
concepts. Assuming input homogeneity and a single technology within a country
effectively attaches attributes of a single entity (i.e., an individual) to an entire economy.
Alternatively, this assumption implies that all individuals within a country are identical in
all respects, including the inputs they own and the technique used to combine these inputs
into final outputs 4 .
To introduce the possibility of a market within a country, there need to be at least
two individuals within its borders. But, if they are identical in all respects, that is, if they
4 It should be noted that, unlike Block et al. (2007) critique of Mises and Rothbard, this paper looks at
homogeneity in the pure mathematical sense implied by the aggregate models of national comparative
advantage. Inputs used by any individual within a country are identical in all possible respects. Given the
properties of the national production function, the basic unit of inputs is infinitesimally small. Constant
Returns to Scale is also one of the standard assumptions. Thus, natural heterogeneity and increasing
returns to scale, identified by Block et al. (2007), do not play a role here.
36
own qualitatively 5 identical, homogeneous and divisible inputs, as implied by the use of
aggregate variables, the need for specialization and exchange of outputs is eliminated.
This applies even in a situation when the initial allocation of inputs is such that
the two individuals own different quantities of some inputs. First, both individuals, by the
nature of their existence, exist in the same time and each possesses only one physical
body. Thus, these inputs are not exchangeable. Since all inputs are qualitatively identical
between the two individuals, their physical bodies must be identical as well. A
consequence of this identity is that both individuals would be equally skilful in
assembling the inputs in any output they may desire. In the mathematical language, these
features would be expressed as identical production functions for the two individuals.
Maintaining the standard assumptions of the aggregate factor endowment trade theory,
this would be a Constant Returns to Scale production function. Other (exchangeable)
inputs, homogeneous in quality and divisible in quantity, could be exchanged in a single
swap of property titles up to the quantities that ensure the highest total productivity. Since
the two individuals have identical production functions, this situation would occur when
both of them own equal quantities of all inputs. Moreover, by the virtue of possessing
identical physical bodies (with all their external and internal features), the desires of the
two individuals would be identical, which is translated into identical utility functions (i.e.,
the representative consumer). Consequently, there would be no logical reason for any of
the two individuals to specialize in the production of one good and exchange some of that
5 Here, quality is defined as any attribute that is relevant for the productivity of a unit of an input. Every not
yet used unit of a homogeneous input is combined with any not yet used unit of another homogeneous input
in a precisely identical way and produce the same quantity of a homogeneous output. This is analogous to
the features of a mathematical variable. For example, in equation y = x1x2, if one wants to produce one unit
of y, the question which, not yet used, units of x1 and x2 are going to be used is immaterial because x1 and
x2, by their virtue of being mathematical variables, are homogeneous.
37
product with the other individual. In this situation, there are no gains either in
productivity or in the alignment of individual means and ends resulting from
specialization and exchange. There is no particular reason for a market to emerge in an
economy inhabited by identical individuals who own identical inputs that are assembled
into outputs in a precisely identical way.
Therefore, heterogeneity is not an additional wrinkle in a general market model—
it is a general attribute of any actual market. Even if all individuals were identical in all
respects before specialization, if this specialization will not change them in any way and
make them more productive in the selected line of production, there is no particular
reason to specialize 6 . In this case, if there were two hypothetically isolated economies
composed of individuals identical within an economy but different across economies, the
only thing we could observe is two groups of self-sufficient individuals. Consequently,
there are no autarky market prices to be observed and compared across countries. Thus,
individual heterogeneity provides a logical basis for the existence of market prices.
2.4 Other Issues with Input Homogeneity
Subasat (2003) points out the unresolved Cambridge Capital Theory Controversy
as a basis for questioning the applicability of the H-O model. The Cambridge Capital
Theory Controversy was a debate that took place in the 1950‘s and 1960‘s between Joan
Robinson and Piero Sraffa of the Cambridge School in the UK and MIT economists Paul
Samuelson and Robert Solow. The central issue in the debate was the implications of
assuming capital homogeneity in economy-level models. As pointed out by Robinson
6 Preference in production of one good over another as a reason for specialization is also excluded since it
is assumed that all individuals have identical preferences. The only remaining reason for specialization and
exchange would be that all individuals prefer exchange for its own sake. But, this would be a trivial
explanation because exchange would be its own end.
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(1953), Blaug (1975), and Harcourt (1972, 1976), the UK side argued against
Samuelson‘s and Solow‘s assumption of homogeneous capital or the attempts to derive
any consistent theoretical results through capital aggregation.
According to Cohen and Harcourt (2003), this controversy was never fully
resolved, and this made the neoclassical paradigm vulnerable to future criticisms. The
controversy has spurred intense research in the theory of aggregation by Solow (1963),
Fisher (1971, 1983, 1987, and 1993) and Harris (1973). Felipe and Fisher (2003, p. 208),
conclude that beside having an empirical appeal stemming from the underlying income
accounting identity,
the most important conclusion is that the conditions under which a well-
behaved aggregate production function can be derived from micro
production functions are so stringent that it is difficult to believe that
actual economies satisfy them. Therefore, aggregate production functions
do not have a sound theoretical foundation.
This suggests that the UK side‘s point was eventually appreciated. While the underlying
dispute over capital aggregation in the Cambridge Capital Theory Controversy was not
motivated by the desire to find a logical basis for the existence of a market, it does
illustrate multiple theoretical issues created by the use of aggregate variables.
2.5 The Importance of not Ignoring Heterogeneity
According to Boettke (1997) and Levy and Peart (2009), the aggregate approach
to representing the market process does not adequately address the implications of the
institutional difference between a centrally planned economy and a decentralized market
economy. The economic calculation problem first pointed out by Mises (1990 [1920]) is
absent from the aggregate economy-level models built on Samuelson‘s 1941 model. All
an economist needed to do, according to those models, is to determine the total quantities
39
of capital and labour (or any other relevant inputs) and the relevant technology to
determine the optimal allocation of production over space.
Taking into account that the market economy is composed of a multitude of
individuals where each individual possesses inputs unknown to others and different in
kind from inputs owned by any other individual reveals that the problem of allocation of
labour in an economy is a daunting task. Any allocation mechanism would need to
employ the knowledge of millions of individuals in a timely manner, since human means,
wants and needs are subject to constant change. Hayek (1945) pointed out that the market
mechanism performs this task by translating the dispersed knowledge of a vast number of
acting individuals into market prices.
However, the above reasoning is omitted in the models of national comparative
advantage. This may minimize the importance of heterogeneity within an economy in our
economic reasoning. Thus, it stands to reason to believe that not ignoring individual
heterogeneity within an economy when it comes to the principle of comparative
advantage may reveal valuable insights about the role of the market process in the
practical implementation of this principle.
2.6 Conclusion
There are importan

linking comparative advantage, supply management and - atrium

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