Theories of International Trade

International trade refers to exchange of capital, goods, and services across international borders. The main difference between the domestic trade and the international trade is of “cost of doing trade” because the international trade involves border costs such as tariffs & customs, time costs due to distance and border delays and other costs associated with cultural and economic differences between the two countries. Further, the labour and capital are more mobile within the country in comparison to cross border mobility. No country today is aloof from the international trade.

There are several theories to explain why international trade takes place.  They have been explained shortly here:

Adam Smith’s Theory of Absolute Differences in Cost

Adam Smith said that trade between two nations is based on absolute advantage. When one nation is more efficient than another in the production of one commodity but is less efficient than the other nation in producing a second commodity, then both nations can gain by each specializing in the production of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage.

Adam Smith

Adam Smith (5 June 1723 – 17 July 1790) was a Scottish moral philosopher and a pioneer of political economy. One of the key figures of the Scottish Enlightenment, Adam Smith is best known for two classic works: The Theory of Moral Sentiments (1759), and An Inquiry into the Nature and Causes of the Wealth of Nations (1776). The latter, usually abbreviated as The Wealth of Nations, is considered his magnum opus and the first modern work of economics. Smith is cited as the father of modern economics and is still among the most influential thinkers in the field of economics today. In 2009, Smith was named among the “Greatest Scots” of all time, in a vote run by Scottish television channel STV. (From wikipedia)

This process helps in utilizing the resources in the most efficient way and the output of both products will rise.

Example

Suppose country A is better than country B in producing roses, and country B is better than country A in producing computers. This is because country A can produce more roses than Country B with the same number of employees per hour (read resources), while country B can produce more computers than country A under the same conditions. Then, it will be an obvious case that each country will specialize in the product that it can produce most efficiently and then trade their products: country A will export roses and import computers from B, while country B will export computers and import roses from A.

Under these circumstances, both countries would gain if each specialized in the production of product of its absolute advantage and traded with the other country. As a result both the products would be produced and consumed in more quantities and both the nations would benefit.

This means that the theory of Adam Smith refutes the assumption that one nation could benefit only at the expense of another nation Adam Smith believed that all nations would gain from free trade and strongly advocated a policy of laissez-faire i.e. free trade.

Criticism of Absolute Advantage Theory

Adam Smith’s theory could not explain why the trade takes place even when one of the trading countries does not have absolute cost advantage in both the commodities compared to the other country. Absolute cost advantage theory can explain only a very small part of world trade such as trade between tropical zone and temperate zone or between developed countries and developing countries. Most of the world trade is between developed countries that are similar with respect to their resources and development which is not explained by absolute cost advantage.

So another theory by David Ricardo, who gave the principle of comparative cost advantage as the basis for trade, we need to discuss here briefly.

David Ricardo’s Theory of Comparative Cost

As in the absolute cost advantage theory, this theory also says that international trade is solely due to differences in the productivity of labour in different countries. However, it says that the trade between countries which don’t have absolute advantage can be explained by the law of comparative advantage. The theory is based upon some assumption such as:

  • Every country has a fixed endowment of resources and all units of each particular resource are identical.
  • The factors of production are perfectly mobile between alternative productions within a country.
  • Factors of production are completely immobile between countries.
  • Labour is the only primary input to production
  • The relative ratios of labour at which the production of one good can be traded off for another differ between countries
  • Countries use fixed technology
  • Production is under constant cost conditions regardless of the quantity produced. Hence the supply curve for any goods is horizontal.
  • There is full employment in the macro-economy.
  • The economy is characterized by perfect competition in the product and market.
  • There is no governmental intervention in the form of restriction to free trade.
  • Transport costs are zero.
  • It is a two-country, two-commodity model.

To understand this model, we suppose that there are two countries A and B producing cloth and wine. The following table gives labour hours required for the production of one unit of two commodities in the two countries.

The above table shows that country A has absolute cost advantage in the production of both the commodities because lesser labour hours required in the production of cloth and wine which is 1 hour per unit of cloth and 3 hours per unit of wine. This is lesser than 2 hours per unit of cloth and 4 hours per unit of wine as required in country B. Even then trade between the two countries can be mutually advantageous so long as the difference in comparative advantage exists between the productions of two commodities.

The example shows that country A is twice as productive as country B in cloth production whereas in wine production it is only 4/3 times as productive as the country B. Hence country A has higher comparative advantage in cloth production. Country B has comparative advantage in wine because its relative inefficiency is lesser in wine. It is half as productive in cloth while in wine the difference in labour productivity is only 1/3 minus 1/4, which is much less than ½.

The summary of Ricardo’s theory is that International trade is mutually profitable even when one of the countries can produce every commodity more cheaply than the other.

Each country should specialize in the product in which it has a comparative advantage that is greatest relative efficiency. When trade takes place between the two countries, the terms of trade will be within the limits set by the internal price ratio before trade. For both countries to gain, the terms of trade should be somewhere between the two countries internal price ratios before trade.

Heckscher-Ohlin model

Two Swedish economists, Eli Heckscher and Bertil Ohlin gave one more model of International Trade. This theory says that in reality, trade is not just determined by technological differences, but it also reflects differences in factor endowments across countries. For example, Canada exports forestry products to the United States not because its workers are more efficient in forestry, but because Canada is more endowed with forests. To explain the importance of resources in trade Heckscher and Ohlin, have developed a theory known as the “factor proportion theory“. This theory essentially says that countries will export products that use their abundant and low-cost factors of production, and import products that use the countries’ scarce factors.

For example, in a capital abundant country, the cost of capital will tend to be relatively low. As a consequence, the cost of production of the capital intensive product, and its price, will tend to be relatively low. The opposite will occur in a labour abundant country – wages will tend to be relatively low and the cost of the labour intensive products will be relatively low. Differences in relative prices of the two goods will lead to trade. Both countries will produce more of the good on which they have a comparative advantage.

The capital abundant country will tend to specialize in the production of the capital intensive goods and export this product, while the labour abundant country will tend to specialize in the labour intensive good and export that product. Like in the case of the Ricardian Model, also in the Heckscher and Ohlin model, it is possible that the global production of both goods may increase with trade. It is therefore possible for both trading economies to consume more of both goods than in the absence of trade and therefore, both countries gain from trade.

Trade Theory: Important Observations

Gains from Trade

There are several gains from international trade which have been mentioned the following graphics:

Income Redistribution by Trade

In a capital abundant country, trade induces a reallocation of resources towards the capital intensive goods – therefore more capital will be demanded and this will increase the domestic price of capital. Owners of the capital will therefore gain more because returns to capital increase. What will happen to the demand of labour in this country? – This is the relatively scarce factor, where the country has not got a comparative advantage. The demand for labour will go down and wages will go down. To sum up, in the capital abundant country, owners of capital will gain and owners of labour will lose. A consequence of these redistributive effects is likely to be that owners of the relatively abundant factor (exporters) will support trade, while owners of the relatively scarce factor will oppose free trade. It is important to bear in mind that despite income distribution effects, the country overall gains – that is gains outweigh losses. In other words, the gains from better utilization of resources (specialization), access to a broader variety of goods and increased competition, are higher than the costs derived from the redistributive effects of trade.

Adjustment Costs: One fallout of the Trade Liberalization

The adjustment costs are the result of the distributive effects of trade. Adjustment costs are the costs incurred, for example, by displaced workers (such as in the import-competing sector) that have to look for another job. Adjustment costs are also the costs of a firm that needs to invest in order to adjust to the new market conditions. Although these costs are unavoidable, as they are a direct consequence of the reallocation effect of trade liberalization, the size of these costs depends on a number of characteristics of the domestic market (e.g. functioning of credit and labour markets, quality of infrastructure and quality of domestic institutions). The fact that there is additional income as a result of trade means that resources are available for governments to redistribute the benefits from those who gain from trade to those who lose (e.g. supplying social safety nets or through appropriate redistributive tax systems).

Why Protectionism?

International trade theory asserts the benefits of free trade. In reality, however, many countries adopt protectionist policies. As explained above, when a country liberalizes trade, some people gain and others lose. In particular, the export sector is likely to gain from opening up to trade, while the import competing sector is likely to lose. Therefore, in most cases protectionist policies are the consequence of the lobbying activity of industries in the import-competing sectors that wish to be protected against competition from the rest of the world. There are theoretical arguments aimed at justifying the use of protection, such as the infant industry argument for protection. The argument is that the country may have a potential comparative advantage in the manufacturing sector, but the industry is too young and too little developed to compete at the international level. Although at first sight reasonable, this theory is not without drawbacks. The evidence shows that even when the protected sector did develop, it needed continued government intervention to stay in the market. In other words, infant industry protection did not led to the development of a competitive industry that eventually could face its competition in the international market. That is because the expected results would be dependent on the ability of a government to identify which industries have a potential comparative advantage.

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