Theories of International Trade

The conflict between means and ends are the building blocks of economics. Every economy aims at optimally allocate its scarce resources. The essay addresses the aspect of resources allocation in context of internal trade in the global economy. Different trade theories indicate different ways of resource allocation but all end to the conclusion trade a country definitely better off from involving in specialization and trade.

The production capacity of nation is limited by resource availability. Nation cannot efficiently produce all goods that it needs. One country is efficient in producing one good while another country may be efficient in producing in some other. The country thus when exchange these goods then both the countries are better off and world output increases (Baumol and Blinder 2014). The theory of international trade tries to explain the basic rationale behind specialization. The difference in technology, cost structure, factor endowment and other factors determine the line of specialization. Different trade theories have developed focusing on each of these factors. Countries enjoy cost advantages in its specialized good and hence, can produce more than it need. Therefore, it can easily export this item in exchange of goods for which it has an unfavorable production and cost structure (Begg and Ward 2013) 

The first pioneering theory of international trade is the theory of absolute advantage. Adam Smith proposed the theory in Eighteenth century. This is known as classical theory of trade. The theory suggests that the absolute cost different among nations is the primary basis of trade. Thee arise an absolute cost difference between two countries when each of the two countries has the ability to produce one good with a lower cost of production than other. The absolute cost difference may exist due to difference in type of soil, different climatic condition, access to technology or human resource (Chacholiades 2017). The absolute cost difference then determines specialization and trade between countries. Both the country should specialize in goods in which it has a lower opportunity cost.

The absolute cost difference and trade theory can be illustrated using a simple two good-two country framework.

The example shows cotton and rice production of two nations with 1 unit of labor. It is clearly seen that China has an absolute cost advantage in rice while US has an absolute cost advantage in Cotton.

The theory of absolute cost advantage is the simplest theory of international trade. The theory however has less connection with practical world. The absolute cost difference may not always exist. There might be situation in which one country has absolute advantage over more than one goods. The line of specialization then cannot be determined following principles of Adam Smith (Dong and Wong 2017). This lead to a new trade theory known as theory of comparative advantage. David Ricardo built the comparative advantage theory based on difference in opportunity cost. Opportunity cost is the cost of sacrificing unit of other goods to have one additional unit of one particular good. The principle of comparative advantage states that one country has an absolute cost advantage in two goods but it definitely has a lower opportunity cost in one good. Specialization and hence pattern of trade then follows the opportunity cost difference between nations. 

Absolute Advantage Theory

The following example give a better understanding of the underlying statement of comparative cost theory.

The above table provides a hypothetical example of production and underlying cost between UK and US. In UK, one unit of labor can produce 100 units of Jute and 100 units of cotton. Japan on the other hand by using same unit of labor can produce only 40 units of Jute and 80 units of Cotton. This therefore shows UK has a greater efficiency in terms of absolute cost difference for both Jute and Cotton. Now, in order to determine comparative advantage and trade pattern the opportunity cost of both the goods should be computed.

The opportunity cost table shows that for producing 1unit Jute UK need to forgo only 1 units of Cotton while US need to forgo 2 units of Cotton. Therefore, UK has a lower opportunity cost and hence comparative advantage over US in Jute production. By similar argument, there US has a comparative advantage in cotton production. The theory of comparative advantage therefore implies UK should specialize in Jute while Japan should specialize in Cotton.

Both absolute and comparative advantage theory suggest that it is always mutually beneficial for two countries to specialize and trade. Nation shifts more and more resources to the industry in which it has a relative cost advantage (Cohen 2016). When all the countries specialize in such a way then world output increases leading to an increase in welfare.

The two trade theories discussed above are easy to understand. Both the theories however based on some assumption that gave rise to criticism of these theories later. The only factor of production considered in both the theories is labor. There is no mention of capital or other factor of production that are integral part of production. The theories however assume labors are homogenous which is again an unrealistic assumption. Another problem is that neither of the theories put emphasis on transportation cost (Grant 2013). The physical distance and high transportation cost often create troubles in international trade by offsetting benefit of relative cost advantage.

The ending point of the traditional trade theories has prepared basis for the development of many trade theories. The Ricardian theory of comparative advantage is further extended by the Heckscher- Ohlin trade theory. The building block of Ricardian theory is the existing difference of opportunity cost. The theory however does not provide any explanatory factor for these cost difference. According to Hechscher Ohlin model the underlying cost difference is explained by the difference in relative prices of factor input (Jones 2018). This is again related to the relative factor endowment across countries. A country faces a relatively low price for its abundant factors while face a relatively higher cost for the scarce factor. The cost advantages and hence specialization under this theory is then explained with factor endowment. A country having abundant labor supply thus has a lower cost for labor input. The country having capital as an abundant factor has a low price for capital (Mankiw et al. 2016). Henceforth, the former should specialize in goods that has high labor intensity while later should focus on goods having capital intensity.

Comparative Advantage Theory

The theory however when tested in real world gave a paradoxical result. The theory was first tested for US industries to find out its pattern of trade. In 1947, the result of the test revealed that despite being one of the most capital endowed nation US has a tendency to import capital intensive goods while exporting labor intensive goods. The findings thus directly contradicted the trade model proposed by Heckscher-Ohlin (Negishi 2014). This paradox was first examined by Professor Wassily Leontief and became famous in trade theory as Leontief paradox.

With passes of time and changing dimension of production pattern other trade patterns came to be known and needed a different explanation from the existing trade theories. It is often found that a good is imported by a country where previously the good is originated. This surprising trade pattern is explained by the product life cycle theory. The model called International Product Life Cycle was developed by Raymond Vernon in 1966 (Cantwell and Salmon 2016). In the model, pattern of international trade is explained beyond the static framework of Ricardian comparative advantage model. Vernon proved that it is beneficial for a country enjoying absolute advantages in all goods to trade and allow specialization in categories of goods that come with highest value added. The theory focuses on dynamic comparative advantages and addresses the issue of a changing trade pattern overtime.

The theory explains a pattern of internalization where a local producer in a developed nation (United States) initiates a new and advanced product and sells the product in the home country. Building product inventory in the local market reduces associated risk and uncertainty of a new product. However, as demand increases from other markets gradually production units shift abroad to enable firm benefit of economies of scale and by pass obstacles in free trade. This is the time when the product enters to the maturity phase (Samli, Fields and McHale 2015). Ultimately the increased number of competitors imposes challenge to the advanced country of origin becoming a net importer of the good.

In the world economy, it is observed that half of the developed nation involve in trading similar type of goods instead of exchanging alternative goods. These high income nations include United States, Canada, Japan, Mexico, the European Union and China. When two nation involve in trade of similar industrial products, then it is termed as intra industry trade (Madeira 2016). United State for example both imports and exports autos. In fact, the worth of imported auto exceeds that for exported autos. More than 60 percent of European Union is of intra-industry trade. For machinery also the intra-industry trade pattern is observed.  There are different variety of machinery. It might be the case that US export machines made with wood but importing machines used for photographic processing (Besanko et al. 2013). The underlying factor for intra-industry trade is not that workers in these country have a higher or lower skill rather it is due to the fact that countries focusing on specific products is able to develop a different and unique skills.

Heckscher-Ohlin Model

Another evolving theory of international trade is the Porter’s Diamond model of national advantage. According to classical theories of international trade the comparative advantage of a nation derived from the factor endowment that countries fortunately inherit. These factors include land, labor, natural resources and size of population. Michael E. Porter suggested that it is possible for a nation to develop advanced factor endowments like skilled labor force, sound knowledge and technological base, support from the government and culture (Huggins and Izushi 2015) In the model the factors responsible for creating national advantage are represented in the shape of a diamond.

The four ingredients leading to national comparative advantage include resource availability and relevant skills of the workforce, the information used by firms to find opportunities to use these resources and skills, the objective of individual companies and the need for companies to invest and innovate. 

Paul Krugman developed a trade model called ‘New Trade Theory’ as a collection of existing economic models of international trade with particular focus on network effect and increasing return to scale (Ranjan and Raychaudhuri 2016). The new theory redundant the assumption of constant return to scale.

The essay focus on dynamic evaluation of international trade theories. In addition to theoretical ground of these theories, the essay has picked example from real world following the above discussed trade pattern.  The essay begins with pioneering trade theory of absolute advantage that explains specialization based on absolute cost difference. The absolutes cost advantage theory is succeeded by Ricardian theory of comparative advantage. The Ricardian trade theory is based on the difference in opportunity cost.  The Heckscher-Ohlin model tries to explain trade pattern depending on factor endowment and relative intensity of goods. The theory however is contradicted by the trade pattern of US as evidenced during 1947. Raymond Vernon developed a trade model of dynamic comparative advantage known as International Product Life Cycle theory. This states that passing through different stage of product life cycle how a good once invented in a nation gradually become import of the original country. An interesting trade pattern is the intra-industry trade gaining popularity in advanced nations. The national comparative advantage of a nation is determined by the factors considered in Porter’s Diamond model. The new trade theory model has made a sharp contradiction with the classical assumption of constant return to scale and diverted focus on increasing return overtime. 

References

Baumol W.and Blinder A., 2014 Economics: Principles and Policy, International Edition, 15th ed. Cengage

Begg, D. and Ward, D, 2013 Economics for Business, Berkshire, McGraw Hill

Besanko D., Dranove, D., Shanley, S. and Schaefer, M., 2013, Economics of Strategy. 6th ed. US, John Wiley.

Cantwell, J. and Salmon, J., 2016. Vernon’s Contribution to International Business. The Palgrave Encyclopedia of Strategic Management, pp.1-4.

Chacholiades, M., 2017. The pure theory of international trade. Routledge.

Cohen,I.K, 2016 Economics for Business – A Guide to Decision Making in a Complex Global Macroeconomy, London. Kogan Page.

Corsi, S., Minin, A.D. and Piccaluga, A., 2015. New Product Development in Emerging Economies. The Handbook of Global Science, Technology, and Innovation, pp.228-244.

Dong, B. and Wong, S.K., 2017. A Theory of Comparative Advantage with Specialized Subnational Regions. Review of International Economics, 25(3), pp.567-577.

Grant, R. M, 2013 Contemporary Strategy Analysis, 8th ed. Blackwell

Huggins, R. and Izushi, H., 2015. The Competitive Advantage of Nations: origins and journey. Competitiveness Review, 25(5), pp.458-470.

Jones, R.W., 2018. International Trade Theory and Competitive Models: Features, Values, and Criticisms. World Scientific Books.

Madeira, M.A., 2016. New trade, new politics: intra-industry trade and domestic political coalitions. Review of International Political Economy, 23(4), pp.677-711.

Mankiw, N. Gregory, Taylor, M.P., Ashwin, A, 2016, Business Economics, 2^nd ed., Cengage.

Negishi, T., 2014. Leontief Paradox. In Developments of International Trade Theory (pp. 87-92). Springer, Tokyo.

Ranjan, P. and Raychaudhuri, J., 2016. The “New-New” Trade Theory: A Review of the Literature. In International Trade and International Finance (pp. 3-21). Springer, New Delhi.

Samli, A.C., Fields, E. and McHale, T., 2015. International product life cycle: introduction to rapid succession theory. In Proceedings of the 1992 Academy of Marketing Science (AMS) Annual Conference (pp. 181-184). Springer, Cham.