Unit 1 Unit Structure 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.

0 Overview

Theories of International Trade

Learning Objectives Mercantilism Theory of Absolute Advantage Theory of Comparative Advantage Heckscher-Ohlin Theory Leontief Paradox International Product Life Cycle Theory

1.0 Overview Trade theory focuses on such questions like: what products to import and export, how much to trade and with whom trade. These decisions largely impact on businesses since they influence which products companies might be able to sell in countries from both domestic and foreign sources. Theories of trade can be categorized firstly under trade patterns under laissez faire conditions and secondly under the presence of governmental interference, whereby the government alters the amount, composition and direction of trade. Since no single theory explains all natural trade patterns, this unit examines a number of theories that explain why international trade benefits a country. 1.2 Learning Objectives By the end of this unit you should be able to understand and grasp the following: 1. Understand and apply the classical theories of international trade 2. Understand and apply more contemporary theories of international trade. 3. Understand the general assumptions underlying such theories

1.3 Mercantilism Mercantilism was the first theory of international trade and it was the economic system of major trading nations during the 16th, 17th and 18th century. Mercantilism stemmed from bullionism, a theory that precious metals equal wealth. As such, the principle assertion of mercantilism was that a nations prosperity depended upon its supply of gold and silver ( at that time, gold and silver were the currency of trade between nations). A country could earn gold and silver by exporting goods and importing goods from other countries would result in an outflow of gold and silver to those countries. The main tenet of mercantilism was based on the premise that it was in a countrys best interest to export more than it imports since by so doing, the country would increase its stock of gold and silver and, consequently, increase its national wealth and power. As the best means of acquiring bullion, foreign trade was favored over domestic trade. Governmental intervention, an essential feature of the mercantile system, was used to achieve surplus in the balance of trade by encouraging exports through subsidies and discouraging imports through the use of tariffs and quotas. However, in1752, David Hume identified a major inconsistency in the mercantilist doctrine. He explained that if England had a balance of trade surplus with France, the inflow of gold and silver would increase the money supply in England, resulting in inflation in the latter country. On the other hand, the outflow of gold and silver in France would produce the opposite effects: Frances money supply would contract and its prices would fall. This change in relative prices between France and England would decrease the demand for English products by French consumers, resulting in an improvement in Frances trade balance until the English surplus is eliminated. Hence, Hume explained that in the long term, no country could maintain a surplus in the balance of trade (Hill 2003). Mercantilism was further criticized since it considered trade as a zero sum game whereby gain in one country results in a loss by another. The Absolute Advantage (Adam Smith) and Comparative Advantage (David Ricardo) theories later showed that trade is in fact a positive sum game, that is a situation in which all countries can benefit.

It is important to note that the mercantilist doctrine is still present in todays trade negotiations and is referred to as neomercantilism, whereby countries attempt to run an export surplus to achieve some social or political objective. 1.4 Theory of Absolute Advantage The major value of Adam Smiths theory was that unlike the mercantile theory, it did not consider trade as a zero sum game but rather as a positive sum game in which all countries benefit. Contrary to the doctrine of Mercantilism, Smith was of the view that a countrys wealth is based on the goods and services available to its citizens rather its stock of gold and silver. In the era of Mercantilism, countries tried to become as self sufficient as possible through local production of goods and services but Smith questioned why the citizens of a any country should have to buy domestically produced goods when those products could be produced more cheaply from abroad. Smith explained that due to the difference between countries to produce goods efficiently a country has an absolute advantage in the production of a product when it is more efficient than any other country producing it. Hence, Smith explains that some countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries. Through specialization, countries could increase their efficiency because labor could become more skilled by repeating the same tasks, labor would not lose time in switching from the production of one kind of product and long production runs would provide incentives for the development of more effective working methods (Daniels and Radebaugh 2003). 1.5 Theory of Comparative Advantage The major limitation of Smiths work was that it did not consider the case when one country has an absolute advantage in the production of all goods. David Ricardo examined this question and expanded on Adam Smiths theory of Absolute Advantage to develop the theory of Comparative Advantage. Ricardo explains that a country should specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself (Hills 2003).

In other terms, if our country can produce some set of goods at a relatively lower cost than a foreign country, and if the foreign country can produce some other set of goods at a relatively lower cost than we can produce them, then it would be best for us to trade our relatively cheaper goods for their relatively cheaper goods. In this way, both countries may gain from trade. To explain the Theory of Comparative Advantage, Ricardo considered 2 countries: England and Portugal producing 2 goods, cloth and wine and labor was considered to be the only input in production. Ricardo further assumed that productivity of labor. That is the quantity of output produced per worker varies across countries. In contrast to Adam Smith who considered that England is more productive in producing one good and Portugal is more productive in the other, Ricardo consider that Portugal was more productive in producing both goods. If Adam Smiths theory of Absolute Advantage is considered, then it would seem that England would not be able to benefit from trade. However, Ricardo demonstrated numerically that if England is specialized in producing one of the 2 goods and if Portugal specialized in the other, then total world output of both goods could rise. Thus, both countries could end up with more of both goods after specialization and free trade than they each had before trade, if an appropriate term of trade is chosen( that is the amount of one good treaded for another). Consequently, England may nevertheless benefit from trade even though it is considered technologically to Portugal in production. Illustrative Example We consider 2 countries; Ghana and South Korea producing 2 goods namely, coca and rice. Ghana is assumed to be more efficient in the production of both cocoa and rice, that is, Ghana has an absolute advantage in the production of both products. In Ghana it takes 10 resources to produce one ton of cocoa and 13.3 resources to produce one ton of rice. Thus, given 200 units of resources (assume fixed amount of resources); Ghana can produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa. In South Korea it takes 40 resources to produce one ton of coca and 20 resources to produce one ton of rice. Thus, South Korea can produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa. It is further assumed that without trade, each country uses half of its resources to produce rice and half to produce cocoa. Thus, without trade, Ghana will

produce 10 tons of cocoa and 7.5 tons of rice while South Korea will produce 2.5 tons of cocoa and 5 tons of rice. Though Ghana has an absolute advantage in the production of both goods, it has a comparative advantage only in the production of cocoa; Ghana can produce 4 times as much cocoa as South Korea but only 1.5 times as much as rice. Therefore, Ghana is comparatively more efficient at producing cocoa than it is at producing rice. Without trade, the combined production of coca will be 12.5 tons and the combined production of rice will also be 12.5 tons. Without trade, each country must consume what it produces. By engaging in trade, the two countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods (Hill 2003). Thus, specialization in any good would not suffice to ensure an improvement in world output. Ricardo demonstrated that each country should specialize in the good in which it has a comparative advantage in production. Therefore, to identify a countrys comparative advantage would require a comparison of production costs across countries. In fact, the opportunity cost of producing goods across countries is used. A country has a comparative advantage in the production of a good (e.g. cocoa) if it can produce the good at a lower opportunity cost than another country. The opportunity cost of producing cocoa is defined as the amount of rice that must be given up in order to produce one more ton of cocoa. Thus Ghana would have the comparative advantage in cocoa production relative to South Korea if it must give up less rice to produce another ton of cocoa than the amount of rice that South Korea would have to give up to produce another ton of cocoa. Thus, the core principle of the theory of Comparative Advantage is that potential world production is greater with unrestricted free trade than it is with restricted free trade. The theory of Comparative Advantage further stresses that consumers in all countries can consume more if there are no barriers to trade. This holds even in countries that lack an absolute advantage in the production of any good. Therefore, unlike the Absolute Advantage theory, this theory suggests that trade is a positive sum gain in which all gain.

Assumptions underlying the Theory of Comparative Advantage 1. A simple world has been assumed, where there are only 2 countries and 2 goods. 2. There are no transaction costs between the countries. 3. Prices of resources are the same across countries. 4. Exchange rate has not been considered. 5. Resources are mobile within national boundaries but immobile across national boundaries. 6. Constant returns to scale have been assumed, but in reality both diminishing and increasing returns to specialization exist. 7. Income distribution within a country has not considered.

Despite these assumptions, economists have shown that the basic result derived from the theory of Comparative Advantage can be extended to a world composed of many countries producing many different goods and research, supported by data, reveals that countries will export the goods they are most efficient at producing (Hill 2003). 1.6 Heckscher- Ohlin Theory The Heckscher- Ohlin theory of comparative advantage is an alternative to the Ricardos model. While David Ricardo argued that differences in labor productivity between nations underline the principle of comparative advantage, Eli Heckscher (1919) and Bertil Ohlin (1933) argue that comparative advantage arises from differences in national factor endowments. Factor endowments refer to those productive factors found locally such as land, labor and capital and these factor endowments give rise to differences in factor costs. In fact, the more abundant a factor, the lower will be its cost. Thus, the basic principle of the Heckscher- Ohlin theory is that for trade to occur between 2 countries, the countries must differ in terms of their availability of their factors of production. Specifically, countries will export those commodities which require for their production relatively intensive use of those factors that are locally abundant and import those commodities which make intensive use of factors that are locally scarce.

As per the Heckscher- Ohlin theory, specialization in production and unrestricted trade between countries generates a higher standard of living for the participating countries. Assumptions underlying the Heckscher- Ohlin Theory 1. The major factors of production, namely labor and capital, are not available in the same proportion in both countries. 2. The 2 goods require produced either require relatively more capital or relatively more labor. The assumption that capital and labor are not available in same proportion in the 2 countries leads to specialization. The country with relatively more capital specializes in producing and exporting capital intensive goods and importing labor intensive goods. According to the Heckscher- Ohlin theory, the greater the difference between the 2 countries in terms of capital to labor ratio, the greater the economic gain from specialization and trade. 1.7 Leontief Paradox The Heckscher- Ohlin Theory has been one of the most influential theories in international economics and in 1954 the Professor W.Leontief tested the theory in US. Using the HeckscherOhlin Theory, Leontief forwarded that because the US was relatively abundant in capital compared to other nations; US would be an exporter of capital intensive goods and an importer of labor intensive goods. However, Leontief reached a paradoxical conclusion that capital-labor ratio embodied in US exports is smaller than the capital-labor embodied in US import. This result has come to be known as the Leontief Paradox. Leontief suggested an explanation for the paradox. He explained that relative to foreign workers, US workers might be more efficient and recognized this superior efficiency in relation to superior economic organization and economic incentives in US. As per Hill (2003), an alternative explanation is that US has a competitive advantage in producing goods from innovative technologies. He further suggested that such products may be less capital intensive as compared to products whose technology had matured and become adaptable for mass production. Consequently, US exports goods that extensively use skilled labor and innovative entrepreneurship, while importing heavy manufactures that use large amounts of capital.

1.8 International Product Life Cycle Theory The Product Life Cycle (PLC) Theory was proposed by Raymond Vernon in the 1960s. The PLC theory states that certain products go through a cycle that consists roughly of 4 stagesintroduction, growth, maturity and decline and the production location moves from one country to another depending on the stage in the products life cycle. Vernons theory was motivated by the fact in the 2oth century, most of the worlds new products, especially consumer durables, were being massively produced in US owing to the wealth and size of its market. Moreover, due to high labor costs and the fact that US was relatively abundant in capital than other nations, US firms developed cost saving process innovations. Initially, the products were produced in US. This was because when a firm developed a new product, its sales are intended primarily for the market in which consumers needs were first observed. The firm might want to keep its production facilities and its center of decision making near its intended consumers so as to obtain market feedback and to save on transport costs. Also, since the demand for new products tends not to be largely influenced by price, firms can charge relatively high prices and this discards the need to look for low cost production countries. Vernon further argued that in the early stages of the life cycle of a product, a small part of the production might be sold to customers in foreign markets who have heard about the product and actively demand it. These foreign customers are likely to be high income groups in countries with similar market segments as US. The relatively low level of demand in the other advanced countries does not make it worthwhile for the companies in these countries to produce the product yet. Over time, as sales of the new product and the demand for the new product grow in countries most similar to US in demand patterns and income like UK, France, Germany and Japan, the US firms start producing in these foreign markets in order to reduce transport costs and tariffs. As the product matures and sales of the product grow rapidly in many markets, cost considerations gain momentum as competitors enter the market. Firms move their production where labor costs are lower than in US. In the maturity stage, there is also more product standardization. Since technologies are now widespread, the innovating country no longer has

production advantages and firms begin moving their production to LDCs, where unskilled but cheap labor can be used for standardized processes. As cost pressures become intense and the product moves to the declining stage, almost all production is now situated in the LDCs which export to the declining or small niche markets in industrial countries. Thus, the cycle by which US lost its advantage to other advanced countries is repeated once more. Location for global production shifts from US to other advanced nations and then from these nations to developing countries such that over time, the innovating country becomes a net importer. Limitations of PLC: 1. PLC did not stand the test of time as US is no longer considered as highest income earners. 2. The technological leadership enjoyed by US gave way to a more balanced competition between US and Japan. 3. Highly innovative products have extremely short life cycle, which makes it impossible to decrease cost by moving production from one country to another.