Trade Theories

Trade Theories

Objectives

• Understand analytical foundations of international trade.
• Know how nations decide their trade policy.
• Understand different trade theories.
• Know FDI approaches to international trade.

4.1 Introduction

• World history is a story of wars and trade.
• Major wars were fought mainly for economic reasons.
• Examples:
  • Britons established colonies for trade.
  • U.S. invaded Iraq and Libya for economic reasons.
  • Africa and Latin America were colonized for trade and commerce.
• Theories of international trade help understand motives and reasons behind wars and explain trade patterns and benefits.
• Understanding international trade theory helps investors, consumers, companies, and governments to determine how to act for their benefit within the global trading system.

4.2 Classification and Importance of Trade Theories

• International Trade Theories are broadly classified as shown in Figure 4.1.
• International trade theory helps explain trade patterns, trade motives, trade trends, and observed trade.
• It helps explain the characteristics of a trading country's trade pattern and deduce what, why, where, and how they trade.
• Trade theory helps understand the effects of trade on the domestic economy/sectors and diagnose cause-and-effect relationships, aiding policymakers in evaluating policies.
• Government can plan policy interventions to boost trade and bring prosperity, generating welfare in society.
• International Trade Theories helps understand why countries trade.
• Why not a strong economy like the United States of America should produce all goods and services at back home rather than import them from countries such as China and India?
• Why do countries specialize in trade for example; a strong economy like Japan import wheat, corn, chemical products, aircraft, manufactured goods, and informational services from other countries.
• International trade theories attempt to solve questions as shown in Figure 4.2.
• Countries are endowed with different natural, human, and capital resources.
• Each country varies in combining these resources (Land, Labor, and Capital).
• In a globalized set-up, each country cannot be efficient as the best at producing all goods and services.
• They trade based on opportunity cost.
• Opportunity cost model helps understand the choice of producing one good or another.
• Production decision depends on producing goods/services with the lower opportunity cost and trading those goods with goods of higher opportunity cost.

4.3 International Trade Theories

• International business began with international trade operations, which were facilitated by the global economy’s laissez faire attitude.
• Improved well-being of many nations, and the position of trade barriers reduced trade gains, giving rise to the search for alternative avenues to boost net exports.
• Alternative trade routes resulted in establishment of companies in foreign countries via FDI.
• It is critical to comprehend the determinants and consequences of international trade and FDI on trading partners, multinational corporations’ international operations, and the economies of home and host countries.
• Several theories have been developed across countries over time, which have served as the foundation for international trade and FDI.

Theory of Mercantilism

• From the sixteenth to the eighteenth centuries, world trade was based on mercantilism, especially in Western Europe (France, England, Germany).
• Elements: belief in protectionism, nationalism, and the welfare of the nation.
• Included planning and regulation of economic activities to achieve national goals, reducing imports and promoting exports.
• Agriculture practices have a very limited impact on a countries economic development because agriculture becomes unproductive after a certain period of time but, economic development through the use of industries has no bounds.
• Mercantilists believed a nation’s power lies in its wealth, which grew by increasing gold and silver reserves by establishing a favorable trade balance.
• Gold could fund military expeditions and wars, and exports would create jobs.
• Adam Smith and Ricardo criticized mercantilism, emphasizing individuals' importance and defining national wealth as “the sum of enjoyments” of individuals in society.
• They believed in liberalism and specialization in the production of goods for which resources were most suitable and easily available.
• Critics of mercantilism accepted any activity that would increase people’s consumption.
• Mercantilists failed to recognize that export promotion and import substitution is not possible in all countries, and that mere possession of gold cannot improve people’s well-being.
• Keeping resources in the form of gold reduces production of goods and services, lowering the welfare of citizens.
• The concentration of production of goods for domestic consumption through less efficient use of resources will result in less production and lower gains from international trade.

Theory of Absolute Cost Advantage

• Adam Smith advocated the theory of absolute cost advantage.

• Many factors influence bilateral trade, including transportation costs, tariffs, internal and external factors, national and international aspects.

• Every country should invest in the production of the commodity that it can produce more cheaply than the other country and exchange it for the commodity that is less expensive in the other country.

• Assumptions:

  • Labor is the only factor of production.
  • The cost of production is the cost of labor; the skill of labor is the same in both countries.
  • Labor is perfectly mobile.
  • Free trade between countries; no tariffs.
  • Constant returns to scale.
  • Technical progress is constant.
  • Both countries manufacture the same commodity.

• Example using Table 4.1:

  Country	Labor Cost Per Day (in hours)	Tractor	Truck	Before Trade	After Trade
  India		10	5	15	20
  France		5	10	15	20

• Trade occurs when there is an absolute cost difference.

• Before trade, India produced 10 tractors and 5 trucks. France produced 5 tractors and 10 trucks.

• If they trade, they specialize in absolute advantage and gain.

• India has an absolute cost advantage in tractor production, while France has an absolute cost advantage in truck production.

• With specialization, they can produce 20 units of each (tractors and trucks).

Theory of Comparative Cost Advantage

• Adam Smith’s theory of absolute advantage failed to explain the basis of trade when a country has an absolute advantage in producing both goods.

• David Ricardo in 1817 explained that if both trading countries do not have an absolute advantage in either of the two goods, how can international trade take place.

• Advantage for both trading countries is not required for trade to occur. Even if one country can produce all goods at a lower labor cost than the other, it would still benefit both trading countries.

• Table 4.2:

  Country	Jute	Leather
  India	120	100
  France	80	90
  *France has an absolute cost advantage in the production of both goods, namely jute and leather, when compared to India.

• France has an absolute cost advantage in both jute and leather production.

• India has a comparative cost advantage in leather, while France has a comparative cost advantage in jute.

• India needs 100 men per year to produce leather and 120 men to produce jute. On the other hand, the same amount of Jute and Leather France requires 80 and 90 labors, respectively.

• France is more capable than India in producing both goods, and it has an absolute advantage in the market.

• France would benefit more from jute production and export it to India because it has a greater comparative advantage in it.

• It is due to the fact that the cost of producing Jute (80/120) labour is less than the cost of producing Leather (90/100) labour.

• India will shift its production to leather production because the country has the least disadvantage.

• International trade will benefit both countries in this manner.

Haberler’s Theory of Opportunity Cost

• Ricardo’s theory was criticized because it was based on the labor theory of value.
• According to the labor theory of value, the value of a good is equal to the amount of labor time involved in its production.
• Ricardo discovered that labour was the only factor of production, that it was homogeneous, and that it was used in fixed proportions in the production of all commodities.
• All of these assumptions were found to be unrealistic because there are other factors of production besides labour, labour cannot be used in uniform proportions, and labour can be substituted with capital in countries where capital is cheaply available.
• Haberler developed his theory of Opportunity Cost.
• If a country produces either A or B commodity, the opportunity cost of commodity A is the amount of commodity B sacrificed in order to obtain an additional unit of commodity A.
• The exchange ratio of the two goods is expressed in terms of opportunity cost.
• The concept has been used in international trade theory along with the production possibility curve.
• Assumptions:
  • Two trading countries, each with two factors of production (labor and capital).
  • Each country produces two goods.
  • Perfect competition in factor and goods markets.
  • Full employment in both countries.
  • Factors are immobile between countries but completely mobile within the country.
  • Free trade between the countries.
  • The supply of goods was assumed to be unlimited.
• A production possibility curve (PPC) depicts various alternative combinations of the two commodities that a country can produce more efficiently by utilizing both factors of production and the technology at hand.
• The slope of PPC calculates the amount of one good that a country must give up in order to obtain an additional unit of another good.
• The slope of PPC explains the marginal rate of transformation (MRT).
• Haberler’s theory was thought to be superior to the comparative costs theory of international trade.
• Its superiority stems from an examination of pre-trade and post-trade conditions under constant, increasing, and decreasing opportunity costs, whereas comparative cost theory was founded on constant production costs within a country and comparative advantage and disadvantage between the two countries.
• Criticisms by Jacob Viner:
  • The opportunity costs approach was found to be inferior as a tool of welfare evaluation to the classical real cost approach, as the theory fails to measure real costs in the form of sacrifices made in providing productive services.
  • Viner also criticized the PPC for failing to take into account changes in factor supply, and the assumptions of two countries, two commodities, two factors, and perfect competition were also found to be unrealistic.

Mill’s Theory of Reciprocal Demand

• J. S. Mill applied Ricardo’s concept of comparative cost.

• Labor productivity varies by country.

• Reciprocal demand is the ratio in which two commodities are traded based on the strength of demand elasticity in both countries for both A and B commodities.

• J.S. Mill used the concept of an offer curve in his theory.

• Marshall and Edgeworth introduced the concept of offer curves.

• Assumptions:

  • Two countries, two goods, and two factors of production.
  • Based on the comparative cost principle.
  • Perfect competition.
  • Full employment.
  • Goods are produced under constant returns.

• Example using Table 4.3:

  Country	Linen	Jute
  France	10	10
  Italy	6	8

• France produces 10 units of linen or jute in one year, whereas Italy produces 6 units of linen or 8 units of jute with the same labor and time factors.

• According to J.S. Mill, “It will benefit Italy to import linen from France and France to import jute from Italy.”

• France has an absolute advantage in both linen and jute production, while Italy has the least comparative disadvantage in jute production.

• Prior to trade, France’s domestic cost ratio was 1:1, and France’s domestic cost ratio was found to be 3:4.

• If they trade, France has a 5:3 (or 10:6) advantage over Italy in linen production, while Italy has a 5:4 advantage in jute production (or 10:8).

• 5/3 is greater than 5/4. France has a greater comparative advantage in linen production.

• France will benefit from exporting linen to Italy in exchange for jute.

• Italy’s position in linen production was determined to be 3/5 (or 6/10), while its position in jute production was estimated to be 4/5 (or 8/10).

• 4/5 is greater than 3/5, so it is advantageous for Italy to export Jute to France in exchange for Linen.

• Mill’s theory is concerned with trade terms under which goods are exchanged.

• Terms of trade refer to barter terms of trade between the two countries, i.e. the proportion of a country’s imports to its exports.

• Domestic exchange ratios recognized by the relative efficiency of labor in both countries set the limits of possible international trade barter terms.

• France, with two labor-time inputs, produces 10 units of linen and the same number of units of jute, whereas Italy, with the same labour time, can produce 6 units of linen and 8 units of jute.

• In France, the domestic exchange proportion between linen and jute is 1:1, while in Italy, it is 1:1.33.

• The maximum possible terms of trade in France were 1 Linen: 1 Jute, while in Italy it was calculated to be 1 Linen: 1.33 Jute.

• The trade terms between the two goods were determined to be 1 Linen or 1 Jute or 1.33 Jute.

4.4 Heckscher-Ohlin Theory

• Heckscher-Ohlin trade theory is another name for the Heckscher-Ohlin trade model.
• Heckscher published a paper in 1919, and Ohlin published a book in 1933.
• Ohlin was awarded a Noble Prize for his theory in 1977.
• This model is also known as the H.O Model.
• The model is 2x2x2 (two goods, two production factors, and two countries).
• Capital and labor are the two factors.
• Ricardo failed to explain how comparative advantage is determined.
• A country will export commodities with abundant factors and import commodities with scarce factors.
• In Adam Smith and Ricardo’s trade models, labor was the only factor input, and the differences in the trade is determined by labor productivity.
• Different countries have different factor endowments, and that the differences in factor endowments facilitate trade between trading partners.
• Based on the assumption that there are trade barriers and that goods and factor markets are perfectly competitive.
• The theory is predicated on comparative advantage in terms of relative factor prices.
• If a country has a large amount of capital, it will produce capital-intensive products and export them in exchange for labor-intensive products.
• Another country, which is rich in labor, will produce and export labor-intensive goods while importing capital-intensive goods.
• “Abundance” refers to the price of the factor and the physical quantity of the factor.
• If there are two countries, A and B, then the prosperity of the country in terms of factor prices means that the price of the factors of production is relatively lower.
• Unlike the classical trade model, H.O. trade theory cannot guarantee the desired income distribution among the country’s various classes.
• Because of the greater demand for producing respective goods for the global market, returns to capital are higher in country A and returns to labour are higher in country B.
• The traditional trade models were predicated on certain assumptions, such as no transportation costs and the free flow of information to all producers and consumers.
  *They do not account for the effects of trade on global prices.
• These trade theories are static and ignore the effects of technological progress on global economic growth.
• These are real concerns that must be addressed in a customized description of classical and neoclassical theories.
• If a country has a monopoly on a particular good, it can have an impact on global prices.
• It can either supplement its gains through “optimal tariffs,” which seek to maximize the welfare of the country.
• Trade has the potential to complicate the growth process.
• It can have an impact on employment and even the overall well-being of the country.
• This is possible in the case of exponential growth (when benefits from the higher output are neutralized by the adverse terms of trade).
• The country ends up with lower real income after growth because the benefits of higher output are washed out by deteriorating trade terms.
• The adapted version of the basic theory does not change the assumption that a country produces and exports the product in which it has a comparative advantage and uses the abundant factor in the production.
• The country benefits from trade, but the distribution of gains can be distorted.
• Change in trade is not free, but the short-term cost of adjustment should be balanced against the long-term benefits of trade.
• Criticisms:
  • The assumption of 2x2x2 model was found to be unrealistic.
  • Unlike classical theory, this theory was also static in nature.
  • Based on the assumption of homogenous factors which was calculated with the help of factor endowment.
  • The techniques of production cannot also be homogenous even for the same good in the two countries as assumed in H.O. model.
  • Based on another assumption of similar taste.
  • Based on the assumption of constant returns to scale, which is also not true because a country with a rich factor endowment frequently obtains the benefits of economies of scale through a smaller amount of production and exports, implying that there should be increasing returns to scale.
  • Does not take into account transport costs in trade between trading countries.
  • The impractical supposition of full employment and perfect competition.
  • The Leontief paradox has been proven.

The Leontief Paradox

• Wassily Leontief conducted an input-output analysis using data from the United States in 1947 to validate the Heckscher-Ohlin model.
• He divided 200 industries into 50 sectors, 38 of which were discovered to be trading their goods directly on the international market.
• Leontief discovered a paradoxical situation in which the United States was importing capital-intensive goods from abroad despite being a capital-rich country and was found to be exporting labor-intensive goods.
• The supporters of H.O. trade theory experienced a slowdown in the early 1950s, when Leontief tested his hypothesis using data from the US economy.
• His findings refuted the H.O. claim.
• Shocking news for economists that the United States, despite being a capital-rich country, was exporting labor-intensive goods a several explanations were considered in order to resolve the Leontief paradox.
• Significant factors identified as supporting the Leontief paradox:
  • The United States’ protective trade policy
  • The import of natural resources
  • The investment in human capital
• William Travis investigated Leontief theory in the context of US tariff policy.
• When Leontief tested his hypothesis, the United States was found to be importing more capital-intensive items such as crude oil, paper pulp, primary copper, lead, metallic ores, and newsprint.
• According to Travis, the United States’ protective trade policy was to blame for Leontief’s findings.
• The United States imports natural resources such as minerals and forest products and exports farm products, according to Leontief’s presentation.
• Human capital investment boosts labor productivity.
• Because of these factors, the United States’ exports were labor-intensive, whereas its imports were capital-intensive and importing capital-intensive goods.
• Leontief analysis was also found to be flawed on statistical and methodological grounds.
• Main points of criticism:
  • The year 1947 was not a normal year for testing the H.O. Model because of World War II, as the United States was the only major industrial country that was not destroyed by war.
  • Economists criticized the aggregation used in the input-output model for computing capital-labour ratios in some way.
  • It was argued that Leontief model with fixed input coefficients was found to be mismatched with world trade equilibrium in which every country achieves.

4.5 Foreign Direct Investment (FDI) Theories

• Despite Multinational Enterprises’ dominance of world production and trade in the post-World War II period, the search for FDI theories is a contemporary phenomenon.
• Stephen, H. Hymer demonstrated in his doctoral thesis ‘The International Operations of National Firms: A Study of Direct Investment’ (published in 1976) that traditional theories of international trade and capital movements were incapable of illuminating the contribution of MNEs in foreign countries in 1960.
• The existence of MNEs was due to local firms manipulating market power and acting as agents.
• Approaches used to clarify the activities of multinational enterprises have been classified into four groups.

Market Imperfections Approach

• The first is the market imperfection approach, whose theoretical framework considers specific, also known as ownership advantages, enjoyed by an enterprise.
• Through these benefits, FDI is restricted, and international companies also collude with other firms to increase their profits.

Product Life Cycle Model

• Second, the Product Life Cycle model examines various stages of the company.
• There are chronological stages in the life cycle of a company’s innovated products.

Transaction Cost Theory of FDI

• Third, the failure of traditional theories of international trade and capital movements based on the assumption of perfect competition, as well as its prevalence in various segments of the international market, provide ample scope.
• It gave rise to the transaction cost theory of FDI, which states that firms make foreign investments to increase their competence and reduce transaction costs.

Eclectic Paradigm

• Finally, the eclectic paradigm that surrounds other FDI theories provides a logical framework for conducting empirical investigations that are most relevant to the problem at hand.
• The eclectic paradigm is not a theory in itself, but rather a synthesis of contradictory theories.

Market Imperfections Approach

• The expansion of MNEs has always perplexed neoclassical economists because of how these enterprises can make profits in foreign countries where production costs are higher than in the domestic market.
• Because many people were unaware of the host country’s history, it was difficult to take advantage of the situation.
• It may be preferable for the foreign company to pass on its reward to local entrepreneurs, who, along with other local (inherent) advantages, could supply at a lower cost than the foreign investors.
• The response to this paradoxical situation was present in the existence of the imperfect market in the foreign countries.
• Hymer presented a case for market imperfection approach.
• According to him, the traditional theories of international trade and capital movements were not enough to explain the association of MNEs in international market.
• Their presence was observed to be due to market imperfections.
• The supporters of this approach thought that the prevailing market imperfections were ‘structural’ (imperfections of monopolistic nature) and arose from the innovation of better technology, access to capital, control of distribution system, economies of scale, differentiated products (by the introduction of different advertising methods) and improved management.
• All these factors facilitated the foreign enterprises more than offset the shortcomings from their operations in the foreign market and the additional cost incurred there.
• Hymer was primarily concerned about the market power of MNEs, which limited the entry of other firms.
• Market power is the result of collusion with others in the industry to avoid competition, resulting in higher profits.
• There is a one-way casual link between the firm’s behaviour and the imperfect market structure.
• Market power was first developed in the home country, and as profit margins in the home country shrank, the firm invested abroad and gained control of the foreign market through patent rights.
• Because the profit margin in the home country has decreased, the firm invests abroad and controls the foreign market through patent rights.

The Eclectic Paradigm

• This theory on FDI was proposed by John H. Dunning in 1979.
• Eclectic Paradigm has three components:
  • OLI Model (ownerships, locations, and internationalization).
  • The theory assumes that institutions will avoid transactions in the open market if the cost of performing the same actions internally is lower.

Ownership Advantage

• This term refers to the competitive advantages of enterprises seeking FDI.
• The greater the investing firms’ competitive advantages, the more likely they are to engage in this foreign production.

Locational/Geographical Attractions

• Locational/Geographical Attractions refer to alternative countries or regions for MNEs to undertake value-added activities.
• The more immobile, natural, or created resources that firms must use in conjunction with their own competitive advantages favour a presence in a foreign location, the more firms will choose to augment or exploit their specific advantages through FDI.

Advantages of Internationalization

• Firms can organize the creation and exploitation of their core competencies.
• The greater the net benefits of internationalizing cross- border intermediate product markets, the more likely it is that a firm will prefer to engage in foreign production itself rather than licensing the right to do so to others.
• The theory states that if a company does not have an ownership advantage, it will conduct its operations in the domestic market and will not seek FDI.
• If, on the other hand, ownership advantage is available, the firm will examine whether it has a locational or geographical advantage; if it does not, the firm will produce in its home country and export its goods to other countries.
• Finally, it will examine the benefits of internationalization and determine which process is the most cost effective, whether to carry out production activities in the host country or to give the license to another country, and whether or not to pursue FDI.

4.6 Summary

• The rational structure of international business is built around the activities of MNEs, which are explained by the internalization process.
• Prior to the advent of multinational corporations, the terms foreign trade and international business were simply interchangeable.
• The international transactions were directed by international trade doctrines based on labour cost differentials and free trade.
• MNEs’ innovative efforts, technological development, and management styles have rendered international trade theories obsolete.
• Theorists began to develop FDI approaches in support of international business for the enhancement and welfare of the world economy.
• Several theories have been developed over time to explain the foundations of international trade and FDI.
• The doctrine of mercantilism was the first in international trade. Its underlying assumption was that a country could become wealthy by acquiring gold from abroad, which could only be accomplished by increasing exports and decreasing imports.
• They were most concerned with the national interest.
• Adam Smith and David Ricardo opposed mercantilist ideas on the grounds that the gains of individuals were the gains of the nation, and any action that increased the consumption of the people should be viewed favourably.
• The investigation of FDI theories is a relatively a new phenomenon.
• Hymer discussed in his doctoral dissertation in 1960 that traditional theories of international trade and capital movements were unable to explain the association of MNEs with foreign countries.
• There are four types of FDI approaches.
  • The first is the market imperfection approach, which assumes that MNEs have certain ownership advantages and control FDI through them.
  • The proponents of this approach believed that the existing market imperfections were monopolistic structural imperfections that arose as a result of factors such as innovation, superior technology, access to capital, distribution system management, economies of scale, differentiated products, and improved management.
  • All of these factors aided MNEs in compensating for the disadvantages of their operations in foreign environments.

4.7 Key Words

• Absolute Advantage: Greater advantage or efficiency in the production of goods enjoyed by one country over another country. This is the basis of trade according to AdamSmith.
• Basis of Trade: Factors that help in international trade.
• Gains from Trade: Gains arising from international trade which takes place on account of specialization advantages of the trading partners.
• Comparative Advantage: It states that trade would still be gainful even if one country is less efficient than the other, but specializes in the production of commodities or goods where its disadvantages are relatively lower (comparative advantage) and exports the same.
• Production Possibility Curve (PPC): It shows the various possibilities of production of two goods in a country, given the factor endowments and technology.
• H.O. Trade Theory: Postulation that countries specialize in the production and export of those goods which require their abundant or cheap factors. A capital rich country exports capital intensive goods and imports labour intensive goods.

4.8 Self-Assessment Questions

1. Explain the theory of mercantilism. Can it be applied in the present context?
2. Examine the implications of AdamSmith’s theory of absolute cost advantage.
3. Critically examine Ricardo’s comparative cost theory of international trade.
4. Discuss the Heckscher-Ohlin Trade Model.
5. Discuss the Market Imperfections Approach. How do the company specific advantages help the formulation of this theory?
6. What is eclectic paradigm? Discuss the applicability of this model in current scenario.

4.9 References/Further Readings

• Krueger, A. O. (2020). International Trade: What Everyone Needs to Know. USA: OUP.
• Krugman, P., Melitz, M., and Obstfeld, M. (2018). International Trade: Theory and Policy. Pearson.
• Suranovic, S. (2010). International Trade: Theory and Policy. Saylor Foundation.