International Trade: Concepts & Theories

International (Global) Trade concepts and theories. Understand free trade, protectionism, role of bodies like WTO in promoting free trade, regional economic integration and trade agreements. Understand the various theories of trade that explain why countries trade, understand the factors affecting countries’ trade patterns, and understand how global efficiency is increased through free trade.

International Trade

International trade involves the exchange of goods, and services between countries because there is a need for certain goods or services or perhaps the country is not efficient in producing certain goods/services.

Globalisation, on the other hand, refers to the growth in international trade (flows of goods, services and especially capital) between countries.

For a long time, economists have preached the advantages of free trade to countries.

However, considering the pros and cons of free trade, in recent years, more countries have been looking at ways to focus on their domestic market and to increase their self-sufficiency.

At the same time they are also looking for opportunities to engage in free trade with other countries.

Related: Risks in International Trade – What trade risks does a multinational company face?

This seems to be a more practical approach considering, the issues with the existing free trade. However, this requires fine balancing acts and it may also cause a country to become part of several regional trade agreements, which may not necessarily be a good thing.

So, the next global economic system is more likely to be a mix of – policies that reduce dependency on foreign powers during times of crisis, more collaboration on certain issues such as scientific developments and climate change, and some sort of free trade in certain regions.

GATT and WTO

Because of harmful effects of protectionism which were most painfully felt during the Great Depression of the 1930’s, 23 nations banded together in 1947 to form the GATT (General Agreement on Tariffs and Trade). The GATT was later replaced by the WTO (World Trade Organization).

Role of WTO in International Trade

Most favoured nation (MFN) principle of WTO agreements

Trade Protectionism

The most common barrier to trade is to impose a tariff (sort of a tax) on imports. The main reasons why many governments offer protection to some of its industries is because certain domestic industries do not have the competency yet to deal with foreign companies who are more competitive and efficient. Industries that are in the infant stage also require more time to compete with the bigger players.

Related: Impact of Tariffs and Trade Barriers on International Trade

Related: Various economic integration levels

Various Theories of International Trade

What Trade theory is important?

Trade theory helps managers and government policymakers focus on three critical questions: What products should be imported and exported? How much should be traded? With whom should they trade?

While descriptive theories suggest a laissez-faire treatment of trade, prescriptive theories suggest that governments should influence trade patterns.

Trade and Investment Policies

• Import substitution: a policy of developing domestic industries to manufacture goods and provide services that would otherwise be imported
• Strategic trade policy: the identification and development of targeted domestic industries in order to improve their competitiveness at home and abroad

Interventionist Trade Theories

Interventionist trade theories prescribe government action with respect to the international trade process.

• Mercantilism: an age-old zero-sum game that claims that a country’s wealth is measured by its holdings of treasure (usually gold) To amass a surplus (a favorable balance of trade), a country must export more than it imports and then collect gold and other forms of wealth from countries that run trade deficits (unfavorable balances of trade).

• Neomercantilism: the more recent strategy of countries that use protectionist trade policies in an attempt to run favorable balances of trade and/or accomplish particular social or political objectives.

Free Trade Theories: Absolute & Comparative Advantage

The theories of absolute and comparative advantage demonstrate how economic growth can occur via specialization and trade.

Free trade (a positive-sum game) implies specialization and requires that nations neither artificially limit imports nor artificially promote exports.

The invisible hand of the market determines which competitors survive, as customers buy those products that best serve their needs.

Nations specialize in the production of certain products, some of which may be exported; export earnings can in turn be used to pay for imported goods and services.

Theory of Absolute Advantage

Absolute advantage [Adam Smith, 1776]: A country can (i) maximize its own economic well being by specializing in the production of those goods and services that it produces more efficiently than any other nation and (ii) enhance global efficiency through its participation in free trade.

Smith reasoned that: workers become more skilled by repeating the same tasks, workers do not lose time in switching from the production of one kind of product to another, longer production runs provide greater incentives for the development of more effective working methods.

Natural vs. Acquired Advantages

A natural advantage may exist because of: given climatic conditions, access to particular resources, the availability of labor, etc.

An acquired advantage may exist because of: superior skills, better technology, greater capital assets, etc.

Real income depends on the output of products as compared to the resources used to produce them.

Theory of Comparative Advantage

Here’s how David Ricardo defined Comparative advantage. A country can maximize its own economic well-being by specializing in the production of those goods and services it can produce relatively efficiently and enhance global efficiency via its participation in free trade.

Ricardo also reasoned that: a country can simultaneously have an absolute and a comparative advantage in the production of a given product; by concentrating on the production of the product in which it has the greater advantage, a country can further enhance both global output and its own economic well-being.

The Heckscher-Ohlin Theorem

Developed by Swedish economists Eli Heckscher and Bertil Ohlin, the Heckscher-Ohlin Theorem (H-O theorem) helps us understand how countries with varying resources and natural endowments trade with one anther. It further builds upon the classical theory of comparative advantage by David Ricardo.

The H-O Theorem is a fundamental principle in international trade theory which explains how trade happens between two countries with varying advantages and natural resources.

The Heckscher-Ohlin Theorem say that when it comes to international trade, countries that have abundant labour will naturally export more labour-intensive goods and countries with more capital will export more of capital-intensive goods.

The model proposes that countries export what they can efficiently produce in large numbers, based on their advantages and endowments.

Stolper-Samuelson theorem

Developed by by Wolfgang Stolper and Paul Samuelson, the Stolper-Samuelson theorem builds upon the Heckscher-Ohlin model and is considered an important concept in international trade theory.

The theorem shows that there is a positive relationship between changes in output prices and prices of factors used in producing that product.

The Stolper-Samuelson theorem says that if prices of a good that relies heavily on a particular factor intensively rises (for example due to tariffs or due to liberalization of trade), those owning that factor will tend to benefit more and owners of others factors will experience diminishing their returns. For instance, if prices of capital-intensive goods increase, those with access to capital will benefit more and those associated with labour-intensive work are likely to face reduced wages.

Assumptions and Limitations of the Free Trade Theories

The theories of absolute and comparative advantage both make assumptions that may not be entirely valid.

The assumptions are: Full employment of resources. Exclusive pursuit of economic efficiency objectives. Equitable division of gains from specialization. Only two countries and two commodities. Exclusion of transport costs. A static rather than a dynamic view. Exclusion of services. Unrestricted factor mobility.

Theories Explaining Patterns of Trade: Country Size, Factor Proportions, Country Similarity

The theories of country size, factor proportions, and country similarity all contribute to the explanations of: what types of products are traded, with which partner nations countries will primarily trade.

Non-tradable products are those goods and services that are impractical to export.

Theory of Country Size

Large countries differ from small countries in at least two critical ways:

Large countries tend to export a smaller portion of their output and import a small portion of their consumption. Large countries are more apt to have varied climates and a greater assortment of natural resources than smaller countries, thus making large countries more self-sufficient.

Large countries tend to have higher transportation costs for exported and imported products. Given the same types of terrain and modes of transportation, the greater the distance, the higher the associated transport costs. Thus, firms in large countries often face higher transport costs in terms of sourcing inputs from and delivering outputs to distant foreign markets than do their closer foreign competitors.

Factor Proportions Theory

Factor proportions (Eli Heckscher, 1919; Bertil Ohlin, 1933):

Differences in a country’s relative endowments of land, labor, and capital explain differences in the cost of production factors.

A country will tend to export products that utilize relatively abundant production factors because they are relatively cheaper than scarce factors.

The composition of a country’s trade depends on both its natural and acquired advantages. With respect to the latter, both production and product technology can be very important.

Country Similarity Theory

When a firm develops a new product in response to observed conditions in its home market, it is likely to turn to those foreign markets that are most similar to its domestic market when commencing its initial international expansion activities.

This tendency is reflective of: the cultural similarity of nations, the similarity of national political/economic interests, the economic similarity of industrialized countries.

Countries that are near to one another enjoy relatively lower transportation costs than those that are more distant, but they may or may not be similar with respect to culture, level of economic development, and/or political/economic interests.

Product Life Cycle (PLC) Theory

The optimal location for the production of certain types of goods and services shifts over time as they pass through the stages of: (i) introduction, (ii) growth, (iii) maturity, and (iv) decline.

Exceptions to the typical pattern of the PLC would include: products that have very short life cycles, luxury goods and services, products that require specialized labor, products that are differentiated from competitive offerings, products for which transportation costs are relatively high.

During the decline stage, a product is often imported by the country where it was initially developed; however, the importing firm may or may not be the innovating firm.

Porter’s Diamond of National Competitive Advantage

The Porter Diamond [1990] theorizes that national competitive advantage is embedded in four determinants: factor endowments, demand conditions, related and supporting industries, firm strategy, structure, and rivalry. All four determinants are interlinked and generally must be favorable for a given national industry to attain global competitiveness.

At times, determinants can be affected by the roles of chance and government.

Factor Mobility

Factor mobility concerns the free movement of factors of production, such as labor and capital, across national borders.

While capital is the most internationally mobile factor, short-term capital is the most mobile of all. Capital is primarily transferred because of differences in expected returns, but firms may also respond to government incentives.

People transfer internationally in order to work abroad, either on a temporary or on a permanent basis. Brain drain occurs when educated citizens leave a country, but a nation may in turn gain from the remittances that citizens who are working abroad send home.

International Trade and Factor Mobility – Potential Effects

Substitution: the inability to gain sufficient access to foreign production factors may stimulate efficient methods of domestic substitution, such as the develop-ment of alternatives for traditional production methods.

Complementarity: factor mobility via foreign direct investment may stimulate foreign trade because of the need for equipment, components, and/or complementary products in the destination country.

While immigrants add to the base of a country’s skills, thus enabling competition in new areas, inflows of capital can be used to develop infrastructure and natural and other acquired advantages, thus enabling increased participation in the international trade arena.

To summarize these theories, most production factors are neither as mobile nor as immobile as theories assume.

While the free trade theories of absolute and comparative advantage are descriptive in nature, the interventionist theories of mercantilism and neomercantilism are prescriptive in nature. The theories of country size, factor proportions, and country similarity help explain patterns of trade; the product life cycle and Porter’s Diamond help explain the dynamics of trade. Although the international mobility of production factors may be a substitute for trade, that same mobility may stimulate trade because of the need for equipment, components, and/or complementary products in the destination country.

References

Autor, David H., David Dorn, Gordon H Hanson, and Jae Song. 2014. “Trade Adjustment: Worker-level Evidence.” The Quarterly Journal of Economics, 129(4): 1799–1860.

Farmer, R., 1970. Tariffs, quotas, and class structure. Business Horizons, 13(6), pp.29-34.

Dollars and Sense Cooperative. 2007. Real World Globalization. 9th edn. Boston: Dollars and Sense. Articles 2, 17, 34.

Krugman, Paul and Wells, Robin, 2008. Economics, 2nd edition. Worth Publishers, New York, pp, 195-205.

Stilwell, Frank. 2002. Political Economy: The Contest of Economic Ideas. Oxford: Oxford University Press. pp. 238-248.

The ten pages in Krugman and Wells explain the theory of comparative advantage. The Stilwell reading explains the argument against the neoliberal position that globalisation and free trade will end poverty and inequality around the world and cautions against globalisation. This is backed up by the three short readings from the Dollars and Sense group. These also provide further narratives for the argument that free trade will help.