INTERNATIONAL TRADE THEORIES

Why do Nations Trade?(i) Nations are different

- Unequal distribution of natural resources

- Difference in Technology

- Cost Advantages:

Cost of production for the same product differs among different locations

Better explained by the Theories of Absolute Advantage and Comparative Advantage

- Different Preferences:

Americans prefer Basmati rice grown in India (taste differences)

Due to different income levels

(ii) To achieve economies of scale in production- The New Trade Theory

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Why study trade theory?

• Talks about benefits of international trade

– theories show why countries should trade for products/ services even when they can produce them domestically (Classical theories)

• Talks about patterns of international trade

– theories show why countries specialize the way they do (Factor endowment theories)

• Talks about the role of intervention

– theories help articulate the role of government policy (tariffs, quotas, etc.)

“International trade theories has long held that …..some trade is better than no trade, and more trade is better than less trade, and free trade is better than restricted trade…”

Free trade is a situation where a government does not influence international trade through quotas and tariffs

“…. Free trade is considered to be fair trade, because what is free must be fair…” !!!!

An overview of trade theory

• Adam Smith: The theory of absolute advantage, 1776

• Ricardo: The theory of comparative advantage, 1817

• Heckscher-Ohlin theory: 20th century

• Leontief Paradox: 1954

• Bretton Woods System : 1944

Learning objective :-Differentiate between Absolute Advantage and

Comparative Advantage theory

In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more number of a good product or service than competitors, using the same amount of resources.

Terms

The theory of comparative advantage is an economic theory about the potential gains from trade for individuals, firms, or nations that arise from differences in their factor endowments or technological progress. In an economic model, an agent has a comparative advantage over another in producing a particular good if he can produce that good at a lower relative opportunity cost i.e. at a lower relative marginal cost prior to trade

The existence of a comparative advantage allows both parties to

benefit from trading, because each party will receive a good at a price that is lower than

its opportunity cost of producing that good.

Absolute advantage compares the productivity of differentproducers or economies. The producer that requires a smallerquantity inputs to produce a good is said to have an absoluteadvantage in producing that good.

The accompanying figure shows the amount of output Country Aand Country B can produce in a given period of time . Country Auses less time than Country B to make either food or clothing.Country A makes 6 units of food while Country B makes one unit,and Country A makes three units of clothing while Country Bmakes two. In other words, Country A has an absolute advantagein making both food and clothing

Absolute Advantage :-

Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another. Even if one country has an absolute advantage in producing all goods, different countries could still have different comparative advantages. If one country has a comparative advantage over another, both parties can benefit from trading because each party will receive a good at a price that is lower than its own opportunity cost of producing that good. Comparative advantage drives countries to specialize in the production of the goods for which they have the lowest opportunity cost, which leads to increased productivity.

For example, consider again Country A and Country B in . The opportunity cost of producing 1 unit of clothing is 2 units of food in Country A, but only 0.5 units of food in Country B. Since the opportunity cost of producing clothing is lower in Country B than in Country A, Country B has a comparative advantage in clothing.Thus, even though Country A has an absolute advantage in both food and clothes, it will specialize in food while Country B specializes clothing. The countries will then trade, and each will gain.

The Heckscher – Ohlin Model

The Heckscher – Ohlin ModelCause of trade

– International differences in labour productivity –Ricardian view

– Differences in countries resources – H-O model.

• Developed by Eli Heckscher and Bertil Ohlin

• Also called Factor-proportions Theory – because it discusses:

– The proportions in which different factors of production are available in different countries, and

– The proportion in which they are used in producing different goods

• Assumptions

– Two factors of production – capital & labour

– Two countries (India and Japan), differ in factor abundance/ endowments

– Two commodities – Steel and Cloth

– Steel is more capital intensive and Cloth is more labour intensive in both countries

– Both goods uses both factors and the relative factor intensities are the same for each good in the two countries.

• Based on these postulates, the H-O modelpredicts that the capital surplus countryspecializes in the production and export ofcapital-intensive goods and the labour surpluscountry specializes in the production andexport of labour-intensive goods.

Consider two countries :

The H-O Theorem

Countries tend to export goods whoseproduction is intensive in factors withwhich they are abundantly endowed.

Gains from Trade

Trade leads to convergence of relativeprices, which in turn has strong effect onthe relative earnings of the factors ofproduction.

H-O Theory: Summary

• Provides a different explanation of comparative advantage.

• Comparative advantage arises from difference in national factor endowments.

• Difference in factor endowments explains the differences in factor costs (prices).

• The more abundant a factor, the lower its cost.

• This theory assumes that technologies are the same across countries.

H-O theory has more commonsense appeal

Example: the US has long been a substantial exporter of agricultural goods, reflecting in part its unusual abundance of arable land

China exports labour-intensive manufactured goods reflecting China’s relative abundance of low-cost labour

The US, which lacks abundance labour imports these goods from China

Note: it is relative, not absolute, endowments that are important

H-O Theory: Summary

Testing the Heckscher-Ohlin Model

Leontief Paradox

Wassily Leontief received a Nobel prize in 1973 for hiscontribution to the input output analysis. Three of hisstudents, Paul Samuelson, Robert Solow and Vernon Smith are also recipients. The Heckscher Ohlin theory states that each country exports the commodity which uses its abundant factorintensively. The HO theory was generally accepted on thebasis of casual empiricism. Moreover, there wasn't anytechnique to test the HO theory until the input outputanalysis was invented. The first serious attempt to test the theory was made by Professor Wassily W. Leontief in 1954.

The first EmpiricalTest of the HOtheory

Result: Leontief reached a paradoxical conclusion that the US—the most capital abundant country in theworld by any criterion—exported labor intensivecommodities and imported capital intensivecommodities. This result has come to be known as the Leontief Paradox.[para = contrary to, doxa = opinion]

Criticism- At first, Leontief was criticized on statistical grounds.Swerling (1953)- complained that 1947 was not a typicalyear: the postwar disorganization of production overseaswas not corrected by that time.

Leontief's SecondTest-

In 1956 Leontief repeated the test for US imports andexports which prevailed in 1951. In his second study,Leontief aggregated industries into 192 industries. Hefound that US imports were still more capital intensivethan US exports. US imports were 6% more capital intensive. (The transition of the USeconomy from a wartime to peace time economy was not complete until the 1960s)

Baldwin's ThirdTest-

More recently, Professor Robert Baldwin (1971) used the 1962 US trade data and found that US imports were 27% more capital intensive than US exports. The paradox continued. [There were some computational problems in this study.]

Afterwards, there were no new empirical studies on US trade.

JAPAN

East Germany

• Tatemoto and Ichimura (1959) studied Japan's tradepattern and discovered another paradox. Japan was a labor abundant country, but exported capital intensive goods andimported labor intensive goods. Japan's overall tradepattern was inconsistent with HO.

• Stolper and Roskamp (1961) applied Leontief's method to

the trade pattern of East Germany. East Germany's exportswere capital intensive. About 3/4 of EG's trade was with thecommunist bloc, and EG was capital abundant relative to itstrading partners. Thus, the EG case was consistent with the

Trade Patterns of Other Countries

Wahl (1961) studied Canada's trade pattern. Canadian exports were capital intensive. Most of Canadian trade was with the US. The result was inconsistent with HO.

CANADA

INDIA Bharadwaj (1962) studied India's trade

pattern. India's exports were labor intensive. Consistent with HO theory.

However, Indian trade with the US was not. Indian exports to the US were capital intensive.

1. Leontief: US was more efficient Leontief himself suggested an explanation for his own paradox.

He argued that US workers may be more efficient than foreign workers. Perhaps U.S. workers were three times as effective as foreign workers. Note that this increased effectiveness of the American workers was not due to a higher capital labor ratio, because we assume that countries have identical technologies and hence identical Capital labor ratios. It means that the average American worker is three times as effective as he would be in the foreign country.

Given the same K/L ratio, Leontief attributed the superior efficiency of American labor to superior economic organization and economic incentives in the U.S. However, Leontief found very few believers among economists.

Explanations for the LP

2. Factor Intensity Reversal

If a commodity is produced by a labor intensive process in the labor rich country and also by the capital intensive process in the capital rich country, then factor intensities are reversed in the production of that commodity.

Example: agriculture is labor intensive in India butCapital intensive in US.

If the US imports agricultural products, then an LP occurs in the US, because a capital abundant country is importing the capital intensive product.

If the US exports agricultural products, then an LP occurs in India, because a labor abundant country, India, is importing the labor intensive good.

William Travis (1964) argued that tariff may have been responsible for the LP. However, tariffs tend to reduce trade volume, but not reverse commodity trade pattern. In other words, an import tariff cannot induce a country to export goods that intensively use its scarce factor. It would only reduce the volume of goods which it would export in the absence of a tariff.

Baldwin (1971) showed that this indeed was the case. Without tariff, the capital labor ratio of imports would have fallen by 5%, which is not sufficient to resolve the LP.

Remark- Tariffs and transport costs tend to reduce the volume of trade, but not reverse the pattern of trade.

3. Tariffs and Transport Costs

A capital abundant country need not export the capital intensive good if her tastes are strongly biased toward Capital intensive goods. Thus, LP can be explained if the US had a strong consumption bias toward the capital intensive goods.

Stefan ValavanisVail (1954)

Example ofdemand bias-

Switzerland leads the world in per capita annual chocolate consumption, 22.5 pounds per person! (Swiss Chocolate). Per capita consumption of chocolates is less than 5 pounds in the United States. Per capita consumption of seafood in Japan is 60 kg per year while that of the US was about 15 pounds in 2001. Thus, the Japanese people consumes 10 times as much seafood as Americans per person. When commodities are narrowly classified, there exists a considerable difference in tastes and consumption patterns between trading countries.

4. Demand Bias

Human capital has not been taken into account in evaluating LP. The idea is simple. Human capital is created by education. Education, like investment in physical capital, requires time and uses up resources. Leontief did not include the value of human capital in his calculations. But he argued that US exports were skilled Labor intensive than US imports.

5. Human Capital

These analyses show that presence of human capital can play an important role in determining trade patterns between countries. However, available empirical evidence is not very conclusive either way.

Evaluation-

Porter’s Diamond TheoryOf

Comparative Advantage

It provides a sophisticated tool for analyzingcompetitiveness with all its implications. The essence ofhis argument is that ‘The home nation influences theability of its firms to succeed in particularindustries.’ Michael Porter considers that these fourattributes shape the environment :

Factor conditions/ Factor endowments

Demand Conditions

Related and supporting industries

Firm strategy, structure and rivalry

Porter speaks of these above attributes as constituting thediamond.

The industry is the arena in which the competitiveadvantage is won or lost.

Michael E.Porter’s Diamond Model

Firm Strategy,

Structure and Rivalry

Demand Conditions

Related And Supporting

Industries

Factor

Cond itions

Being the inputs which effect the competition in anyindustrycomprises a no.of categories such as human resources,capital resources, physical resources, infrastructureresources.Depending upon the degree of investment required for thepossession of a particular factor, factor’s of production aredivided into two groups:BASIC FACTORS : They require the modest, private andsocial investment. They include natural resources, climate ,location, semi-skilled labour.ADVANCED FACTORS : These comprises of the highlyeducated personnel, research facilities. These factors requirethe large and sustained investments for their development.

Factor conditions

There is another division which accounts for theestablishment of the competitive advantage most.These are as follows : Generalized factors: The meaning comes fromtheir name as they could be deployed in a widerange of industries. Specialized factors : They are characterised by narrow field of application due to the higher

degree of the customization to the needs of a particular industry.

Contd...

Demand Conditions

Porter emphasises that role home demand plays in upgrading competitive advantage. Firms are typically most sensitive to the needs of their closests customers. This means that, regardless of the state of the other determinatsin the daimond, competitively in an industry it is impossible to achieve unless demand conditions allow for a successful realisation of firm’s products. The sources of this are being divided into the 3 broad attributes: Home demand cpomposition Demand side and pattern of growth Internalization of domestic demand

Related and supporting industries

The third attribute is the related and supporting industries.

Important benefit of home based suppliers is expressed in

the process of innovation and upgrading. Supplier help firms

to perceive new methods and opportunities to apply new

technology.

Related industries are those in which the firms can share in

the value chain. Another way by which related industries

could influence competitiveness is by means of pulling

through the demand for complementary products and

services.

Firm Strategy, Structure and Rivalry

The fourth broad attribute of national competitive advantage

in porters model is the strategy structure and rivalry of firms

within a nation.

This is reflective of company goals and individual goals as

well as national prestige and national priority. Domestic

rivalry not only creates pressure to innovate but to innovate

in ways that upgrade the competitive advantages of a nation

firms.

Their pressure lowers the significance of advantages

created through the little effort and investment.

Porters considerers the two additional variables which are notas important as the determinants but are significnat inshaping the direction of the influence. These two are Chance and Government.Chance : These are developments beyond the control of

firms such as pure investors etc. Government : It is important to extent to which its

policies can influence the entire system of determinants either in the direcion of undermining or enhancing competitive advantage.

Contd...

Conclusion

He contents that the degree to which a nation is likely to achieve international success in a certain industry is a function of the combined impact of the four attributes. He argues that the presence of all the four factor components is usually required for this diamond to boost its competitive advantage .

Before World War I, nearly all of the world economy was on the gold standard

A government would define a unit of its currency as worth a particular amount of gold, ready to sell/buy any amount of gold at that time

The currency was convertible could be converted into gold freely

The currency’s price in terms of gold was its parity

The Bretton woods system was born in 1944 in Bretton Woods, New Hampshire , endorsed by the 730 delegates of 44 countries.

Goal:

To establish a postwar international monetary system of convertible currencies, fixed exchange rates and free trade.

BUT

With 2 rival plans !!

Keynes’ plan centred on the idea that a new international financial institution, the International Clearing Union, would be created whose role was much like that of a central bank.

The ICU would issue an international currency called the Bancor and its value would be fixed in terms of gold.

Countries would then set par values in terms of Bancor and create accounts with the ICU which would be used to settle trade.

The American plan foresaw a world free of trade restrictions and of currencies that were pegged, all overseen by an international institution that had significant veto power over parity changes.

For this reason the White Memorandum focused on creating another institution known as the United Nations Stabilisation Fund.

Each nation would contribute a quota of their domestic currency and gold to the UNSF and would fix the value of their currency in terms of unitas,

Deficit countries would then draw resources by selling

Features from both the memorandum were taken and this led to the creation of Bretton woods system.

This was accompanied by the creation of international institutions, including the International Bank for Reconstruction and Development( presently known as WORLD BANK )and the International Monetary Fund (IMF).

IMF was entrusted with the supervision of the new international monetary system and with granting loans to deal with balance of payments difficulties,whereas the WORLD BANK specialised in granting loans for the reconstruction of Europe and for development purposes.

To establish stable exchange rates;

To eliminate exchange controls;

To bring about convertibility of currencies and to supervise orderly maintenance of exchange rates.

The first problem encountered was the question of choosing the appropriate exchange rate regime, i.e. Whether a fixed exchange rate system or a floating rate system or any other variant of either of these two or a combination of both.

The experts gathered at Bretton Woods finally chose the fixed exchange rate system with some flexibility also called adjustable peg or adjustable par values.

Second problem: was to have an institution with both authority and resources to facilitate and ensure the smooth working of the fixed exchange rate system. To achieve this, the INTERNATIONAL MONETARY FUND(IMF) was set up

in1946.

Fixed but adjustable peg was chosen. Therefore, the dollar was pegged to gold at the fixed rate of USD 35/ounce and the United States was prepared to buy/sell unlimited amount of gold at this price.

Other countries were required to declare the rates of their currencies in terms of gold/dollar and to defend the declared rates in the forex market by buying and selling dollars, exchange rate could only vary within the INTERVENTION POINTS, initially fixed at +/- 1%.

Multilateral trade

World economic growth and trade.

The BW suffered from a no. of problems that led to its eventual demise.

FIRST PROBLEM: countries which are IMF members are required to declare parity rates of their currencies in terms of gold/ dollar.

SECOND PROBLEM: to ensure flexibility, par values are allowed to fluctuate but only within a margin of not exceeding 1% on either side of the parity rate. In December, 1971, this margin was increased to 2.25% .

THIRD PROBLEM: whenever the fluctuations in the exchange rate exceed permitted margins, the countries are obliged to intervene in the exchange market to keep the fluctuations within the permitted band.

FOURTH PROBLEM: to keep the fluctuations in the exchange rates within limits, central banks of member countries have to maintain adequate foreign exchange reserves, and if the reserves are found inadequate, members countries are eligible to borrow foreign currencies temporarily.

LAST, if the foreign exchange difficulties persist over long periods, the situation is described as “fundamental disequilibrium”, and in this situation if borrowings exceeds in amount and duration corrective measures are taken by the countries concerned.

BW System worked very well during 1946-71. and proved beneficial to the growth of the economics particularly in the western world.

Problems started developing from 1964 and led finally to the collapse of the system in 1971.

3 main problems that led to collapse: (1) adjustment (2) liquidity (3) confidence

The entry of US in Vietnam War.

The huge military spending for purchase of material and supplies for war led to inflation in the US; and this in turn affected the competitiveness of US exports.

While Germany and japan were resisting revaluation of their currencies.

1962, france began to exchange dollars for gold despite the objection of the united states.

French action led other countries to worry about whether sufficient gold would remain for them after the French had finished selling dollars.

Feeling the pressure, the united states, on 15th august 1971, responded to a record USD30 billion trade deficit by making the dollar inconvertible into gold, led to the collapse of BWS !!

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