Two-Way International Trade: A Comment

By

Robert Davies

R ecent articles in Weltwirtschaflliches Archly have a t tempted to

formulate and test hypotheses on two-way international trade 1. The purpose of this comment is to offer criticism of the underlying

theory and to suggest that, though the hypotheses put forward may be sound, they do not follow from this theory.

The model advanced by Gray can be discussed in terms of Figures I and 2. There are two countries (A and B) and a single group of differen- tiated products. Each differentiated commodity can be considered as facing a negatively sloped demand curve and it is regarded as likely that

Figure I Figure 2

q2 ql

Price Pr

Demand in ~ c o u n t r y B

\

xmin x 1 Quantity

q2

ql

c e

Demand in x,,,N c o u n t ry A

\

• x 1 Quantity

"there may exist in the foreign country (B) some effective demand for one or more of A's differentiated products ''*. In Figure I, a demand curve for A's differentiated product in B is drawn in terms of B's currency

t H. Peter Gray, "Two-Way Internat ional Trade in Manufactures: A Theoretical Un- derpinning", Wel~wirtschaflliches Archly, Vol. lO9, I973, pp. I9 sqq. - - Emilio Pagoulatos and Robert Sorensen, "Two-Way Internat ional Trade: An Econometric Analysis, ibid., Vol. i i i , i975, pp. 454 sqq.

t Gray, op. cir., p. 22.

1 2 e

I 8 0 Kritisehe Bemerkungen

assuming given tastes, prices of competing goods and income distribution. Gray then defines an "expor t price range" on this demand curve which is limited at one extreme by a price condition and a t the other b y a quant i ty condition. Unless a positive demand exists at a price which covers long-run marginal costs of production (ql) exports will be zero. At the other extreme there is considered to be a minimum sales volume (x min) below which it is not worth exporting because of the existence of selling costs which do not vary greatly with outputL Provided the price at which the minimum sales volume can be sold (q~) is at least as great as the supply price (ql) exports will be positive. They will be sold at price ql and the volume of sales will be x 1.

Two-way trade is explained b y reference to "reciprocal" export price ranges. Suppose, as in Figure I, tha t q2 is at least as great as ql so tha t A exports to B. If a demand curve can now be drawn for country A, as in Figure 2, for a competing differentiated product produced in B such that the price at which min imum sales are achieved is at least as great as the supply price, then A and B will exchange these differentiated commodities. The possibility for two-way trade is determined entirely by the positions of qx and qz within each country; provided qz is greater than or equal to ql in each case, two-way trade will develop.

Gray 's analysis is intended to explain why two-way trade occurs. In addition, certain hypotheses are deduced as to the economic circumstances which are favourable or unfavourable to its existence. As an explanation of two-way trade, the analysis is not wholly satisfactory. By implication, countries indulge in two-way trade in order to allow consumers access to varieties of goods not domestically produced. The var ie ty of the commodity produced in country A is not identical to tha t produced in B and the economic welfare of some consumers in both countries can be increased as a result of exchanging these goods. This is a reasonable view of the gains to be obtained from two-way trade provided there is also an explanation of why consumers' choice is limited in the absence of trade. Other explanations in the li terature suggest tha t the existence of increasing returns to scale is important either as a reason for the restriction of consumer choice or because the provision of choice incurs increased costsL But Gray explicitly assumes tha t there are constant returns to scale and thus no restriction on the number of varieties produced. If choice is limited in the absence of trade this, in Gray 's model, can only

a This constraint should be expressed in terms of a minimum v~lue ra ther than a mini- mum volume of sales.

See, for example, Herbert G. Grubel and P . J . Lloyd, Intra-Industry Trade, The Theory and Measurement o/ International Trade in Diffe~en~ia2ed Products, London, I975.

R o b e r t D a v i e s I 8 I Two-Way International Trade

be because producers do not respond to market demand. In country B, for example, a positive demand exists for the variety of the product produced in country A at a price sufficient to cover costs of production. If it is assumed that producers will seek out opportunities for earning profits, this demand will be met by home firms and two-way trade is not necessary. Only in cases where producers ignore the presence of profitable markets will two-way trade bring a gain. While such circum- stances might occasionally prevail, they are surely not so common as to provide a good basis for a general explanation of two-way trade.

A second difficulty is that the analysis does not deal with the issue of how international trade is influenced by and influences relative costs of production. Referring to Figures I and 2, it appears that B's costs of production at existing exchange rates are lower than A's (A's ql in Figure r is higher than B's ql in Figure 2). Provided q2 is at least as great as ql in each case, Gray states that two-way trade will occur. But B is clearly a relatively low-cost producer of this group of commodities and it would be to the advantage of both countries if B was to take over production of both varieties and export them to A. The operation of the market mechanism would presumably achieve this result and all exports of this commodity group would flow from the low to the high cost country. Again, one of the effects of international trade is that it causes costs of production and prices to change in the trading countries and the conse- quences of the resulting changes in the qjs on two-way trade are ignored.

Even if these criticisms are ignored, it can be argued that the hypotheses which Gray formulates do not follow from the model. Most importantly, it is stated that two-way trade is most likely to occur when both ql and q~ are equal for both countries. This will come about when countries have similar factor prices and per capita national incomes. The hypothesis tha t two-way trade is likely to be most important between countries which have similar factor prices is, as argued elsewhere by the present writer, economically defensible x, but it does not follow from Gray's analysis. As can be seen from Figures x and 2, two-way trade can occur when ql and q2 are quite different in each country. The condition for the existence of two-way trade is tha t q~ should be greater than ql in each country and this condition is consistent with a wide variety of values of ql and qg..

1 Robert Davies, On tke Relation between Product Di~erentiation and Interna2ional Trade Flows, University of Bath, Discussion Papers in Economics, 1976.