Modern Theories of International Trade

Introduction

This report aims to analyse the modern theories of international trade. The study has focused mainly on the modern trade theories like, Hecksher and Ohlin Theory, Trade and Economic Growth theory by Rybczynski, Trade and the Distribution of Income: The Factor Price Equalisation Theorem by Samuelson and Linder Model. The report has mainly two parts. In the first part, the report examines the effectiveness of the modern international trade theories to understand the trade patterns in certain countries in the world. In the second part, the focus is made on the partial trade theories, which explains the trade patterns between two countries.

a. Examining the effectiveness of the “Modern Theories of Trade” understanding the trade patterns in certain countries

The term ‘trade’ refers to the exchange of goods and services between two persons against money. On the other hand, the ‘international trade’ refers to the transfer or exchange of goods and services between two or more countries (Viner 2016). In the Theory of Comparative Advantage (classical theory of international trade), David Ricardo explained that the international trade takes place between the countries when each country achieves specialization in production of any goods or services (Neary 2016). At the same time, Ricardo has also explained that a country exports that goods or service in the production of which it has comparative advantage. However, many people have criticised the classical theory of comparative advantage by saying that the assumption under the comparative advantage theory are unrealistic (Jackson and Sørensen 2016). In order to examine and understand the international trade between the countries in a better way, the modern theories of international trade are developed. Bertodo (1991) stated that the modern theories of international trade explain the trade patterns in the countries far better than the classical theories. One of the most effective theories of international trade is the Hecksher and Ohlin Theory of international trade. This particular theory is based on certain assumptions, which are mentioned below:

The production function of a particular product is identical in every country.

The production function of each product is different (Salvatore 2012).

There is no tariffs, no transport cost and no intervention from government’s end.

Tastes of the people in the countries are identical.

Every country has different factor endowments.

Krugman and Obstfeld (2010) has mentioned that the modern international trade theory by Hecksher and Ohlin is very effective in understanding the trade patterns in some countries in the world. For example, if the trade pattern between the India and UK is considered, it can be noticed that India is labour abundant country and UK is capital abundant country. Both of these two countries produce agricultural and automobile products. Agriculture is more labour intensive and automobile is more capital intensive. The following table can be considered for understanding the international trade mechanism between these two countries:

The above table is clearly indicating that United Kingdom is capital abundant country and so it will produce the automobile more than agricultural product. On the other side, India is labour abundant country and so it will specialise in producing the agricultural products. Achieving the specialization in this way, the two countries involve in international trade. Appleyard, Field and Cobb (2005) commented that the Hecksher and Ohlin theory of international trade also explains the equilibrium in international market. If the above example is considered, it can be identified that India is labour abundant, so it will export agricultural product and UK is capital abundant, so it will export automobile. Due to export, the prices of agricultural products in India will start to rise and in UK the prices of automobile products will start to rise (Hinkelman 2000). In this way, the two countries come to the state of ‘Congruent’ trade triangle and so the internal trade price within the countries will be same (Potter 2000). Therefore, the equilibrium situation will take place in the countries as well as in the international market. There is another modern theorem of international trade that has developed by Tadeusz Rybczynski. As per this particular theorem, at the point, where the prices of relative goods are constant, an increase in endowment of one production factor will lead to the increase of production of the goods, which intensively uses that factor and at the same time, an absolute decline will take place in the production of the other goods (Rodrik 1997). This theorem can be better understood with the help of a simple example. Looking for further insights on Right of Entry for Ships in Distress? Click here.

Example

International trade is taking place between UK and Japan. Both of the countries produce Dry Foods (F) and Automobiles (A). F is labour intensive product and A is capital intensive product. Now, the below diagram is showing how the trade will happen between the countries:

The above diagram is showing the production system in UK. As per the above diagram, if the labour endowment increases in UK and the labour constraint line shift to the outer side. If this happens, then the Production Possibility Frontier or PPF and the production shift from point P to point Q. As the dry foods or F is the labour-intensive product, the outward shift of the labour constraint will increase the production of F from F1 to F2 (Thirwell 2004). On the other side, as automobile is capital-intensive product, the production of automobile in UK will come down from A1 to A2. In this position, UK will produce more dry foods. On the other side, if the opposite situation takes place in Japan, then Japan will produce more automobile than dry foods. At this type of situation, UK will export dry foods to Japan and import automobile from Japan. At the same time, Japan will import dry foods and export automobile to UK. Criticising this theorem, Reinert (2016) mentioned that the theorem of Rybczynski is applicable when the prices of the production factors are measured in the same currency. In support of this, Chaney (2016) noted that the theorem developed by Stopler Samuelson describes the international trade in a better way. The theorem is known as the Factor Price Equalization theory. The Factor Price Equalization theory assumes that there are two products in the international market and at the same time, there are also two factors of production – labour and capital (Dixon, Jerie and Rimmer 2016). Apart from these, the theory also assumes that the international trade is taking place between two countries and the prices of the commodity in the countries are same because of free trade between the countries (Thirwell 2004). The theory believes that the prices of the production factors will be equalized in both the countries though the production factors are immobile. The theory states that before the economic integration between two countries, which factor of production is priced low will become more expensive after the international trade and vice-versa (Rodrik 1997). The main idea behind this theory can be better understood if the example of North American Free Trade Agreement is considered. After this agreement, the price of unskilled labour in America came down, which was previously priced high, but the prices of unskilled labour in Mexico increased, which was previously priced low (Salvatore 2012). Appleyard, Field and Cobb (2005) stated that the main idea of Factor Price Equalization theory is that when the prices of the final products in the countries are equalized, they move to the system of free trade and this ultimately equalizes the prices of factors of production in the countries.

The Linder Model also explains the international trade between the countries. As per Linder Model, demand is the key determinant of the international trade (Jackson and Sørensen 2016). According to this theory or model, the domestic demand in the countries determines the product varieties in the countries and the countries take part into the international trade, when there is similar demand of these product varieties in another country or countries. Chaney (2016) believed that the Linder Model was developed to address the issues in the Heckscher-Ohlin theory. According to HO theory, the international trade takes place between two countries, when one is capital intensive (means income level is higher) and the other is labour intensive (means income level is lower), which means the international trade happens between two countries with unequal income level. However, the Linder Model states that the international trade between the countries takes place, when the income levels of the countries are same or equal and both the countries have the demand of similar products (Rodrik 1997). Therefore, from the above discussion, it can be stated that the modern theories of trade or international trade are very effective to explain the international trade pattern between the countries. The modern theories explain the international trade patterns between the countries from different point of views, which helps to understand the international trade in a better way. However, there are some conflicts between the theories, but most of the theories have focused on the factors of production in the countries. Evaluating the modern theories of trade, it can be stated that the trade pattern between the countries or certain parts of the world depends upon the factors of production and their prices.

b. Explaining how the “partial” trade theories can be seen as better ways to explain modern trade pattern

At modern scenario of international trade, the governments in different countries are more interested in the international trade. If the current pattern of international trade is considered, it can be seen that the governments of the countries are taking part in the international trade by implementing new policies regarding tariffs and quotas. However, Booth and Erskine (2016) has mentioned that the current pattern of international trade has changed after the global financial crisis in 2008. Korting and Just (2016) added that global economy is changing every day and after the international financial crisis, some changes have taken place in the global trade pattern. The changes in the current international trade patterns are as follows: The current international trade pattern reflects the introduction of regional trade blocs, where the free trade option is available to the member countries only, for example, the NAFTA and European Union (Teotónio et al. 2017). The developed countries are trading more in commercial good and financial services rather than the manufactured goods. Deindustrialisation has taken place in several developed economies The former communist countries like, India and China are taking place more in the international trade (Luthfi and Kaneko 2016). Therefore, it can be said that the modern trade pattern has changed mostly from the earlier trade pattern in the international market. Tuan and Somwaru (2016) commented that the modern trade pattern between the countries can be better understood with the help of theory of partial trade or partial equilibrium. Egger and Egger (2016) mentioned that partial equilibrium is an economic condition that considers only a part of the market to reach to the equilibrium point. In the other words, it can be said that the theory of partial equilibrium indicates the equilibrium in a particular sector or market. The key assumptions under this theory are as follows:

Price of the commodity is given and constant in the market The income level, habits and tastes and preferences of the consumers are constant The prices of the prolific resources of the commodity and the other products related to that commodity are constant and known (Gocht et al. 2016). The factors of production are easily available and their prices are constant and known The prices of the other products are constant and known (Luthfi and Kaneko 2016) Perfect mobility is presented in context to the factors of production between the places and occupation.

Now, if the current pattern of international trade is analysed in detail, it can be understood that the current international trade is based on the partial equilibrium theory. As stated above, after the global financial crisis in 2008, the regional trade blocs are introduced in the international economy (Teotónio et al. 2017). This means, some countries based in a particular geographic region are commencing trade among them. On the other side, the governments are using tariffs to improve the international trade (Booth and Erskine 2016). The current trade pattern can be better understood with the help of the following diagram, which has showed the use of tariffs in the international trade to bring partial equilibrium.

The above diagram is showing the use of tariffs in a small country, which is one of the major pattern in the modern international trade. The above diagram is showing the demand and supply pattern of a particular product within a specific small country. At point PW, the world price of the product is shown, which is below the price of the product in the domestic market. As the world price is below the domestic price, the product has excessive demand. Therefore, at point PW, the country will import the product from the international market if there is free trade between the countries. Now assume that the country will impose tariffs on import. Due to tariffs, the domestic price will increase more to the point of PW+T. However, the price in the international market will remain unchanged that is PW. The diagram is showing that if the price increases from PW to PW+T, then the supply of the product in the country increases from SF to ST through import. This happens because due to the use of tariffs, the price of the product increases, which increase the benefits to the suppliers (Gocht et al. 2016). On the other side, the increase in price level will lower the consumer surplus and due to that the demand for the product will decrease (Teotónio et al. 2017). However, in this situation the government of the country will get benefit because due to the tariffs, the revenue level of the government will increase. However, Egger and Egger (2016) has mentioned that the use of tariffs in the small country will cause ultimate loss to the country because the benefits of the government and the suppliers will not be more than the decrease in the domestic price. Due to the increase in price, the suppliers will import more, but there will be decrease in the demand and so a large amount of the product will be unsold (Tuan and Somwaru 2016). Hence, loss will occur. Luthfi and Kaneko (2016) has stated that the situation will be different if the country is a large one. If the country is large enough, then due to the decrease in domestic demand, will decrease the world price also. The situation can be better understood with the help of the following diagram:

As per the above diagram, WP is the world price before imposing the tariffs in a large country. Now the tariff is imposed and the world price increases from WP to WP+T and with that the demand for the product decreased. At this point, if the world price of the product increases more, then the demand for the product will again decrease and at that point the demand and supply curve will intersect each other and the equilibrium will take place (Tuan and Somwaru 2016). However, at this point, there will be equilibrium without trade. Hence, beyond the point WP+T, the world price will not grow further, rather, it will start to fall down. When the world price falls down from WP+T to W’P+T, the supply decreases but the demand increases. However, at that point, the consumer surplus is still in loss and there is producer surplus and tariff revenue (Booth and Erskine 2016). In order to increase the consumer surplus, the price of the product will again decrease and when it comes at point reaches at point W’P, the quantity demanded will be high. At this point, there will be import under free trade (Gocht et al. 2016). Therefore, from the above discussion, it can be said that the current trade pattern in the countries includes tariffs. However, inclusion of tariffs causes net loss to the small countries because in small countries the aggregate demand cannot push the world price of the product. On the other hand, in case of the large countries, the impose of excessive tariffs causes decrease in the world price after certain point.

Conclusion

In this study, it has been identified that there are several theories in this modern era, which can explain the international trade between the countries in a better way. Most of the modern theories of international trade state that the international trade between the countries depends on the prices and availability of factors of production. The study has identified that the modern theories of international trade explain the reasons for trade from different point of views. However, the Price Equalisation Theory of international trade has emphasised on the demand for and supply of the product while describing the international trade. On the other side, the study has also identified that in the modern era, the international trade pattern between the countries include tariffs which determine the prices of the product and at the same time, it also determines the demand and supply of the product. The study has indicated that due to the imposition of tariffs, the small countries face net loss, whereas, the situation is different in case of the large countries.

Reference list

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