20 International Trade Theories-II

Tejinder Sharma

Objectives

After reading this module, students will be able to:

a) Understand what fosters the international trade

b) Know the theories of international trade

Introduction

Since times immemorial, goods have moved across nations and people have made profit by selling the products to other countries, which were not available there. As per the principals of classical economics, there are four basic factors (resources) of production –Land, such as land, trees and minerals; Labor- the mental and physical skills of individuals; Capital- such as tools, machines and factories used in production or to facilitate production; and Entrepreneurship -The availability of natural resources, labour and capital is not sufficient to ensure economic success. These factors of production have to be combined and organised by the enterprising people who see opportunities for making a profit and who are willing to take risks by producing goods and services in the expectation that they will be sold. However, for success in business, it is not just a matter of what resources we have but also of how well we use them. Since the times of Adam Smith, people have been pondering on what underlies the movement of goods and services across nations, giving rise to the theories of international trade. As the times changed, the nature of economic activities also underwent a change and accordingly the ways to look at the underlying factors also underwent a change. Several economists proposed different theories of international trade. In this module, we shall study various theories of international trade.

Heckseher-Ohlin Trade Model

Adam Smith and Ricardo’s trade models considered labour as the only factor input and the differences in the labour productivity determining the trade. Eli Heckscher (1919) and Bertin Ohlin (1933) developed the international trade theory (H.O. Trade Model) with two factor inputs, labour and capital, pointing out that different countries have been bestowed with different factor endowments, and the differences in factor endowments cause trade between the trading partners.

According to Bertil Ohlin, trade arises due to the differences in the relative prices of different goods in different countries. The difference in commodity price is due to the difference in factor prices (i.e. costs). Factor prices differ because endowments (i.e. capital and labour) differ in countries. Hence, trade occurs because different countries have different factor endowments.

The Heckscher Ohlin theorem states that countries which are rich in labour will export labour intensive goods and countries which are rich in capital will export capital intensive goods.

The theory is based on the assumption that there are impediments to trade, and that there is perfect competition in both the product and factor markets. Further, the theory is based on the comparative advantage in terms of the relative factor prices. A country specialising in the production of the goods which require its abundant factor can export them. Thus, if a country is rich in capital, it will produce capital intensive products and export them in exchange for the labour intensive products. On the other hand, another country, rich in labour, will produce labour intensive goods and export them. It will import capital intensive goods.

Heckscher-Ohlin’s theory explains the modern approach to international trade on the basis of following assumptions :

(a) There are two countries involved. For the sake of theoretical modelling, it is assumed that the trade is happening between two countries.

(b) Each country has two factors (labour and capital). This is an extension of the classical theories, which considered labour as the only factor.

(d) There is perfect competition in both commodity and factor markets. Perfect competition leads to fair prize mechanism and normal profits for all the players.

(e) All production functions are homogeneous of the first degree i.e. production function is subject to constant returns to scale.

(f) Factors are freely mobile within a country but immobile between countries, i.e. labour and capital can be utilized within the countries.

(g) Two countries differ in factor supply.

(h) Each commodity differs in factor intensity.

(i) The production function remains the same in different countries for the same commodity. For e.g. If commodity A requires more capital in one country then same is the case in other country.

(j) There is full employment of resources in both countries and demand are identical in both countries.

(k) Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers.

(l) There are no transportation costs.

In light of these assumptions, Ohlin’s thesis proposes that a country export goods which use relatively a greater proportion of its abundant and cheap factor. The same country imports the goods whose production requires the intensive use of the nation’s relatively scarce and expensive factor.

The Concept of Factor Abundance

In the two countries, two commodities & two factor model, implies that the capital rich country will export capital intensive commodity and the labour rich country will export labour intensive commodity. But the concept of country being rich in one factor or other is not very clear. Economists quite often define factor abundance in terms of factor prices. Ohlin himself has followed this approach. Alternatively factor abundance can be defined in physical terms. In this case, physical amounts of capital & Labour are to be compared.

• Price Criterion for defining Factor Abundance

A country where capital is relatively cheaper and labour is relatively costly is said to be capital rich country. Whereas a country where labour is relatively cheaper and capital is relatively costly is said to be labour rich country. For the sake of developing the mathematical equation, let us assume that the trade is taking place between two countries – America and India.

Price of the factor can be measured as per the following equation:

PK/PLa > PK/PLi

In this equation, P refers to price of the factor, K refers to Capital, L refers to Labour, a stands for England, and i stands for India.

In this equation, we observe that in America, capital is cheaper and hence it is a capital abundant country, while in India, labour is cheaper because it is abundant here.

The emerging pattern of trade can be explained in the form of the following exhibit. As explained earlier, we have taken an example of same two countries i.e. America and India where America is a capital rich country while India is a labour abundant nation. In Exhibit 7.1, diagram XX is the isoquant (equal product curve) for the commodity X produced in America. YY is the isoquant representing commodity Y produced in India. It is very clear that XX is relatively capital intensive while YY is relatively labour incentive. The factor capital is represented on Y-axis while the factor labour is represented on the horizontal X- axis. PA is the price line or budget line of the country America. The price line PA is tangent to XX at E. The price line PA is also tangent to YY isoquant at K. The point K will help us to find out how much of capital and labour is required to produce one unit of Y in America.

Exhibit 1 Heckscher Ohlin’s H-O Theory

P1B is the price line of the country India, The price line P1B is tangent to YY at I. The price line RS which is drawn parallel to P1B is tangent to XX at M. This will help us to find out how much of capital and labour is required to produce one unit of commodity X in India.

Under the given situations, the country America will choose the combination E. Which means more specialisation on capital goods. It will not choose the combination K because it is more labour intensive and less capital intensive.

Thus according to Ohlin, America will specialise on production of goods X by using the cheap factor capital extensively while India specialises on commodity Y by using the cheap factor labour available in the country.

The Ohlin’s theory concludes that the basis of internal trade is the difference in commodity prices in the two countries. Differences in the commodity prices are due to cost differences which are the results of differences in factor endowments in two countries. A capital rich country specialises in capital intensive goods & exports them. While a Labour abundant country specialises in labour intensive goods & exports them.

Limitations of Heckscher Ohlin’s H-O Theory

(a) Unrealistic Assumptions : Besides the usual assumptions of two countries, two commodities, no transport cost, etc. Ohlin’s theory also assumes no qualitative difference in factors of production, identical production function, constant return to scale, etc. All these assumptions makes the theory unrealistic one.

(b) Restrictive : Ohlin’s theory is not free from constrains. His theory includes only two commodities, two countries and two factors. Thus it is a restrictive one.

(c) One-Sided Theory : According to Ohlin’s theory, supply plays a significant role than demand in determining factor prices. But if demand forces are more significant, a capital abundant country will export labour intensive good as the price of capital will be high due to high demand for capital.

(d) Static in Nature : Like Ricardian Theory the H-O Model is also static in nature. The theory is based on a given state of economy and with a given production function and does not accept any change.

(e) Wijnholds’s Criticism: According to economist Wijnholds, it is not the factor prices that determine the costs and commodity prices but it is commodity prices that determine the factor prices.

(f) Consumers’ Demand ignored: Ohlin forgot an important fact that commodity prices are also influenced by the consumers’ demand.

(g) Haberler’s Criticism: According to Haberler, Ohlin’s theory is based on partial equilibrium. It fails to give a complete, comprehensive and general equilibrium analysis.

(h) Leontief Paradox: American economist Dr. Wassily Leontief tested H-O theory under. U.S.A conditions. He found out that U.S.A exports labour intensive goods and imports capital intensive goods, but U.S.A being a capital abundant country must export capital intensive goods and import labour intensive goods than to produce them at home. This situation is called Leontief Paradox which negates H-O Theory. Leontiff Paradox is explained in details in the subsequent discussion.

(i) Other Factors Neglected: Factor endowment is not the sole factor influencing commodity price and international trade. The H-O Theory neglects other factors like technology, technique of production, natural factors, different qualities of labour, etc., which can also influence the international trade.

The Leontief Paradox

There was a setback to the proponents of the H.O. trade theory in the early 1950’s, when Leontief tested his hypothesis that capital rich countries export capital intensive goods and import labour intensive goods and vice versa with the help of the input-output data of the United State’s economy. His results refuted the H.O. contention. It was a shocking news for the economists that the U.S. being a capital rich country should be exporting labour intensive goods and importing capital intensive goods. Several, explanations were looked into for resolving the Leontief paradox. The key factors identified in support of the Leontief paradox were: U.S. protective trade policy, import of natural resources and the investment in human capital.

Economist William P. Travis examined the Leontief theory in terms of the U.S. tariff policy. When Leontief tested his hypothesis, the U.S. was importing more of such items as crude oil, paper pulp, primary. copper, lead, metallic ores and newsprint, which are capital intensive. Thus, according to Travis, the U.S. protective trade policy was responsible for Leontief’s findings.

The U.S. imports of natural resources like minerals and forest products and the exports of farm products further support the Leontief presentation. Investment in human capital raises the productivity of labour. That is why the exports of the U.S. consisted of labour intensive products and its imports were of capital intensive nature.

Modern Theories of International Trade

The issue of international trade has been studied by the modern day economists as well because several changes have happened in the business environment. The present age of multipolar world, emergence of globalization, liberalization and privatization of trade, technological developments, particularly the developments in information technology have changed the nature of trade. The age of competition has given way to collaboration and the theories of yesteryears have undergone a shift. Some of the important theories of the modern times are as under:

1 Specific Factors and Income Distribution

2 The Standard Model of Trade

3 The Competitive Advantage

The following discussion explains these theories of the modern times.

1. Specific Factors and Income Distribution (Paul Samuelson – Ronald Jones Model)

This theory was proposed by two American economists, Paul Samuelson and Ronald Jones, who elaborated a trade model based on specific factors:

There are at least two reasons why trade has an important influence upon the income distribution:

a) Resources can’t be transferred immediately and without costs from one industry to another.

b) Industries use different factors and a change in the production mix a country offers will reduce the demand for some of the production factors whereas for others it will increase it.

While the earlier models were based on one or two factors, this is a tri-factorial model because it is based on 3 factors- labour (L), capital (K) and territory (T). Products like food (X) are made by using territory (T) and labour (L) while manufactured products (Y) use capital (K) and labour (L). From this simple example it is easy to observe that labour (L) is a mobile factor and it can be used in both sectors of activity, while territory and capital are specific factors.

A country having capital abundance and less land tends to produce more manufactured products than food products, whatever the price, while a country with a territory abundance tends to produce more food. If the other elements are constant, an increase in capital will mean an increase in marginal productivity from the manufactured sector, while a rise in the offer of territory will increase the production of food in the detriment of manufacturers.

When the two countries decide to trade, they create an integrated global economy whose manufacture and food production is equal with the sum of the two countries’ productions. If a country doesn’t trade, the production for a good equals the consumption. The gains from trade are bigger in the export sector of every country and smaller in the sector competed by imports.

2. The Standard Model of Trade

The standard model of trade has been proposed by Paul Krugman and Maurice Obsfeld. This theory implies the existence of the relative global supply curve resulting from the production possibilities and the relative global demand curve resulting from the different preferences for a certain good.

The exchange rate (the rapport between the export prices and the import prices) is determined by the crossing/intersection between the two curves, the relative global supply curve and the relative global demand curve. If the other elements remain constant, the exchange rate improvement for a country implies a substantial rise in the welfare of that country.

3. The Competitive Advantage

This has been proposed recently by American management guru – Michael Porter, who proposed the concept of value chain analysis. A firm’s activities could be segregated as primary and secondary activities. The primary activities were those, which directly contributed to creating value, while the secondary activities supported the happening of the primary activities. The firms’ individual value chains integrated to become the industry value chain and this could gain strength if there existed a competitive advantage. The competitive advantage could be created by way of exclusive access to the resources (factor based development), having low cost investments, or developing innovation led competitive advantage. Porter proposed a competitiveness diamond, which comprised on the five determinants:

– The capacity of internal factors

– The specific of the domestic market

– The links between the industries

– Domestic competition environment

The nations needed to develop and sustain these factors in order to remain competitive in the international trade.

Summary

The same country imports the goods whose production requires the intensive use of the nation’s relatively scarce and expensive factor. However, Leontiff identified a paradox in Ohlin’s theory and observed that America continued to export the products despite having costly labour. The modern theories extended the factors from two to three and the most recent theory proposed by Porter gave the concept of competitive advantage. Nations could gain competitive advantage not by the factors alone, but could develop and sustain it with the help of the investment and innovation, which could restrict competition by controlling the entry of newer players into the market.

Suggested Readings

Books:

(i) Terpstra, Vern and Sarathy, Ravi, “International Marketing”, 7th edition, The Dryden Press.

(ii) Onkvisit, Sak and Shaw, John J, “International Marketing: Analysis and strategy”, Ist edition, Merrill Publishing Company.

(iii) Keegan, W.J., “Global Marketing Management”, 5th edition, Prentice Hall of India Pvt. Ltd., New Delhi.

(iv) Philip R. Cateora, and John L. Graham, “International Marketing”, 10th edition, Tata McGraw Hill Publishing Co. Ltd., New Delhi.

(v) Charles W. Hill, “International Business – competing in the Global marketplace”, Tata McGraw Hill Publishing Co. Ltd., New Delhi.