Modern Theory of Trade

The contemporary theories of trade deviate from the assumptions of perfect competition and constant returns to scale made both in the classical and the neoclassical models. In the modern theories the market structure is either monopolistic or oligopolistic. In the former case a large number of producers produce goods that are not identical but differentiated in quality or design. In the latter case only a few producers serve the market with either identical products or differentiated products. The products which are just differentiated horizontally are similar in quality but different in design, like a red pen and a blue pen, white wine and red wine or wooden furniture and steel furniture. Vertical product differentiation involves quality differences as in small cars and large cars, lf the products are horizontally differentiated they are produced by more or less the same technology. Vertical product differentiation would. Invariably mean that the technology varies with quality or type of the product.

The modem theories assume economy of scale in production. An example of economy of scale is shown in the following Table:

One may easily check that the technology described above is a departure from the constant returns to scale we have been using so far. For example the output is doubled from 1 to 2 as labour is less than doubled from 3 to 5. Suppose that there are two similar goods, A and B being produced by the above technology, the economy has 10 units of labour. The consumers will consume the two goods in 1:1 proportion. Therefore the labour force will have to be equally divided in the production of the two goods and 2 units each of A and B will be produced and consumed in the economy. Now suppose there is another economy with the same technology to produce A and B having 10 units of labour. Then it is quite easy to see that one economy produces only A and the other produces only B and then trade with each other then the consumers in each country will be able to consume 3.5 units each of A and B and be better off than autarky. This is an example of trade taking place between two countries having the same technology and factor endowments simply due to economy of scale. But there is difference in the nature of trade. In the earlier models the products were different and produced by different technologies and the trade was between two industries, such as one country exporting cloth and importing wheat. This kind of trade is called inter-industry trade. But in the contemporary models trade is intra-industry, i.e., in the same industry located in two different countries. It is like one country exporting white wine and importing red wine - both goods requiring the same technology as in the above example. It turns out that a very substantial part of world trade is intra-industry in nature which shows the importance of modern theories in the contemporary world.

NEO CLASSICAL TRADE THEORY

The pattern of trade in the Ricardian theory depends entirely on the technological differences between two trading countries, as reflected in their respective labour productivity ratios. It does not depend on how much labour each country has. The neoclassical theory, on the other hand, focuses on the latter aspect, namely factor endowments. In contrast to the Ricardian theory the neoclassical theory assumes that there are at least two factors, say labour and capital which are used in the production of goods. But the two countries have the same technology or the same production functions. They differ only in respect of relative factor endowments : one country being relatively labour abundant and the other relatively capital abundant. If K is the total supply of capital and L the total labour supply, then [ WL], > [KL], implies that the home country is relatively capital abundant and the foreign country relatively labour abundant. This is called the physical definition of relative factor abundance. There is an alternative definition. If the foreign country is relatively labour abundant, then labour must be relatively cheaper there. In other words, if w is the wage rate and r the rental of capital, then [w/r]h > [w/r]f would imply that the home country is relatively capital abundant, or relatively scarce in labour endowment and would therefore have a relatively higher wage rate. One should note that the second definition does not necessarily follow from the first. The reason is very simple. A country may be relatively scarce ill labour, but this does not necessarily mean that the relative wage rate will be high because it is quite possible that there is very little demand for the goods that require the use of labour intensively. Similarly, in a country where labour is plentiful, wage rate may be still very high because of extremely high demand for the goods in which labour is used intensively. The lesson that we learn is that it is not possible to determine the price of a factor only by looking at its supply. One has to look at the demand side also.

Neoclassical trade theory is based upon the assumption that states act to maximize their aggregate economic utility. This leads to the conclusion that maximum global welfare and Pareto optimality are achieved under free trade. While particular countries might better their situations through protectionism, economic theory has generally looked askance at such policies... Neoclassical theory recognizes that trade regulations can... be used to correct domestic distortions and to promote infant industries, but these are exceptions or temporary departures from policy conclusions that lead logically to the support of free trade.

Historical experience suggests that policy makers are dense, or that the assumptions of the conventional argument are wrong. Free trade has hardly been the norm. Stupidity is not a very interesting analytic category. An alternative approach to explaining international trading structures is to assume that states seek a broad range of goals. At least four major state interests affected by the structure of international trade can be identified. They are: political power, aggregate national income, economic growth, and social stability. The way in which each of these goals is affected by the degree of openness depends upon the potential economic power of the state as defined by its relative size and level of development.

Let us begin with aggregate national income because it is most straightforward. Given the exceptions noted above, conventional neoclassical theory demonstrates that the greater the degree of openness in the international trading system, the greater the level of aggregate economic income. This conclusion applies to all states regardless of their size or relative level of development. The static economic benefits of openness are, however, generally inversely related to size. Trade gives small states relatively more welfare benefits than it gives large ones. Empirically, small states have higher ratios of trade to national product. They do not have the generous factor endowments or potential for national economies of scale that are enjoyed by larger particularly continental states.

The impact of openness on social stability runs in the opposite direction. Greater openness exposes the domestic economy to the exigencies of the world market. That implies a higher level of factor movements than in a closed economy, because domestic production patterns must adjust to changes in international prices. Social instability is thereby increased, since there is friction in moving factors, particularly labor, from one sector to another. The impact will be stronger in small states than in large, and in relatively less developed than in more developed ones. Large states are less involved in the international economy: a smaller percentage of their total factor endowment is affected by the international market at any given level of openness.

Ricardo’s theory of trade

David Ricardo was one of the most influential economists of the early nineteenth century, but he came to economics by a circuitous route. Born to a Jewish family in Amsterdam, he left the country and broke off relations with his family (and they with him) to avoid an arranged marriage — he married a Quaker instead. He set himself up in London as a government securities dealer and became, in his words, “sufficiently rich to satisfy all my desires and the reasonable desires of all those about me.” Looking for something to occupy his time, he developed the modern theory of international trade.

Many people of Ricardo’s day (and ours!) regarded trade as a zero-sum activity: if you gain from trade, then I must lose. As Adam Smith in his Wealth of the Nations puts it:

All political writers since the time of Charles II had been prophesying that in a few years we would be reduced to an absolute state of poverty [by international trade], but we find ourselves far richer than before.

That trade is good for consumers is easy to understand; more trade means more choices and having more choices is at least as good as not having them. That trade is good for producers is a bit less immediate. The argument uses the idea of specialization. Take Minnesota and Florida: Minnesota is good at producing corn and Florida’s good in producing oranges and both Minnesotans and Floridians like to consume oranges and corn. In absence of trade some oranges will be produced in greenhouses in Minnesota and some corn will be grown in the Florida swamps: but productivity in those two activity is not very high and thus producers in those two sectors will not be doing very well. When Florida and Minnesota open up to trade Minnesota can specialize in corn and Florida in oranges, meaning, for example, that producers of oranges in Minnesota can turn to producing corn. The demand for their corn will come from Florida and they will have higher productivity so they are also better off. But this story relies on absolute advantage (Florida on oranges and Minnesota on corn) and that was Smith had in mind. What if Florida is better than Minnesota in both oranges and corn?

Ricardo insight was that trade is advantageous even in this situation. What matter is not absolute advantage but comparative advantage, that is as long as Minnesota is better than Florida in the corn to orange ratio (even though it is worst than Florida in both) then trade will be advantageous to both. This result has been referred to one of the few in results economics which is neither trivial nor false, so in class we will discuss the Economist’s note “The miracle of trade” in detail.

The note develops Ricardo’s theory in a particularly simple setting: two countries produce and consume two products, and both products are produced with labor alone. In many respects this version of the theory is unrealistic, but the lack of realism is exactly what makes the analysis simple and understandable. We’ll discuss later whether the lack of realism plays an undue role in our conclusions. (For the most part, it does not.)

Bottom line

• The driver of trade are differences in prices. In absence of trade wine is expensive in the North and cheap in the south. That calls for the North to buy wine from the South. The symmetric holds for bread.
• Why is South producing and exporting wine when the North could do it more efficiently? Because wages of wine producer in the South are lower. Think like this: how much bread does it cost in the North to switch one worker from bread to wine? 1 loaf. How much in South? only 1/3 of a loaf.
• Consumers are better off in both countries with free trade because they both take advantage of cheap goods.
• Free trade changes the distribution of production. In this case, the North shifted out of wine into bread, and the US did the reverse. In other models, the change in production may not be so extreme, but it’s generally true that they predict that every country will stop producing some products, and import them instead. The result is a far more efficient system of production, as each country produces those goods for which its relative productivity is the highest.
• Moving to free trade is similar to an increase in productivity: when you shift production to high productivity products, aggregate productivity rises. The impact is similar to our discussion of capital markets. Countries with good capital markets allocate capital more effectively to the high-return projects and increase aggregate productivity as a result. This is a natural feature of trade models. If we were NIPA people, we might compute GDP like this: sum production of wine and bread, valued at a fixed set of prices. In this case we’ll use the free trade prices, which is similar to PPP adjustment (apply the same prices in every country). GDP at world prices (in bottles of wine) is Free Trade No Trade.
  

Once trade shows up in GDP, it shows up in aggregate productivity, too. We don’t have capital in this model, so the production function is Y = AL. Since L is unchanged across trade regimes, the change in Y reflects an increase in TFP.

• No jobs were lost — or found. In our example, every unit of labor was used whether trade was possible or not. This is only a little extreme: no trade models suggest that trade will have much long run impact on employment. Any effect there might be comes from the impact on labor supply of an increase in the wage. So when you read the newspaper, especially in an election year, remember: trade has an impact on what the jobs are, not on how many there are.

THEORIES OF INTERNATIONAL TRADE: INTRODUCTION & OBJECTIVES

INTRODUCTION OF TRADE THEORIES

Foreign trade has recently, and particularly after 1991, become an important as well as debatable issue for the Indian economy. The Union budget presented in 1991 introduced a wide range of economic policy reforms related with industry and trade, ushering in an era of economic liberalism in the Indian economy. These reforms were designed to transform a closed and inward-looking economy into an open and outward-looking one by lifting controls on  import  and export of goods and services and by  making rupee convertible. In the years that followed, our trade and industrial production have been growing at fairly high rates.  There is no doubt that the liberal approach to economic policy will continue and the previous bias against international trade and investment will remain subdued in the foreseeable future.  In this new economic environment the, teaching of economics will develop a serious gap if the students are not made aware of the basic principles and concepts of international trade. 

OBJECTIVES OF TRADE THEORIES

The purpose of a trade theory is to explain the pattern of trade between two countries.  What is meant by pattern of trade? Suppose India exports garments, gems and jewellery and a few other products to the United States, while the latter exports computer parts, such as hard disks, and other machines to India. This pattern of export and import of goods is known as the pattern of trade. The theory of international trade explains why such a pattern emerges and lists the factors which cause such a pattern. Trade between two nations is not just in goods. Trade in services is also quite important. If the United States provides banking and insurance services to the Indian citizens, say to the Indian exporters and importers, and if these services are provided from the United States, then it is to be regarded as the U.S.  Export of services to India. There are two main theories on pattern of trade: the classical or the Ricardian theory and the neoclassical theory or the Heckscher-Ohlin-Samuelson theory.

The second objective of trade theory is to explain the pattern of specialization. A pattern of specialization tells us the kinds of products and their quantities a country would produce. In the above example, India would produce garments, gems and jewellery and other products and the United States would produce computer parts and other machines. India may or may not produce computer parts and machines which USA would produce and similarly USA may or may not produce garments and the gems and jewellery. The pattern of trade and the pattern of specialization will depend on the model you are using to explain these patterns. If you are using the Ricardian theory then you come to the conclusion that USA would not produce garments or gems and jewellery in which India has specialized. But if you are using the neoclassical theory then you would say that USA would produce the goods it is importing from India. The domestic industries that produce the goods that the country imports are known as import competing industries (e.g.  Garments for USA computer parts for India) and those producing goods that the country exports are called export industries (e.g.  Computer parts for USA and garments for India). A country however will have industries whose products are neither exported nor imported and the goods produced by them are called non traded goods, such as domestic transportation, electricity, etc.

The third objective of trade theory is to show that international trade is mutually beneficial to the trading countries. A country which is not engaged in trade with any country is in a state of autarky. The theory says that trade is better than autarky under any circumstances. However, how much trade a country should have and whether a country should restrict the quantities of exports and imports by customs duties, tariffs, quotas and taxes is quite another matter.