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.
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