Theories of International Trade

Introduction Resources are not distributed by nature in all the countries of the world in the same proportion. Some countries are richly endowed by such resources, while others are not. Therefore, those countries, which are richly endowed by natural resources, have more production facilities may produce goods at a lowest cost, and may have production surplus compared to other countries. In such a case, they may have a comparative advantage over others. Due to this comparative advantage of production of one country over others, international trade takes place, because the exchange of such surplus production is possible only through the international trade. Prof. A.P. Lerner, in this regard, has said divergent scarcities of factors are the moving forces behind international trade. Although comparative advantage of one country over other is the basis of the present international marketing, this concept has been explained by various economists in different ways. Here, we will deal especially the following theories of international trade. 1. 2. 3. 4. 5. Adam Smith Ricardian Theory Factor Proportion Theory Leontief Paradox Linders Representative-Demand Hypothesis

Adam Smith: Adam Smith may have been the first scholar to investigate formally the rationale behind foreign trade. In his book wealth of Nation, Smith used the principle of absolute advantage as the justification of the international trade. According to this principle, a country should export commodity that can be produced at al lower cost than can other nations. Conversely, it should import a commodity that can be produced only at a higher cost than other nations. Ricardian Theory: David Ricardo has propounded Comparative Cost Theory of International Trade in 1817. This theory is popularly known as Classical Theory. According to this theory, a country in the long run tends to specialize in the production and export of those commodities in which it has got a comparative advantage or where its costs are lower than in other countries; and it tends to obtain by import those commodities which can be produced at home at a comparatively disadvantage or where the costs of imported commodities are lower than the commodities produced at home. Let us analyze this theory with the help of some suitable examples

Case-I Country Nepal Japan

Cost of production/meter of cloth/labor (Rs) 8 4

Cost of Exchange Ratio production/pairs of between cloth and shoes/labor (Rs) shoe 4 2:1 8 1:2

In this case, Japan enjoys absolute advantage in the production of clothe while Nepal enjoys absolute advantage in the production of shoes. In Japan the cost of production of cloth is twice as cheap as in Nepal, similarly, in Nepal the cost of production of shoe. Therefore Nepal tends to specialize in the production and export of shoe and import cloth from Japan. Similarly, Japan will enjoy benefit if it tends to specialize in the production and export of cloth and import shoes from Nepal. In other words, Nepal will produce shoe and export it to Japan; while Japan will produce clothe and export it to Nepal; and will import shoe form Nepal. Case II Country Nepal Japan Cost of production/meter of cloth/labor (Rs) 4 8 Cost of Exchange Ratio production/pairs of between cloth and shoes/labor (Rs) shoe 3 1:0.75 4 2:1

In this case, figure shows that in Nepal the cost of production of both the products-clothe and shoe is comparatively cheap than in Japan. Although Nepal can produce both the product at minimum cost, it does not produce both the products. Because figures also show that Nepal has greater advantage in the production of cloth and has least advantage in the production of shoe. Therefore, Nepal will try to import shoe from another country if it enjoys more advantage by importing than by producing at home. The above figures show that Nepal has relative disadvantage in shoe production. Similarly, Japan has comparatively disadvantage in cloth production but has relative advantage in shoe production. Therefore, Nepal will enjoy comparative advantage if it specialize in the production and export of cloth and import shoe. Similarly, Japan will enjoy a comparative advantage if it specializes in the production and export of shoe to Nepal and import cloth. In this way there will be exchange of goods between Nepal and Japan. Case III Country Nepal Japan Cost of production/meter of cloth/labor (Rs) 8 4 Cost of Exchange Ratio production/pairs of between cloth and shoes/labor (Rs) shoe 4 2:1 2 2:1

In this case, figures show that Japan can produce both products comparatively at a lower cost; while Nepal has a comparative disadvantage in both the products. In this situation, therefore, Japan will try to specialize in both the productions if it finds importer for its products. As such there will be no exchange of goods between these two countries because Nepal has to search for another country where it can export its products. In other words, this situation does not benefit both countries. So this situation is known as No trade situation. Assumption of Ricardian Theory: Ricardian theory of international trade is based on the following assumption 1. Labor is the only factor of production; 2. All labor is uniform in quality or performance and troublesome; 3. Labor is perfectly mobile within country; 4. there exists free competition among labors; 5. No transport cost or other costs are involve; and 6. There is full utilization of labor.

Factors Proportion Theory:

The Factor Proportion theory was developed by two economists- Eli Heckscher and Bertil Ohlin. After their name the theory is popularly known as Heckscher-Ohlin Theory. The classical theorys comparative cost advantage explains that a country tends to specialize in the production of commodities for which it enjoys a comparative advantage or where its costs are lower than other countries. But this theory fails to answer why do comparative cost difference arise? And why such production cost ratio differs at all? According to this theory, comparative cost differences arise because of two reasons: 1. Different goods require different input (factors); and 2. Different countries have different factor endowments In some countries some factors are abundant and in other countries some other factors of production may be abundant. Here two factors of production are taken. These are labor and capital. Therefore, if wheat is technologically best produced with lots of land relative to labor and capital, countries that have an abundance of land will be able to produce wheat more cheaply. That is why Australia, Argentina, Canada, Minnesota, United States, and the Ukraine export wheat, on the other hand, if cloth requires much labor relative to capital and land, countries that have an abundance of labor such as Hong Kong, Japan, and India will have a comparative advantage in cloth manufacture and be able to export. This theory basically explains that a country will specialize in the production and export of those goods whose production requires a relatively large amount of factors with which

the country is relatively well endowed. Therefore, those countries which have an abundance of labor will specialize in the production and export of labor-intensive products; countries which has an abundance of capital will specialize in the production and export of capital-intensive products; and countries which have an abundance of land will specialize in the production and export land-intensive products. This theory can be clearly explained with the help of the following example: Country Supply of Capital A 20 units B 15 units Supply of labor 25 units 12 units Ratio of Capital to labor 0.8 1.25

In the above example, figures clearly show that, even though country A has more capital in absolute terms, country B is more richly endowed with capital because the ratio of capital to labor in country A (0.8) is lower than in country B (1.25). Therefore, country A will specialize in the production and export of labor-intensive product and will import capital-intensive products. Similarly, country B will specialize in the production and export of capital-intensive products. Both the countries will benefit if they exchange goods accordingly. There are some commodities which require more capital and there are some commodities that need high capital When a commodity which requires more labor, if produced in the country having abundant labor, then that commodity will be automatically becomes cheaper. For example in developing countries, the labor intensive commodities are produced in cheaper price due to cheap labor Whereas, the commodity that require huge amount of capital, if produced in the country that can fulfill the capital requires for the production of that commodity i.e. if there is new technology and huge amount of capital, then the price of the commodity will be cheaper than that is produce in the developing countries due to the lack of capital Therefore all the labor intensive commodities e.g. textile, carpet, garment, handcraft etc. are being produced in the developing countries having abundant labor but low capital. We can take the example of Nepal. Similarly the commodities that require high capital i.e. the capital-intensive commodities come form the developed countries having abundant capital and required higher cost to produce that product than that are produced in capital abundant countries, i.e. in developed countries.

Assumptions: The factor-Proportion is based on the following assumptions: 1. It is a two-by-two-by-two model, i.e., there are two countries, two commodities and two factors of productions. 2. In both the countries, there exist perfect competition in both the factors and commodity markets; 3. Factor endowments differ quantitatively between the two countries but qualitatively they are homogenous; 4. Resources are fully employed in both the countries; 5. The production functions are different for different commodities, but they are same for each commodity in the two countries. 6. There is a constant return to scale in the production of each commodity. 7. There are no transportation costs, insurance costs, tariffs, etc,, or any other trade barriers, i.e., free trade exists between two countries; 8. The production function of the two commodities have different factor intensities, i.e., labor-intensive and capital-intensive; 9. Factors of production are immobile between countries but are freely mobile within country. The Leontief Paradox: The first serious attempt to test Heckscher-Ohlin Theory or Factor Proportion Theory empirically was made by Wassily W. Leontief, a Harvard University economist in 1953. Leontief, who was later awarded the Nobel Prize in Economics, reached the paradoxical conclusion that the US, the most capital-abundant country in the world by any criteria, exported labor-intensive, and imported capital-intensive commodities. This result, which came to be known in the literature as Leontief Paradox, took the profession by surprise and stimulated an enormous amount of empirical and theoretical research. To perform his test, Leontief (in 1953) used the 1947 input-output table of US economy. He aggregated industries into 50 sectors (38 of which traded their products directly on the international market) and factors into two categories-labor and capital, then he estimated the capital and labor requirements for the production of a representative bundle (one million dollars worth) of US exports and a representative bundle of US importcompeting commodities (also one million dollars worth). He surprised himself with the discovery that US imports replacements required 30 percent more capital per worker than US exports. Leontief was criticized by several economists on his methodological and statistical grounds in particular, Swerling complained that 1947 was not typical year; the post-war disorganization of production overseas had not been corrected by that time, and the results were biased both by the capital-labor ratio of a few industries. Leontief repeated the test in 1956 using the average composition of US exports and imports which prevailed in 1951. At this time he collected the information of comparatively more sectors of commodity groups. He found the US import replacements

were still more capital intensive relative to US exports, even though their capital intensity over US exports was reduced to only 6 percent. In 1959 two Japanese-Tatemoto and Ichimura studied Japans trade pattern and discovered that Japan, a labor-abundant country, exported capital-intensive and imported labor-intensive commodities. In 1961 Stolper and Roskamp applied Leontiefs method to the trade pattern of East Germany and found that East German, a labor-intensive country, exports were capitalintensive relative to its imports. In the same year, Wahl studied Canadas pattern of trade and found that Canadian exports were capital-intensive relative to Canadian imports. Since most Canadian trade was with the US, Wahls result apparently runs against Factor-proportion Theory. In 1962 Bharadwaj studied Indias trade pattern and found that Indian exports were laborintensive relative to Indian imports. Nevertheless, when he considered the Indian trade with United State, he found that Indian exports to the US were capital-intensive relative to Indian imports from the US. In 1871 Baldwin, using the 1985 US production structure but 1962 composition of US exports and imports, found that he US import-competing sector was 27 percent more capital intensive relative to the US export sector. By the study of export and import what he found that the basis in not only the labor and capital. There are other factors than these; they are: Large amount of human capital embodied in the labor force The technology factors The theory of product cycle Economy of Scale Labor that means all types of labor i.e. skilled and unskilled. In developing countries there is abundant labor, but are unskilled. The product is produced in high cost. But, in developed countries the labor are skilled and labor-intensive products are produced in cheaper price. It doesnt mean that the factor endowment theory is not suitable, but it should be redefined. If same skill and same capabilities of labor are found in all countries, then the factor endowment theory is applicable. But, in reality we can not find such case. Developing countries lacks skilled labor Alternative Explanation of the Leontief Paradox: Several explanations of the paradox have been provided in the literature. Some of them attempt to bring about reconciliation within the Heckscher-Ohlin model itself. Other attempts to go beyond the H-O model and provide new theories which are basically

dynamic in character and deal with technical progress and the product life-cycle. These alternative explanations of the Leontief Paradox are summarized below: 1. Labor Productivity: Leontief argued those American workers are much more productive than foreign workers. In particular, he suggested that 1 man-year of American labor is equivalent to 3 man-years of foreign labor. Leontief attributed the higher productivity of American labor not to the employment of larger amount of capital per worker, superior organization, and favorable environment. 2. Human Skill: Human skill is the best human capital which is crated by investing in education like investment in physical capital requires time and uses resources. The skills and expertise which education and training crate last a long time and tend to increase the productivity of the labor force substantially. In other words, US labor is more trained and skillful than others, as such; US exports should be described as human capital intensive products. 3. Consumption Pattern: Capital abundant country need not export the capitalintensive commodity of its tastes are strongly biased toward the capital-intensive commodity. As per capita income rise, people tend to spend more on laborintensive goods (such as service) rather than capital-intensive goods. Hence, if there is needed a consumption bias in the US, the bias must be toward laborintensive rather than capital-intensive goods. 4. Factor Substitution: it is also possible to argue that factor substitution can be easily carried out to that we get factor-intensive reversal. For example, India could produce and export cotton textile by using labor-intensive technology, and the US can produce and export the same goods buy using capital-intensive techniques of production. For this reason, there may arise paradox to the H-O model. 5. Tariffs and other distortions: Travis (in 1964 and 1972) has argued that tariff and non-tariff barriers to trade may have been responsible for the Leontief Paradox in as much as they restricted US imports of labor-intensive commodities. Tariff alone cannot reverse the pattern of trade, of course. Baldwin has argued that if all tariff and non-tariff barriers were removed, the capital-labor ratio of US imports would fall by only 5 percent, and this is not enough to explain the Leontief Paradox. 6. National Resources: Vanek (in 1963) has argued that labor is relatively abundant and natural resources are relatively scarce in the US, while capital occupies an intermediate position. He assumed that capital is strongly complement to natural resources and conclude that, although capital may well be a relatively abundant factor in the exports because natural resources, the scarce factor, enter efficient production only in conjunction with large amounts of capital.

Linders Representative-Demand Hypothesis or Per capita Income theory:

Staffan Burenstam Linder, a Swedish economists and politician, makes argument that income growth affects demand and trade. Linders Representative-Demand Hypothesis draws casual arrows form income to tastes to technology to trade , as follows: a rise in per capita income shifts a nations representative demand pattern towards luxuries that a the nation can afford, as Engels law also implied; this new concentration of demand on

affordable luxury manufactures causes producers to come up with even more impressive improvements in the technology of supplying those goods in particular; their gains in productivity actually outrun the rise in demand that caused them, leading the nation to export these very luxury goods and to lower prices. Thus, we should expect to see nations exporting goods in which they specialize in consuming. Linder has expounded a descriptive per capita income theory of international trade, which claims predictive power. The range of a countrys exportable products is determined by internal demand. In the rich industrial countries, manufactures are developed that are consumed at home and exported to other countries. The prediction is that there will be large trade flows between per capita rich countries and small flows between rich and poor. Linders theory basically states two facts: 1. Domestic demand is a prerequisite to a products exportation, a proposition about the export product mix; and 2. Trade is likely to be most intensive between countries with similar pattern of domestic demand, a proposition about the volume of trade. Linder argues that a manufactured product will not get generally exported until after a domestic demand for the product exists, because a clear domestic need for the product must exist before it can be produced either for home consumption or for exports overseas. In other words, exporters will tend to direct their products to countries with similar demand patterns. But demand pattern in two countries are likely to be similar only when average per capita incomes in these two countries are about the same, and conversely. It clearly reveals that the scope of trade is potentially greatest between countries with the same per capita income level and, per capita income differences are a potential obstacle to trade. Linder concede, however, that the law of comparative advantage is pertinent to trade in primary products. In the case of such products, relative factor proportions are the determinants of costs; and since the product is undifferentiated, the technology and other variable that affect trade in manufactures do not pertain. Linders explanation is consistent with much of the observed pattern of trade. Trade Theories and Their Implications: Advanced and developing countries like India, China etc., have already adopted and applied the concept of comparative advantage in their international trade and they have taken all the possible factors into consideration as mentioned above. However, Nepal has not yet adopted and applied this concept because of low productivity, small size of domestic market, lack of appropriate technology, lack of entrepreneurship, least attempt on exploring new exportable products, and lack of managerial skills for export management.