The Evolution of International Trade Theory

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TheEvolution of International Trade Theory

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TheEvolution of International Trade Theory

Tradingis the exchange of goods and services between people or entities.International trade involves the exchange of goods and servicesbetween people or entities in different countries. The reason forpeople or entities to get involved in trade is because there is abenefit accruing as they require the products produced in anothercountry that are not available in the domestic country. It couldalso be that due to the cost of different factors of production,goods and services from a foreign nation cost less than those goodsand services produced locally.

Understandingthe evolution of the international trade is vital in helping aninterested party to predict and prescribe the direction, content andsize of trade between nations (Wild, 2013). An international tradetheory is important in giving insight in knowing who the traders are,the geographical, economical and political factors that govern thetrade and the consequences of the trade.

Tradeat the international plane involves the exchange of goods andservices across borders and due to this, the cost of tradingincreases. The factors that make trade at the international plane tobe more costly include: restrictions, time costs, tariffs and legalcosts. these factors are interlinked and this can be seen clearly inthe case where tarrifs are low but importing a car id hard justbecause the tail lights of that car do not conform to the legalstandardards in that country (The Economist, 2014).

Initially,international trade was well explained through the traditional tradetheory. However, its implications did not tally with data and thisled to the rise of different theories of trade. These theories haveundergone many changes over the years and they have alos beencriticized by those who felt that they did not give a sufficientexplanation on how trade at the international plane takes place.These theories seek to show that the primary aim of trade is tomaximize the gains for the parties that are involved in the exchangeof goods and services.

Themodels of international trade seek to analyze the patterns of tradeon the international plane. They also seek to suggest ways in whichthe parties exchanging goods and services can maximize the gains fromtrade.

Inorder to have a better insight into modern international trade, onewill have to look trade between countries was conducted in the past.In the 16thcentury the popular belief was that for a country to be successful,it had to maximize on its exports and minimize its imports (Cavusgil,Knight, &amp Riesenberger, 2013).Theinitial explanation was through the country based theories but todaythere is a shift to firm based theories. There are several modelsunder each category but for purposes of this paper, three models willbe discussed, i.e. the Ricardian model, the Hecksche- Ohlin model andthe Gravity model.

TheRicardian model

Thismodel is a creation of David Ricardo and it is a development on thetheory of comparative advantage. Proponents of this model state thata country only engages in the trade that will put it at a comparativeadvantage over the others (Costinot, Donaldson &amp Komunjer, 2012).

Accordingto David Ricardo, for international trade to be inexistence, therehas to be the difference in comparative costs of production (Zhang,2008). This theory is premised on the role of technology and seeks toshow that differences in technology between counties will determinethe division of labor, trade and consumption patterns on theinternational plane.

Thismodel focuses on labor as a single factor of production of goods andservices. The variance in the production of labor, according to thismodel, implies a difference in technology between nations. Thedifference in technology is thus a key factor in putting a country atan advantage on the international plane.

Othermodels of trade show that in international trade some countries winand others countries lose. However, in the Ricardian model, it ispossible for every country to be a beneficiary in a free trade. Thebenefits of free trade allow countries with a poor economy to alsoenjoy the benefits of trade (Cavusgil,Knight, &amp Riesenberger, 2013).The reason for the assumption that free trade will work to thebenefit of all countries is that this model only focuses on onefactor, that is, technology as the only determinant of a country’scompetitive advantage.

Inthis model, the only major factor of production is labor. This factoris mobile between different sectors in the domestic boundary, but notmobile across countries. Labor can only be transported to othercountries at a cost unlike in the domestic plane where labor canfreely move from one sector to another. It also seeks to show thatthe units of labor are homogenous within a country.

TheRicardian model presents a general equilibrium which means that it isa description of a complete circular flow of money when it comes tothe exchange of goods and services. When goods and services aretraded, they generate revenue. This revenue is used to cater for thewages of the workers i.e. the labor used in the production of thosegoods and services. The wages paid to the workers are then used topurchase the goods and services produced by the firms. In turn, thepurchases generate income and the cycle repeats itself. If all theprices of goods, services and other factors of production canequalize the supply and demand in the market, then a state of generalequilibrium is achieved.

Thistheory is important in determining the limits in which the terms oftrade lie but fails to set those terms. It is criticized for failingto explain the reasons for a country’s comparative advantage. Usingthis model in analysis will show that in case of autarky, everycountry will produce some of each product. This means that if acountry is technologically endowed, the workers in that country willget higher wages as these wages are based on productivity.

TheHecksche- Ohlin model

Thismodel is also a basic model of trade and production. It was developedin 1919 by Eli Heckscher and Bertil Ohlin. It was later developed byPaul Samuelson and Ronald Jones. This model focuses on the factors ofproduction as key factors in international trade. This proportionadvances the argument that countries participate in export trade ofthose products that maximize on domestic factors of productioncompared to those products where factors of production are notreadily available in the country. In modern economics, this model hasbeen dominant. It focuses on factor use and factor rewards system(Zhang, 2008).

Thismodel expands the factors of production to two unlike the Ricardianmodel that only focuses on labor. For this model, capital is also animportant factor of production. The word capital here is used inreference to the physical machines and equipment used in theproduction of particular goods and services.

Theproductive capital is either owned by the government in the case of asocialist economy, or by individuals and businesses in a capitalisticeconomy. This model puts more emphasis on the private ownership ofcapital as a factor of production. The use of capital in productionof goods and services will generate income for the owner and so whilea worker earns wages, the owner will earn rents for the capitalinvested.

TheH-O model explains the reality in production where the two factors ofproductivity may differ in different industries. This means that theproduction of one product may require more labor than another productmay require more capital in its production. For this reason, themodel focuses on both factors to explain the patterns ofinternational trade.

Thereare four main proportions of this model: the Heckscher- Ohlinproportion, the Stolper- Samuelson theorem, the Rybczynski proportionand the factor- price equalization theorem. The H-O model states thata country will prefer to trade in the product that maximizes on thefactor that that country is well endowed in. This means that acapital-abundant country will prefer to export capital-intensivegoods and services whereas a labor-abundant country will prefer toengage in the production of labor-intensive goods and services.

Thedifferences in how different countries are endowed propelinternational trade. The capital-intensive countries exportcapital-intensive goods and services because those products willfetch higher prices in other countries unlike in the domestic marketwhere the same goods will be priced at a lower value. This means thatmore profits will be realized in sales in other countries unlike inthe sales done in the local market.

TheStolper-Samuelson theorem states that when there is an increase inthe price of one commodity, it will raise the returns of the factorthat was used in its production. Consequently, it will lower the realreturn of the other factor. Originally, this proportion wasdeveloped to show how tariffs affect the wages and rents within acountry. However, it is important to note that this suffices onlywhen it is applied to trade liberalization.

Thefactor-price equalization theorem implies that if there is freetrade, the wages and rent earned on capital will be equal throughoutthe world. Notably, the factor-price equalization is not likely toapply in a real world as there are many barriers. For example, asassumed in the Ricardian theory, technology differs in differentcountries and it is thus hard to equalize the free trade.

TheRybczynski theorem seeks to show that any increase in one factor willlead to an increase in the goods or services that are dependent onthat factor and a decrease in the production of the goods or servicesthat depend on the other factor. This theorem is important inaddressing issues of emigration, migration. Population growth,investment and labor force growth.

TheGravity model of international trade

Thismodel was developed in 1962 by Tinbergen and Poynohen. The proponentsof this model state that the size of the economy and the distancebetween nations are they key determinants of the pattern ofinternational trade. What this model seeks to show is that there ismore interaction between large economies and less interaction betweena large economy and a lesser economy (Bergeijkand Brakman, 2010). It utilizes the concept of gravity to explainvolume of capital flows, trade and migration among countries.

Accordingto Tinbergen, countries with a large economy are able to assert poweron people and attract other economies to their products. It seeks toshow that the large the volume of exports, the more the nationalincome and this is what reduces the distance between the twocountries involved in the trade.

Apartfrom identifying the artificial barriers to trade and the role ofdistance in trade, this model helps in analyzing the effect ofcountries membership to certain custom unions and preferred tradegroups. These relationships arise in all trade models where the costof trade increases with the increase in distance between the tradingparties.

Further,proponents of this model state that countries that trade more arethose countries with similar levels of income. It is for this reasonthat the Heckscher-Ohlin model is disputed.

Theoriginal estimation by Tinbergen was criticized as not beingcomprehensive. It has being criticized as being ad hoc and lacking inthe theoretical underpinnings even though it is comprehensive in itsempirical analysis. Further, they state that this model is not linkedwith anyone and thereby creates more problems in identifying the roleof distance in trade. This model was also seen to be overlapping withother trade frameworks. These challenges nad other factors like therole of trade preferences called for further inquiry.

In1979, Anderson advanced this model by stating that import demandrises when a country produces goods and services that are differentfrom those produced in other countries. According to him, the reasoncountries buy certain goods and services from a particular country isbecause they evaluate those goods and services differently. heapplied the product differentiation by the source of those products.By doing this, he explained the presence of income variables in themodel as well as their log linear.

Chaney(2011) in explaining the role of distance states that in order for acountry to create contacts, there is the need for one to learn thecontacts of one’s contacts. He further states that the way a firm’sexports are geographically distributed will depend on the waydistance affects the cost of creating the contacts.

Internationaltrade is carried out because a firm believes that there is a benefitthat will accrue as a result of the exchange. In order to understandthe different patterns in international trade, it is important forone to understand the theories that explain how these patterns comeabout. This information is important for economist and investors. Thetheories that explain international trade have evolved over time,some being rendered inapplicable in today’s economy.

Forone to be able to predict and prescribe the direction, size andcontent of multilateral trade, there is the need of identifying fourkey aspects: the nations that are involved in the import and exportof particular goods, the countries that these nations trade with, thegeographical, economical and political circumstances, as well as theconsequences of that trade. One is able to assess these factors bylooking at the theories that explain the pattern of trade between thenations that one is looking at. All the three theories explained inthis paper have contributed a great deal in explaining trade at theinternational plane. As discussed, there was a shift from countrybased theories like the Ricardian theory to firm based theories tohelp explain aspects of international trade. Entities import productsthat put them at a comparative advantage by looking at the cost ofproduction and this factor facilitates international trade.

References

Atroubling trajectory Fears are growing that trade’s share of theworld’s GDP has peaked. But that is far from certain. (2014,December 13).&nbspTheEconomist.

Cavusgil,T., Knight, G., &amp Riesenberger, J. (2013). Theories ofinternational trade and investment. In International Business: TheNew Realities (3rd ed.). Prentice Hall.

Costinot,A., Donaldson, D., &amp Komunjer, I. (2012). What Goods Do CountriesTrade? A Quantitative Exploration of Ricardo`s Ideas.&nbspReviewOf Economic Studies,&nbsp79(2),581- 608.

Wild,J. (2013). International business: The challenges of globalization,student value edition. Place of publication not identified: PrenticeHall.

VanBergeijk, P., &amp Brakman, S. (2010). The Gravity Model inInternational Trade: Advances and Applications. Cambridge: CambridgeUniversity Press.

ZhangW. B. (2008). International Trade Theory: Capital, Knowledge,Economic Structure, Money, and Prices over Time. SpringerScience &amp Business Media.