The Basis of International Trade - Term Paper Example

The law of comparative advantage forms the basis of international trade Introduction The theories of international trade have been developed through the decades of years along with the development of the world economics. Searching for the best answer to the question “what to sell and to whom?” economists and economic theorists tried to predict the direction, composition, and volume of goods traded (Ball and McCulloch, 1996, p.74). However, economists could not discuss the effects of international trade or recommend changes in government policies toward trade with any confidence unless they knew their theory was good enough to explain the international trade that was actually observed (Krugman and Obstfield, 2006, p.5). The first formulation of international trade theory was politically motivated by Adam Smith who stated that “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of our own industry, employed in a way in which we have some advantage” (Adam Smith, The Wealth of Nations 1776, cited by Ball and McCulloch, 1996, p.72). Trying to destroy the mercantilist theory, Smith has developed the theory of absolute advantage, suggesting that one nation was capable to produce more of a good with the same amount of input than another country (Ball and McCulloch, 1996, p.74-75). In the early 19th century David Ricardo, inspired with the Smith’s theory, offered an explanation of trade in terms of international differences in labor productivity, known as a comparative advantage (Krugman and Obstfield, 2006, p.5). Today, the law of comparative advantage forms the basis of international trade. This paper aims to analyze to what extent both David Ricardo’s and Heckscher and Ohlin trade theories explain the patterns of trade in the real world. For more evidence there are provided some relevant examples to current affairs of international trade. Theory of comparative advantage by David Ricardo In 1817 David Ricardo presented an innovative approach to the international trade, according to which “a nation having absolute disadvantages in the production of two goods with respect to another nation had a comparative or relative advantage in the production of the good in which its absolute disadvantage was less” (Ball and McCulloch, 1996, p.77). In other words, comparative advantage takes place when a nation (or somebody else) can produce a good at lower opportunity cost comparing to another country (Suranovic 2006, 40-4). Ricardo’s theory of comparative advantage can be easily explained by considering few examples. One of them is presented below: An Example. Assume that there is perfect competition on the market and no costs for transportation in a world of two countries and two products (Ball and McCulloch, 1996, p.75). Suppose that one unit of input can produce the following quantities of rice and coffee in Japan and Brazil; each nation has two input units it can use to produce either rice or coffee. Let us assume that population in every country consists of 2 people: one is growing rice, the other is growing coffee. According to the example, presented below Japan has absolute advantage in producing rice, while Brazil’s absolute advantage is due to coffee production. Commodity Japan Brazil Total Tons of rice 10 1 11 Tons of coffee 1 2 3 Considering the absolute advantages of these countries, for Japan it is more beneficially to focus on rice production and export it to Brazil, while for Brazil it is more beneficially to focus on coffee production and export it to Japan (Ball and McCulloch, 1996). Gains from Specialization and Trade: Commodity Japan Brazil Total Tons of rice 20 0 20 Tons of coffee 0 4 4 In result of specialization on the production in accordance with an absolute advantage, total gains increased significantly: world output of rice has grown from 11 to 20 tons/year and world output of coffee has grown from 2 to 4 tons/year. Therefore, Japan has a comparative advantage in rice production, and Brazil has a comparative advantage in coffee production (Ball and McCulloch, 1996). It is important to consider that total output increased without additional labor resources. However, the increase of total output does not benefit Japan and Brazil, until they can trade with each other after they have focused on specialization production (Suranovic 2006, 40-5). The surprising result of the theory of comparative advantage is that a country which is technologically inferior to another in the production of all goods can nevertheless benefit from trade with that country (Suranovic 2006, 40-5). According to the Ricardo’s theory, the surplus of the total world output should be divided between two countries (Suranovic 2006, 40-5). International trade is the only way for two countries to get some of each good after specialization (Suranovic 2006, 40-5). There arises a necessity to a construct a terms of trade between the countries, so that each country could export its specialized product and import the production it lacks. It follows the law of comparative advantage forms the basis of international trade. Heckscher- Ohlin theory of Factor Endowment Ricardian model of international trade was expanded by the Hecksher-Ohlin model which incorporated a number of important realistic production characteristics (Suranovic, 2010, p.103). While David Ricardo assumed only labor as a factor needed to produce goods and services, Hecksher and Ohlin introduced the second factor of production – capital (Suranovic, 2010, p.103). All physical machinist equipment, office buildings, computers and much more used in production process refer to the capital factor (Suranovic, 2010, p.103). Thus, the H-O model of 2 productive factors enabled countries to differ factor proportions across and within (Suranovic, 2010, p.103). H-O model defines the capital-labor ratio, the ratio of quantity of capital to the quantity of labor used during the process of production (Suranovic, 2010, p.104). Another realistic characteristic of the international trade is that countries have different endowments of capital and labor available for goods/service production (Suranovic, 2010, p.104). Therefore, to define relative factor abundancy between countries, the H-O model introduces the ratio of aggregate endowment of capital to the aggregate endowment of labor (Suranovic, 2010, p.104). Introducing two goods, two factors and two countries the H-O model allows for interactions across goods markets, factor markets, and national markets simultaneously (Suranovic, 2010, p.103). According to the Hecksher-Ohlin theory, the international and interregional differences in production appear in result of differences in the supply of production factors (Ball and McCulloch, 1996, p.78). H-O theorem enables countries to predict the pattern of trade: it says that capital abundant country will import the labor intensive good and export the capital-intensive good (Suranovic, 2010, p.107). The H-O theory suggests that international trade causes both redistribution of income between different factors of production and improvement of economic efficiency (Suranovic, 2010). The net effect is still likely to be positive, while some countries will gain and others will lose from trade (Suranovic, 2010). The fundamental distinction between the Ricardo’s and Heckscher-Ohlin model is the assumption of production technologies. While the Ricardian model assumes that production technologies are different between countries, the Heckscher-Ohlin model contradicts it by assuming that production technologies are the same (Suranovic, 2010, p.104). The international trade in real world The theories developed by David Ricardo and Heckscher and Ohlin explain that international trade enables countries to specialize in the production of what they do best and make the most efficient use of their labor and capital resources, thereby decreasing the prices of goods and services (Globalization 101, 2010, p.18). Thus, in spite of the fact of efficiency with which a country produces its goods it can always have a comparative advantage in at least one of produced goods or services (Globalization 101, 2010, p.18). Although these theories of international trade clarify the process of trade between nations, in the real world the majority of international deals occur between private enterprises and individuals from different countries (Globalization 101, 2010, p.6). Undoubtedly, governments also directly participate in export/import procedures; however this participation comprises only a small percentage of world trade (Globalization 101, 2010, p.6). Even though the current process of international trade is not qualitatively different from the processes that people have been conducted for hundreds of years, the parameters of speed, volume, diversity, complexity, and geographic reach have changed dramatically (Globalization 101, 2010, p.6). The law of comparative advantage works in the current international business as well, because countries continue to import economically essential goods and services that are either unavailable at home country, or available at an unreasonable cost (Globalization 101, 2010, p.6). For the years of industrial and technological development, international trade has gained additional feature that was not mentioned in the Ricardo’s theory: “goods and services from abroad that may be similar in function and price to those available at home, but which differ in quality of features” (Globalization 101, 2010, p.6). Another distinctive feature that is different from the real international trade and Ricardo’s/ Heckscher-Ohlin theories is that some goods and services that can be produced more cheaply at home, but which home country companies, farms, and individuals have chosen not to produce in favor of producing more sophisticated and expensive goods and services (Globalization 101, 2010, p.6). This real world trend of international trade is at variance with the Ricardo’s model, which emphasizes producing goods and services that can be produced more cheaply than in other countries (Globalization 101, 2010, p.6). Current theory in international trade is comprised not of one or two factors of production, but of three: labor (Ricardo’s theory), capital (Heckscher-Ohlin’ theorem), and land and natural resources (Globalization 101, 2010, p.6). Exactly these three factors help to identify the direction and content of international trade (Globalization 101, 2010, p.6). One of the real world examples clarifies this approach to international trade factors: Labor factor: today many businesses outsource their production to other countries (developing countries) where low-skilled labor is cheaper than in industrialized countries. The recent trends include professional outsourcing from the USA, Europe to China, India, and some other Asian countries. Capital factor: goods and services whose production and technology requires relatively large amounts of capital can be produced more cheaply in countries where capital is more abundant and less expensive (for example: the United States) (Globalization 101, 2010, p.15). In reality, the theories of David Ricardo and Heckscher and Ohlin do not work as it was suggested by the theorists, because of such factors: No country specializes exclusively in the production and export of just a single product or service (Globalization 101, 2010, p.18); All countries produce at least some goods and services that other countries can produce more efficiently (Globalization 101, 2010, p.18); A lower income country might, in theory, be capable to produce some products more efficiently that the high income country can. However, that country with lower income might not be capable to identify potential buyers of high level income country or transport the product cheaply to that country. In result, the country of higher income continue to manufacture the product, despite the fact that there is a lower income country that might manufacture the same product cheaper (Globalization 101, 2010, p.18). Also many citizens do not support specialization and trade because of concern that import goods/services inevitably replace domestically produced goods and services (Globalization 101, 2010, p.18). Even though in reality trade specialization does not work precisely the way the theory of comparative advantage assumes, it forms the basis of international trade (Globalization 101, 2010, p.6). The law of comparative law helps to explain the situation in real world on international trade and offers a broad guidance to countries and businesses as they are taking a decision which goods and services to produce, to export and to import (Globalization 101, 2010, p.18). Conclusions The theory offered by David Ricardo, and expanded by Heckscher and Ohlin provides an explanation of trade in terms of international differences in labor and capital productivity, known as a comparative advantage (Krugman and Obstfield, 2006, p.5). The theories clarify that international trade enables countries to specialize in the production of what they do best and make the most efficient use of their labor and capital resources, thereby decreasing the prices of goods and services (Globalization 101, 2010, p.18). Thus, in spite of the fact of efficiency with which a country produces its goods it can always have a comparative advantage in at least one of produced goods or services (Globalization 101, 2010, p.18). According to the Ricardo’s theory, international trade is the only way for two countries to get some of each good after specialization (Suranovic 2006, 40-5). Even though in reality trade specialization does not work precisely the way the theory of comparative advantage assumes, it forms the basis of international trade (Globalization 101, 2010, p.6). The law of comparative law helps to explain the situation in real world on international trade and offers a broad guidance to countries and businesses as they are taking a decision which goods and services to produce, to export and to import (Globalization 101, 2010, p.18). References: Ball D.and McCulloch W. (1996) International business: The challenge of global competition. 6th ed. Irwin McGraw-Hill, US, pp. 73-78. Globalization 101 (2010). Trade and globalization. Trade issue Brief; The Levin Institute The State University of New York, pp.6-20. Retrieved from http://www.globalization101.org/uploads/File/Trade/tradeall2010.pdf Heath W. (2006). Teaching Comparative Advantage and International Trade: Pitfalls and Opportunities. Journal of Economics and Economic Education Research, Vol.7:1, pp.29-35. Krugman, P. and Obstfield, M. (2006) International Economics: THeory and POlicy, 7th Ed., Pearson Education Suranovic S. (2010). International Trade Theory and Policy. The link to the main content list http://internationalecon.com/v1.0/toc.html Suranovic S. (2006). International Trade Theory and Policy, Chapter 40, pp.4-9B. Retrieved from http://internationalecon.com/Trade/Tch40/T40-9B.php Read More