The Ricardian Model of International Trade - Essay Example

?International Trade Introduction The growing interdependence between countries is as a result of trade. Various scholars have tried to explain how countries benefit from trading activities amongst them with various views emerging as to how trade is conducted. Classical theorists continue to influence modern theorists on international trade with some of their ideas mirroring one another. This paper is going to examine some of the concepts of international trade beginning with the Ricardian model, followed by the Heckscher and Ohlin model. It will then look and how tariffs, quotas and subsidies affect real income in small countries. Lastly, it will look at arguments against free trade and their validity from a national perspective. The Ricardian Model of International Trade The Ricardian model of international trade is one of the earliest models of international trade. This model of trade emphasizes comparative advantage that comes about due to technological differences which act as a critical factor behind trading activities. Unlike the other theories of international trade that argue that trade only benefits certain countries and is unfavorable to others, this model contradicts this notion arguing that trade is beneficial for all countries that take part in the international trade (Feenstra, 2003). Its built on six basic assumptions: (1) Two countries are involved in the trade; (2) there are only two goods produced; (3) labor is the sole factor of production (Goodwin, Nelson, Harris, Roach, & Devine, 2009); (4) there is perfect competition across all markets such that goods are priced at cost in the nations producing them; (5) an assumption that labor is homogeneous within domestic boundaries, however, its productivity is different across the nations; and (6) the goods produced are viewed as homogeneous across the countries (Stern, 2011). According to this model of trade, gains from the trade become possible because of the comparative advantage. The basic idea is that if a country has to benefit from the trade, it is the country’s opportunity cost that matters and not its actual costs. The opportunity cost of a given product (a) is how much of some other product, (b); one country has to give up in order to produce one unit of the other product (a) (Carbaugh, 2010). Based on this explanation therefore, each country will stand to benefit only if it produces a particular good for which it has the lowest opportunity cost. A country’s opportunity cost is what will create gain in the free trade. The gains from the trade are made possible due to comparative advantage that one country has over the other. Comparative advantage comes in if the opportunity cost of producing that good in terms of others goods is less compared to the other country. Thus if the opportunity cost of country A is lower than the opportunity cost of country B, then country A has a comparative advantage over country B. Therefore both countries benefit from the free trade if each country exports the goods with which it has a comparative advantage over the other. The Heckscher-Ohlin (H-O) Model of Trade Heckscher and Ohlin in there theory explain that the basis for international trade is due to factor endowments. This theory is an advancement of the Ricardian model of international trade that advocated for the comparative advantage as the basis for international trade. The Ricardian model failed to explain how the comparative cost advantage exists (Goodwin, Nelson, Harris, Roach, & Devine, 2009). This theory on the other hand proposes that this difference in comparative costs is due to: (1) differences in endowment of the factors of production; (2) the fact that production is dependent on the factors of production which are used with different degrees of intensity in the two countries. Therefore, this theory advances that the differences in factor intensities in the production functions of goods and the actual differences in relative factor endowments of the countries which explain international differences in the comparative cost of production. Thus each country will specialize in producing and exporting goods with which their production requires a relatively a large amount of the factors of production which the country is relatively well endowed (Cherunilam, 2008). In this model factors of production are viewed as scarce or abundant in relative terms. The scarcity or abundance is explained in relation to other factors. Thus, given two countries A and B; A with an Abundance of capital and B an abundance of Labor, A will export capital intensive goods to B and B will export labor intensive goods to B, creating a pattern of trade. If one country produces a product using highly skilled labor and the other produces another product using highly unskilled labor and the two countries trade, the wage level for the skilled laborers and unskilled laborers for both countries will be high and profitability will also be high in those products. However, wage levels for unskilled laborers will be low and profitability in those goods will also be low. The same is true for the skilled laborers in the second country. These conclusions may not be true because a number of factors may falsify them. Such factors may include aspects such as tariff barriers, monetary policies and systems across the two nations, differences in demand patterns and differences in human capital and skill. All these will have an impact on these trade patterns between the two countries affecting the way trade is carried out and the mounts of wages and profitability (Feenstra, 2003). Tariffs, Quotas and Subsidies and effect on real Income Most governments impose tariffs especially import tariffs which are taxes that are levied on imports with the aim of promoting those industries considered to be very important to a country’s economy. They are also imposed for the purpose of improving the balance of payment. Import tariffs generally create a wedge between external world prices and the prices which are paid domestically for a given good by the size of that particular tariff (Feenstra, 2003). A small country, defined as one that does not have an influence on international prices, a rise in the domestic price is equal to the amount of the tariff itself. This induced tariff price contributes to a gap between prices in the importing and exporting countries. This causes a sudden increase in supplies (production) in the importing country and a subsequent drop in demand (consumption). The tariffs generate different benefits (to the government) and costs (to the consumers); the net cost to a country is the cost to the consumers less the profits to the producers minus government revenues. This will be equivalent to the sum of the efficiency loss due to the distortions caused to the pricing system and the profits from better terms of trade caused by reduced international prices. The effect on a small country is negative because there is no improvements in the terms of trade as their tariffs have no impact on international trade. As earlier mentioned, the cost of buying goods for the consumer increases as a result of this tariff and they are forced to buy less. This is viewed as a reduction in consumer income (Carbaugh, 2010). In comparison, quotas and subsidies on the other hand leave the consumers unaffected since the domestic prices of products remain the constant. When a production subsidy is imposed by a small country, the domestic price of the good rise to the value equivalent to that of the subsidy. Due to the fact that free trade is maintained and the importing country is small in size, the domestic consumer prices remain constant. The impact of the subsidy acts to raise the level of supply while demand remains relatively low. What this does is that the amount of imports of that particular good drops. Consumers in this case remain unaffected because the prices of the goods remain the same (Stern, 2011). Arguments against free trade and their validity from a national point of view Many economists are of the notion that free trade improves the overall welfare of the society. However, there are many counter-arguments against free trade. The first such argument is the jobs argument where domestic producers are put out of business because of the introduction of free trade that introduces lower costs for competitors at the international front. This is incorrect because there are two important factors that are not considered. First, the loss in jobs is coupled by reduced consumer prices of goods and secondly the loss in jobs is specific to certain industries but there are other industries where jobs are created. Some domestic producers end up being exporters and income by foreigners’ benefits domestic economy as it is used to but domestic goods, in both cases increasing employment in the nation (Cherunilam, 2008). The second argument concerns national security where free trade could be risky especially where a country is dependent on a hostile country for essential goods and services. Therefore this argument is for the protection of some industries in order to protect the interests of national security. This argument is not entirely true because of the fact that the argument is made in order to protect the interests of producers within the nation and some interest groups. However, as much as this is done, consumers are not considered in this argument making the argument technically misleading (Goodwin, Nelson, Harris, Roach, & Devine, 2009). The infant industry argument is the third argument against free trade and this argues that trade protection is necessary because there are those companies which are still growing and thus, introducing international competition will kill their chances of growing and being competitive (Carbaugh, 2010). This argument stems from the fact that companies follow some learning curve in that their production curve increases with the age of the company as it gets better at what it is doing. Introducing competition brings about short term losses which other growing companies cannot withstand due to liquidity constraints. This should not be the case as the government can come to the aid of such companies and provide liquidity in terms of loans instead of initiating trade protection mechanisms (Stern, 2011). The unfair competition point is the fourth argument. It is argued that allowing free trade introduces competition from other nations which actually do not play by the same rules in that they have different costs of production and other things. This argument is true to some extent but what is forgotten is that the lack of fairness is beneficial to them rather than being detrimental to them. If a country has implemented policies to keep domestic prices low, consumers will benefit from imports that are lowly priced. This competition has the ability to put some of the producers out of competition (Feenstra, 2003). However, is worth noting that consumers benefit more than producers actually lose in exactly the same dimension as it would be when other countries are playing fair, but happen to be producing at a much lower cost (Cherunilam, 2008). Conclusion Models of international trade have different views on how countries benefit from trade between them with Ricardian model advocating for a comparative advantage and Heckscher arguing for resource and endowment and degree or intensity of use in production. Tariffs affect real incomes in that consumers spend more buying goods and in doing so buy fewer goods as compared to a situation where there are subsidies. Free trade is beneficial but many arguments are against it, most of which have no substantial evidence to support them. It is thus important that trade is left to thrive in an environment that is free from barriers among other things. References Carbaugh, R. J. (2010). Contemporary Economics: An Applications Approach. New York: M. E. Sharpe. Carbaugh, R. J. (2010). International Economics. New York: Cengage Learning. Cherunilam, F. (2008). International Economics. New York: Tata McGraw-Hill Education. Feenstra, R. C. (2003). Advanced International Trade: Theory and Practice. London: Princeton University Press. Goodwin, N. R., Nelson, J. A., Harris, J., Roach, B., & Devine, J. (2009). Macroeconomics in Context. London: M. F Sharpe. Stern, R. M. (2011). Comparative Advantage, Growth, and the Gains from Trade and Globalization. New York: World Scientific. Read More