Trade Theory and Development - Research Paper Example

Trade Theory and Development Contents Introduction 3 Discussion 3 ical Theories of International Trade 3 Modern Theories of International Trade6 Recent Structuralist Theories 7 International Trade Liberalization and the Developing Countries 8 Conclusion 12 Reference List 13 Appendix 15 Introduction International trade is the process of exchanging goods, services and capital across countries in order to enhance their gross domestic product and accelerate economic development. International trade is conducted in two ways such as selling of domestically produced goods and services across countries which are known as export and buying of goods and services manufactured and designed by other countries, which is known as import activities. It can be experienced that the main benefits of such international trade are enjoyed by the developing nations such as Brazil, Russia, India, China and South Africa. The growth of economic expansion of these companies increases, investment opportunities are broaden, access to the latest technologies are gained as well as social and infrastructural developments are established. Understanding the relevance and importance of international trade since ages, many classical, neo-classical and modern trade theories have been developed over a large period of time (Morton and Tulloch, 2012). In this paper, all the theories and literatures related to international trade and development will be evaluated in order to analyse the effect of international trade on the openness of the economies of developing countries and how the growth and development of those countries have been facilitated by such cross border trade. For the purpose of analysis, the data and information of the developing nations such as China and Brazil will be evaluated. Discussion The theories of international trade and development are imperial aspects in the studies of international economics and finance. In the next segment, a comparative analysis will be done on the progressive theories of international trade. Classical Theories of International Trade Following are the Classical Theories of International Trade: Mercantilism Mercantilism is the most traditional philosophies of international trade that led to the onset of commercial revolution. The theory established a rapid transition from local economies to national economies and from fundamental trade to international trade at a larger scale, ensuring government assistance and protectionism. The theory used to hold good during 16th to 18th century on the basis of the concept that the national wealth and power are best utilised through enhancing export volume of a nation and accumulation of precious metals like gold and silver in exchange. According to mercantilism, the amount of wealth is fixed in the world and the nations can increase their possession of wealth through exporting domestically produced goods and services. Based on this trade theory, many western countries such as the United Kingdom, France, Portugal and Spain expanded their export activities. However, as the concept did not involve provisions for import, all such nations failed to strike a positive Balance of Trade. However, this theory has been criticised on a number of grounds such as mercantilism ignited colonialism because of the conviction that if a nation can acquire other provinces and build a large emperor, it will be able to maximize its wealth possession. The theory was also considered as zero sum game in which utility or gain of one nation is always balanced by the loss of the other nations. Such criticisms influenced the economists to come up with a more rational theory of international trade (Gopinath, Helpman and Rogoff, 2014). Absolute Advantage Theory Famous economist Adam Smith set forth the theory of Absolute Advantage in the year 1776. Absolute advantage arises when a country becomes capable of producing more number of a product or services by utilizing the same level of resources as compared to other countries. The underlying assumption behind this theory is that division of labour prevails in the economy. Provision for free trade allows countries to export those goods and services which facilitates the attainment of absolute advantage. On the other hand, they import those goods in which the export countries have an absolute advantage. The cost of the product in which a country is having absolute advantage should be low as compared to other nations. Labour is the only factor of production which is perfectly mobile within the country but immobile across nations. Based on all such assumptions, Adam Smith’s absolute advantage theory explains that when one country gains absolute advantage in one product through producing it at a lower cost and another country produces another product at comparatively cheaper cost as well, then both the countries should enjoy cost advantages by exchanging the goods in which it has an absolute advantage. In this way, the world economies are benefitted by engaging into international trade. However, this theory was also criticised as it failed to recognize the concept of comparative advantage and capability of producing a particular good, taking into consideration the prerequisite of opportunity cost. In fact, Smith considered labour to be the only factor of production and productiveness of labours were considered to be the magnitude for evaluating the absolute advantage. As all these factors cannot exist in real world, significance of this theory was also nullified (Krugman, 2008). Ricardian Trade Theory of Comparative Advantage Drawbacks of Adam Smith’s Absolute Advantage theory instigated the requirement of further development in international trade theories. The theory of comparative advantage proposed and developed by David Ricardo in 1817 states that a country should produce that good in which it has a comparative advantage and acquire other goods through engaging in international trade. The theory of Ricardo is based on two country- two commodity model. More specifically, the theory considers that there are two countries in the world viz. Home Country (H) specializing in producing food products (F) and Foreign Country (F) that are specialised in producing manufacturing products (M). As the theory also considers that labour (L) is the only factor of production, the labour required for producing one unit of Food product in home country is aLF and labour required for producing one unit of manufacturing goods by foreign country is aLM. In such circumstances, if it is considered that home country gains a comparative advantage in producing foods and foreign country receives comparative advantage in manufacturing items, then the home country should continue to produce food items and obtain manufacturing goods in exchange of food products from foreign country. Similarly, the foreign country should continue its production of manufacturing goods and obtain food products through international trade with home country. However, this simplified version of Ricado’s international trade was also discredited on several grounds. First, the theory is based on the assumption of perfectly competitive market where all firms are engaged into producing homogeneous and non-differentiated goods. Labour is the only factor of production. All such assumption does not hold good in real world. The assumption of existence of two countries producing and exchanging only two goods also appears to be unrealistic. In fact, Ricardo also assumed the consumption functions of the two countries to be homothetic i.e. both the countries consume the produced goods at a fixed proportion and such homothetic preferences are associated with same price level, regardless of the income level of the citizens. From the discussion, it can be understood that Ricardo’s Trade Theory of Comparative Advantage holds limited relevance in the real world (Narlikar, 2004). Modern Theories of International Trade Modern theories of international trade mainly puts emphasise on two concepts in order to overcome the shortcomings of traditional trade theories. These are: factor proportion and product lifecycle. Heckscher-Ohlin Model Heckscher-Ohlin Model is a modern theory of international trade which was developed on the foundation of Ricardo’s trade theory. Heckscher- Ohlin model states that countries tend to export those goods that are abundant in their countries and can be produced by using cheap factor of production. Conversely, those goods are imported, production of which involves scarce resources of the country (Bown, 2010). The model considers that profitability from producing goods and services depend on the prices of the relative endowment of factor of productions such as land, labour and capital. Hence, comparative advantage arises for a country when it produces those goods, factors of production for which are abundant in the country. Thus, the countries get benefitted by exporting such abandoned goods. In exchange, the country can equally better off by importing those goods, when the prices of inputs required for production are very high and are scarce in nature. Though the model holds some significance in the real world, it was also criticised on the basis of a number of factors. Since, the model involves the importance of price level and wages, consideration of factor equalizations does not hold relevance for developing or underdeveloped countries. For example, the wage rate of the United Kingdom is 50 times higher than that of Somalia. Therefore, following the H-O model, trade relationship cannot be established between the two countries. The assumption of identical production function i.e. identical level of production in all the countries and use of similar technologies everywhere is also unrealistic. Apart from that, considering capital as homogeneous and endowment made the model more irrelevant in the present global context. Nevertheless, H-O model portrays a better picture of international trade, considering many factors such as more than one factors of production, presence of price level etc, which were absent in the traditional trade theories (Farmer and Schelnast, 2013). International Product Life Cycle The theory states that maturity of products highly affects the level of import and export among countries. In general, it has been noticed that the advanced countries tend to be more innovative and continue to develop new products and services. Initially, such countries gain expertise and earn huge profits in producing and exporting such products. Gradually, the developing countries adapt the production process of such products and services and the import-export equilibriums between developing and developed countries hamper (Fajnzylber and Maloney, 2005). Recent Structuralist Theories Recent structuralist theories of international trade and development involve two important hypothetical aspects. Strategic Trade Theory  Strategic trade theory describes that the level of international trade depends on the strategic interaction of the firms involved in international trade. Unlike Heckscher-Ohlin Model, this theory assumes the concept of industry and it believes that industry of a product is dominated by a small number of firms. Strategic reaction among all such firms determines the level of import and export in international market. It also involves the scope for the strategies such as import tariffs, research & development and export subsidies which are very much applicable for continuing business in global world and sustaining in high level of competition in international market (Pearce, Barbier and Markandya, 2013). In contrast to the traditional and modern theories of international trade that presumes constant returns to scale of production, this theory is based on increasing returns to scale. The concept of Prison’s dilemma has been raised from this theory of trade where it is expected that the first mover may have to pay off substantially as the other player can determine its strategy by analysing the movement of the first-mover. In fact, the model considers the provision for government intervention and protection of welfare of the countries in international trade. In contrast with H-O model, the strategic trade theory also confirms that substantial amount of international trade can take place between developed and developing countries if such countries hold identical factor endowment (Hasan, Mitra and Ramaswamy, 2007). The Porter Diamond Model The Diamond model of structural trade theory proposed by Michael Porter is based on gaining of competitive advantages by the nations through international trade. Porter considered six conditions to be satisfied for a nation to gain competitive advantage. These are factors condition such as availability of physical resources, human resources as well as infrastructural and capital resources to be satisfied for gaining competitive advantage. Demand condition such as presence of relevant buyers is important support the demand consideration of the domestically produced goods. Supporting industry and firms rivalry is also considered to be important conditions. For innovation and expansion of a product, it is very much important for the producer to easily avail the important raw materials. Such raw material can be finished goods for another producer (Todaro, Smith and Smith, 2015). Therefore, presence of such supporting industries is of utmost importance for continuing production of the product in which the nation has competitive advantage. Presence of rival firms is important because such factors enhance competitiveness of the firms which in turn increases the scope for innovation and modification of such products and makes them internationally demanded. Government intervention is also important to monitor and regulate demand, supply and price level when required. Finally, the model considers chance or occurrence of events which are beyond control of the firm and may benefit the firm to gain competitive advantage (Narlikar, 2004). International Trade Liberalization and the Developing Countries Trade liberalization and opening up of the economy may be defined as the process of reducing the limitations on foreign trade. It involves reduction of both tariff and non-tariff barriers that may affect cross-border trade. Recently, the world economy has experienced rapid economic growth, especially for the developing countries. Such growth has become achievable through technological progression and expansion of international trade in those economies. Reduced trade barriers and opening up of many economies to gain full opportunities of international trade has further accelerated economic developments of those countries. Advancement in the level of international trade has substantially helped the developing nations such as China, India, Brazil, and Russia, South Africa etc to expand their investment avenues and develop their private sectors. Such international trade has also enhanced competitiveness among the developing nations which in turn improves the scope for innovation in the production process of those countries and reduces the price of inputs, making the products highly cost competitive. The countries got an access to new markets and attained further scope for business development. Entrance of foreign capital and expansion of the scope for foreign direct investment largely facilitated the countries to concentrate more on technological knowhow and R&D. Liberalization of economies and expansion of international trade has also widened the choice of goods among the consumers of developing nations. As a result, the price of goods and services has been reduced because all producers have become keen to produce products at a competitive price, without compromising on quality aspect. International trade is largely regulated and monitored by many international authorities such as World Trade Organization (WTO), International Monetary Fund (IMF), General Agreement on Tariffs and Trade (GATT) etc (Bown, 2010). Under superlative guidance of such international organizations, developing nations are also learning to modify their business process complying with the quality, labour and environmental standards and understanding the importance of incorporating best practices and best fit in their business. The process of international trade has also initiated economic integration where the countries are striving to formulate strategies of business that will be mutually beneficial for all the nations engaged in international trade. In this way, the scope of economic warfare on allocation of resources are decreasing among the developing countries, reaping the prospect of world peace. The opportunity of employment has been drastically increased, reducing the level of poverty in those countries as a positive consequence of economic growth (Bonnie and Khayum, 2003). Research Objective It has been experienced that expansion of international trade and liberalisation of economies in developing countries over the last 20 years has stimulated economic growth of those countries. Many developing countries experienced that the facilities and expertises the developed economies incorporate are derived from international trade. Therefore, in the long run many developing countries also opened their economies to enjoy such benefits and accelerate their economic growth. In fact, some of the economies have raised their standards from under-developed to developing nations, relying on the advantages of international trade. Therefore, it is often implied by many economists that trade openness impacts the growth and development positively. In this segment, justification of the statement will be evaluated by analysing the indicators of economic growth. For the simplification of analysis, pattern of international trade of the most promising developing country, China will be examined. International Trade Pattern of China China is one of the significant developing countries in the world. It is the second largest economy in the world when valued on the basis of Gross Domestic Product (GDP). It is the fastest growing nation with an average growth rate of 10% annually (Nooruddin and Rudra, 2014). The import and export activities of the country are very strong as well. In 2013, the combined amount of import and exports accounted for as high as $4.2 trillion which was higher than the total exim volume of America itself. However, it has also been experienced by some of the economists that the volume of international trade appears to be so high because of the size of the economy. In fact, the relative proportion of the GDP of China to its import and export is below the world average. In 2014, the import and export of China constituted for 53% of its GDP, whereas, the aggregate global trade amounted over 63% of the world GDP (Lu, Liu and Filatotchev, 2014). Research Question Is there any positive correlation between economic growth of the developing countries such as China and international trade? Research Methodology Research methodology indicates the system of accumulating data required for conducting the research and applying appropriate technique in order to arrive at an error free solution to the research question (Creswell, 2013). Two aspect of research methodology applicable to this research paper will be discussed below. Data Collection: Secondary Data In order to investigate the international trade of China, more specifically the import and export of the country, it is impossible to collect and analyse primary data. Therefore, the research will be based on secondary data obtained from various sources such as the database and records of World Bank, World Development Indicators (WDI), World Economic Outlook (WEO), Database of the United Nations, reports from International Monetary Fund etc. Apart from that, journals and research papers of various eminent economists and financial analysts will also be evaluated (Creswell, 2013). Research Technique For analysing the data related to international trade of China and its influence on the economic growth of the country, quantitative research technique will be incorporated. Quantitative research technique is the best way to conduct systematic investigation and accordingly arrive at an authentic decision, using statistical or computational method of analysis. In this research, the gross domestic product of the country is considered to be the dependent variable and import and export of the volume of China is taken as independent variable. Therefore, a correlation analysis will be done to examine the association of these two variables i.e. to confirm whether international trade contributes positively towards the economic growth of the country or are they negatively related. Analysis of the Obtained Information Figure 1: Import- Export and GDP growth of China over the last 10 years Analysing the graphical representation, the data of import and export of China as well as GDP of the country, it becomes explicit that the import and export of the country has increased at a higher rate as compared to the rate of growth of the GDP of the economy. Therefore, it is implied that the GDP of the Chinese economy has been sufficiently infuenced by the contribution from its international trade. Analysing the coorelation between aggregate imports and GDP of the economy, the result has shown that the coorelation coefficient between the two is 7.22 thereby indicating strong correlation between the independent and dependent variables. From the statistical outcome, it can be easily understood that China tends to import highly innovative and latest technologies, raw materials and other equipments from foreign countries. The country incorporates all such techologies and other considerations into their production process in order to produce superior quality of domestically produced goods and services. This is the main reason why China gives more emphasis on domestic goods and infuence the Chinese consumers to use doemstically produced goods rather that foreign products (Yang and Zarzoso, 2014). Therefore, the coorelation between export of goods and services in China and its economic growth is very less (0.28). Such low coorelation indicates the economy’s expertise to attract huge Foreign Direct Investment (FDI) and technological flows towards the country and combining all such physical and technological resources along with cheap labour available within the country in order to produce world class product and services. In this way, employement rate of China increases. As a positive consequence, poverty ratio decreases, relying on the incremental per capita income. In fact, as the employemnet opportunity increases as a result of expansion of institutional investment avenue within the country, purchasing power of the citizens also increases. Hence, China government influences the local consumers to consume more the domestic products. In this way, the GDP of the economy increases. Thus, China’s economic growth and international trade volumes are positively correlated (World Bank, 2015). Conclusion International trade is one of the most important considerations in world economics. Understanding the importance of the phenomenon, many economists have developed different theories over the period of time. Though the traditional trade theories of Ricardo and Adam Smith still holds importance, requirement of developing more contemporary theories of international trade and development has given rise to Heckscher-Ohlin Model, strategic trade theory and many such theoretical perspectives in recent study of economics. In fact, according to many economists, importance of international trade can be associated positively to the economic growth of the developing nations. In other words, trade liberalisation and openness of the economies of the developing countries is one of the main reasons behind economic expansion and huge growth of such nations. Analysing the data of import and export of one of the most emerging nations in the world, China and correlating the data of the country with the GDP of the economy, it can be inferred that international trade of the country is highly correlated with the economic growth of the economy and the country will be able to experience such uniform and positive economic growth if it continue to expand its economic activities related to international trade. Reference List Bonnie, J. B. and Khayum, M., 2003. Contemporary Economic Issues in Developing Countries. California: Greenwood Publishing Group. Bown, C. P., 2010. Self-enforcing Trade: Developing Countries and WTO Dispute Settlement. Washington DC: Brookings Institution Press. Creswell, J. W., 2013. Research Design: Qualitative, Quantitative, and Mixed Methods Approaches. London: SAGE Publications. Fajnzylber, P. and Maloney, W.F., 2005. Labour demand and trade reform in Latin America. Journal of Development Economics, 66(5), pp. 423-446. Farmer, K. and Schelnast, M., 2013. Growth and International Trade: An Introduction to the Overlapping Generations Approach. Berlin: Springer Science & Business Media. Gopinath, G., Helpman, E. and Rogoff, K., 2014. Handbook of International Economics. Amsterdam: Elsevier BV. Hasan, R., Mitra, D. and Ramaswamy, K.V., 2007. Trade Reforms, Labour Regulations and Labour-Demand Elasticities: Empirical Evidence from India. Review of Economics and Statistics¸89(3), pp. 466–481. Krugman, P. R., 2008. International Economics: Theory And Policy. New Delhi: Pearson Education India. Lu, J., Liu, X. and Filatotchev, M. W., 2014. International experience and FDI location choices of Chinese firms: The moderating effects of home country government support and host country institutions. Journal Of International Business Studies, 45(4), pp. 428–449. Morton, K. and Tulloch, P., 2012. Trade and Developing Countries. London: Routledge. Narlikar, A., 2004. International Trade and Developing Countries: Bargaining Coalitions in GATT and WTO. London: Routledge. Nooruddin, I. and Rudra, N., 2014. Are Developing Countries Really Defying the Embedded Liberalism Compact? World Politics, 66(4), pp. 603-640. Pearce, D., Barbier, E. and Markandya, A., 2013. Sustainable Development: Economics and Environment in the Third World. London: Routledge. Todaro, M. P., Smith, S. C. and Smith, S., 2015. Economic Development. New York: Pearson Education. World Bank, 2015. China: Data Catalog. [Online] Available at: < http://datacatalog.worldbank.org/> [Accessed 6 April 2015]. Yang, S. and Zarzoso, I. M., 2014. A panel data analysis of trade creation and trade diversion effects: The case of ASEAN–China Free Trade Area. China Economic Review, 29(4), pp. 138–151. Appendix China China China GDP (current US$) Exports of goods and services (current US$) Imports of goods and services (constant 2005 US$) $1,931,644,329,934 $658,305,423,280 $631,905,550,690 $2,256,902,590,825 $836,877,618,137 $712,252,341,469 $2,712,950,885,444 $1,061,701,636,817 $816,960,558,181 $3,494,055,942,162 $1,342,196,220,822 $950,190,486,012 $4,521,827,271,026 $1,582,468,852,414 $999,809,433,195 $4,990,233,518,752 $1,333,195,516,629 $1,048,380,175,460 $5,930,502,270,313 $1,743,608,308,051 $1,262,417,472,076 $7,321,891,954,608 $2,089,797,247,806 $1,413,667,709,400 $8,229,490,030,100 $2,248,352,597,991 $1,528,924,037,753 $9,240,270,452,047 $2,440,533,155,296 $1,693,619,735,091 Code Indicator Name Long definition Source NY.GDP.MKTP.CD GDP (current US$) GDP at purchasers prices is the sum of gross value added by all resident producers in the economy plus any product taxes and minus any subsidies not included in the value of the products. It is calculated without making deductions for depreciation of fabricated assets or for depletion and degradation of natural resources. Data are in current U.S. dollars. Dollar figures for GDP are converted from domestic currencies using single year official exchange rates. For a few countries where the official exchange rate does not reflect the rate effectively applied to actual foreign exchange transactions, an alternative conversion factor is used. World Bank national accounts data, and OECD National Accounts data files. NE.EXP.GNFS.CD Exports of goods and services (current US$) Exports of goods and services represent the value of all goods and other market services provided to the rest of the world. They include the value of merchandise, freight, insurance, transport, travel, royalties, license fees, and other services, such as communication, construction, financial, information, business, personal, and government services. They exclude compensation of employees and investment income (formerly called factor services) and transfer payments. Data are in current U.S. dollars. World Bank national accounts data, and OECD National Accounts data files. Read More