Trade between Countries - Essay Example

Running head: Trade between Countries TRADE BETWEEN COUNTRIES Goes Here al Affiliation Goes Here This essay discusses various reasons and theories behind trade between countries around the world. The essay further discusses various types of trade theories such as monopolistic competition, Heckersher-ohlin and comparative advantage.  Introduction International trade can be broadly defined as the continuous exchange of products, capital and services across different countries around the world. Today, international trade represents one of the significant elements of the GDP of any country. Defining Trade between Various Countries Since the ancient days, international trade has played a vital role in political, social and economic environment of any society. As per Blaug(1992), there are many significant theories that are vital for studying the international trade as a subject. Comparative Advantage International Trade Theory Also known as Ricardos theory, the comparative advantage theory can be broadly defined as the potential gains from international trade that arises from various differences n technological progress or factor endowments.  In 1817, David Ricardo developed this classical theory for explaining the reason of trading between different countries. As per this theory, the comparative advantage is the key point of international trade between two countries. As per this theory, the international trade is primarily based on the differences in opportunity costs, for instance - technology difference (Maneschi, 1999).  The comparative advantage economic theory is one of the most important concepts in international trade. This is also one of the most misunderstood principles of the economic theories. There are many points that can be misunderstood such as the results from the application of formal models are opposite of the simple logic (Suranovic, 2010). Further, it is very easy for the students to confuse the theory with another economic theory that is  absolute advantage. The third reason is the fact this theory is mostly presented only in  mathematical form. Although, it is easy to understand the basic results, but most of the people do not understand the basic intuition of this economic theory (Suranovic, 2010).  During 1817, in his book On the Principles of Political Economy and Taxation, David Ricardo offered a famous example to support his theory. There are two countries, England and Portugal who are capable of producing both cloth and wine. In Portugal, it is relatively easy to product both cloth and wine at low cost when compared with cost in England (Ricardo, 2004). But in England, it is cheaper to produce cloth than the wine. So, it is beneficial for both countries if England produces cloth and trade with Portugal for wine. Conversely, it is beneficial for Portugal to produce wine and trade it with England (Ricardo, 2004). Some Assumptions of this Economic Theory Every economic theory is based on some assumptions. The comparative advantage theory is based on these assumptions. The first assumption is that the world economy is based on 2 countries and 2 goods. This economic theory is the same for the actual larger number of countries. However, due to this assumption, the principles become clear and the arguments become easy to follow (Ricardo, 2004). The second assumption is about the equal size of economies. This is a simplification, but the main reason behind it is to make the argument simple and clear(Ricardo, 2004). The next assumption is based on nil production as well as transportation cost incurred during the production of the goods as well as the services (Ricardo, 2004). Criticism of this Economic Theory Many scholars have advanced arguments against using competitive advantage theory to advocate free trade; some of them include Barbara Spencer and James Brander (Krugman, 1987). They demonstrated that when only some firms compete in any economy, the national firms can prevent foreign firms from competition with the help of import restrictions as well as export subsidies. It increases the welfare throughout the country that implements the strategic trade policies (Krugman, 1987). Testing and Validation of Comparative Advantage Theory Any economic theory can become valid only after it has been tested by various experts. The comparative advantage economic theory was first tested by MacDougall in 1951 and 1952. One of the major predictions of the two countries’ comparative advantage economic model is that the countries export products when the productivity of the workers is higher (MacDougall, 1952).So, there is a positive and close relationship between the number of exports and productivity rate.  McDougall collected data from US as well as UK and found the positive relationship (MacDougall, 1951). During 1962 and 1963, Stern and Balassa conducted the same test respectively with current data and obtained the positive results. Since then, many scholars such as Dosi in 1988, Dornbusch in 1977 and Davis in 1995 have tested this economic theory from various angles and have validated it further. The recent studies within this area have been done by Golub and Hsieh in 2000 and Nunn in 2007 who have also validated the positive results. Take an example, India and Philippines are the best locations for call centers. However, the human resource in India is more educated and trained in IT technology services.  Predictably, India is getting more business regarding IT technology services whereas the percentage of call center handling tele calling and customer care services is increasing in Philippines. The main reason behind this trade is the difference between is quality of manpower (Maneschi, 1999).  Stolper–Samuelson Theorem The basic theorem behind Heckscher–Ohlin trade theory can be described as the Stolper–Samuelson theorem. Stolper–Samuelson theorem has been derived by Wolfgang Stolper & Paul Samuelson within the framework of Heckscher–Ohlin trade theory (Jones, 2014). This theorem offers the specific relation between relative factor rewards such as real returns of capital and real wages with the relative prices of the output (Stolper & Samuelson, 1941). As per this theorem, under some particular economic assumptions, any rise in the relative price of any product will result in the rise of the return in a particular factor that has been used most intensively during the production of that product or service (Jones, 2014). This will further result in fall in value of return of any other factor of that product or services. The specific economic assumptions in this situation include perfect competition, constant returns and equality in number of factors for the production in equal number of products (Stolper & Samuelson, 1941). But, with continuing of research in this area, this theorem has also been applied in less restricted models. In 1977, as per Ronald W. Jones and José Scheinkman, this theorem can also be applied to various general conditions that exist in the international trade. As per this theorem, when applied to international trade, the returns for scarce factors go down with the prices of the product. But, the additional corollary to this theorem also confirms the existence of compensation for the scarce factor that enables the recovery and growth of international trade (Stolper & Samuelson, 1941). The original Heckscher–Ohlin model is 2-factor model that includes a labor market that has been specified with a single number. So, the early models could not study or make any predictions regarding the effects on unskilled labor in high-income countries with trade liberalization. But, with more sophisticated later models, the effects of Stolper–Samuelson theorem could be calculated with any labor class. It has been surmised that with the increase in international trade, the living as well as the working conditions of the unskilled labor becomes worse (Stolper & Samuelson, 1941). This theorem has a close relationship with factor price equalization theorem. Factor Price Equality Theorem or FPE The factor price equalization theorem states that, the factor prices tend to become equal across various countries that have same technology for similar products, in spite of international factor mobility factor (Stolper & Samuelson, 1941). As per Heckscher and Ohlin, the factor price equalization theorem was an econometric success as the international trade during 19th as well as 20th centuries coincided with factor and commodity prices everywhere. However, when this theory was tested during coming decades, it failed to explain the issues in international trade of that time. One of the contradictions that were found in this theory is known widely as Leontief’s Paradox. Leontief’s Paradox In 1954, Wassily W. Leontief attempted to test Heckscher–Ohlin theory empirically and found that US, the country that had abundant capital resources, imported capital intensive commodities. The export products of the country consisted of labor-intensive commodities (Baldwin, 2008). This situation was in complete contradiction with H–O theory or Heckscher–Ohlin theory. After almost 20 years, the situation had not changed, the import of USA consisted of 27% more capital-intensive products than the last figures. Hecksher-Ohlin or H-O international trade theory The H-O theory of the international trade can be broadly defined as the general equilibrium of the mathematical model. This theory or model was developed at Stockhholm School of Economics by Bertil Ohlin & Eli Heckscher. The Hecksher-Ohlin or H-O theory of trade builds on the theory of Comparative advantage by David Ricardo by offering further patterns of the production that are based on the factor endowments of any trading region(Blaug, 1992). The main idea behind this model is the fact that any country that exports a certain product uses cheap as well as abundant resources available throughout the country. It further states that countries import products that are not available or are rare throughout the country. As per this theory, the pattern of international trade is determined solely by variation in the factor endowments. While explaining the theory, this model takes some fundamental assumptions in consideration such as the free flow of capital as well as labor between different sectors (Maneschi, 1999). The other assumption includes the difference in availability or endowment of the capital and the labor between those two countries. With continuance of the previous example, as per H-O or Hecksher-Ohlin theory, there is a cost difference between call center services of India and Philippines. Although, the customer can get call center services in both countries, he can get better IT technology related technical troubleshooting assistance in India. Further, India can get more value by offering IT technology services than promoting customer call center services (Blaug, 1992). Monopolistic Competition International Trade Theory Developed by Edward Hastings in 1933, monopolistic competition international trade theory can be broadly defined as a type of imperfect competition in the market. There are many producers and sellers in the market in this type of competition who offer products that are differentiated both by quality or the prices (Hastings, 1962). Due to these issues, they are not perfect substitutes for each other. In this type of competition, any company can take the prices charged by its competitor into consideration, while trading and ignore the influence of its own prices (Krugman, 2011). As per Krugman, there are some common characteristics of this type of the trade. It includes few or non-existent barriers for entry or exit in the market, producers who do not have sole control over the market, and sellers who have certain control over the prices (Krugman, 2011). Assumption of the Economic Theory Some assumptions of this theory are as follows: Each company can differentiate its product and service from its rivals. Smartphonex can be one of the best examples. Each of them is different, but they are in competition with each other in the market. It means that there will be consumer loyalty in play, so the companies have some flexibility to move their price level at the next stage. The customers who are loyal to a brand may not leave due to prices (Hastings, 1962). This economic model does not include the issue of interdependence when it is time for setting prices. The company acts as it has a monopoly in the market and does not consider any response from the competitors. The main concept behind this approach is the fact that there are so many companies in the market, that any one company does not receive much attention (Hastings, 1962). Testing and Validation of the Theory Any economic theory goes through three life cycle stages. The first stage is when theorists arrive at a logical and rigorous theory as an attempt to explain a particular trade flow (Hummels & Levinsohn, 1995). The next stage consists of subjecting the proposed theory to a barrage of empirical tests that most often, yields contradicting evidence. The third stage of this cycle is when the experts try to sort out various paradoxes or puzzles to deduce a set of facts that try to define the theory (Hummels & Levinsohn, 1995). For monopolistic economic theory, one of the important empirical tests was done by Helpman in 1981 and published during 1985 (Helpman, and Krugman, 1985). In the study, they showed that a monopolistic model could depict the trade flow in products that are similar. There are many models of international trade as well as monopolistic competition that have diverging set of assumptions. As this is one of the youngest economic theories, there are very few studies that are done on this topic.  Helpman conducted many empirical tests on monopolistic economic theory by taking various sets of the hypothesis. One of the important papers during these tests was published in 1987, where he developed a series of monopolistic competition models and tested various hypotheses, motivated directly by economic theory (Helpman, 1987). The economist constructed two simple theoretical models that were expressly designed for yielding testable hypotheses. Then, he asked whether the data yielded by the models were consistent with the prediction of the models. Helpman also took help of graphical methods and some simple regression methods to find the result positive (Helpman, 1987). During 1995, Hummels & Levinsohn did the same test by replication of same models, however they used different econometric methods and distinct data for the validation of monopolistic economic model. The results successfully replicated of the earlier results ( Hummels & Levinsohn, 1995). Conclusion Since ancient days, international trade has been defined as the exchange of products, services as well as capital. Today, this trade has become a vital part of world economy. The theories that have been studied in this paper are real and play a vital role in international trade (Morrow, 2010). However, all of them have some limitations as the situation in international trade is fluid and there are many variables that can change the outcome. Nevertheless, these theories fit in as they are fundamental to the topic (Morrow, 2010). Works Cited Baldwin, R.E.( 2008), The Development and Testing of Heckscher-Ohlin Trade Models: A Review (Ohlin Lectures). Edition. The MIT Press. Blaug, M. 1992. The Methodology of Economics, Or. How Economists Explain, Cambrige Surveys of Economic Literature, Cambridge University Press. Deardorff, A. V. (2005), How Robust is Comparative Advantage?. Review of International Economics, 13: 1004–1016. doi: 10.1111/j.1467-9396.2005.00552.x Helpman, Elhanan, (1987), "Imperfect Competition and International Trade: Evidence from Fourteen Industrial Countries," Journal of the Japanese and International Economies, I 2-81. Hummels, D, & Levinsohn J., (1995), Monopolistic Competition and International Trade: Reconsidering the Evidence, The Quarterly Journal of Economics,, [ONLINE], 110(3), 799-836 Available: http://web.econ.ku.dk/Nguyen/teaching/hummels%20levinsohn%201995.pdf, [ Accessed : 21 June, 2015]. Hastings, E.C. 1962. The theory of Monopolistic Competition: A Re-orientation of the theory of value, 8th Edition. Harvard University Press. Jones, R. W, (2014), “Protection and Real Wages”: The History of an Idea”, [ONILNE] Available at: http://www.econ.rochester.edu/people/jones/Protection_and_Real_Wages.pdf [Accessed on 20 Jun, 2015]. Krugman, P. 2011. International Economics: Theory and Policy, 9th Edition, Addison Wesley Krugman, P.R.(1987), Is Free Trade Passe? The Journal of Economic Perspectives, [ONLINE], 1(2), 133-144, Available at http://www.jstor.org/stable/1942985, [Accessed 21 June, 2015]. McDougall, G. D. A. (1951). "British and American exports: A study suggested by the theory of comparative costs. Part I.". The Economic Journal. 61(244). pp. 697–724 Maneschi, A. 1999. Comparative Advantage in International Trade: A Historical Perspectives, Edition. Edward Elgar Pub Morrow, P. 2010. Richardian- Heckscher-Ohlin Comparative Advantage: Theory and Evidence [ONLINE], Available at http://www.economics.utoronto.ca/morrow/morrow_rho_Aug2010.pd [Accessed 09 June, 15]. Ricardo, D. (2004), The Principles of Political Economy and Taxation, Edition, Dover Publications. Stolper, W.F,& Samuelson, P.A. (1941), Protection and real wages, The Review of Economic Studeis Ltd., 9(1), pp. 58-73) Suranovic, S. (2010), International Trade: Theory and Policy. Edition, Flat World Knowledge, Inc. Read More