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Theory of International Trade

Abstract

International trade theory is based on comparative and specialization theory. The gains accruing from international trade are incentives to international trade. The Ricardo theory and Heckscher-Ohlin model explains the theory surrounding the international theory. This paper discusses on this theory and free trade concept.

            Trade cross borders of certain country may be accompanied by gains to the countries involved. Various theories have been put forward to explain the international trade, the gains, its effect on income distribution, and trade policies employed in international trade. These theories includes the Ricardo theory and Hecscher-Ohlin model

Heckscher-Ohlin model

The Heckscher-Ohlin is based on specialization from differences in endowment of resources. The theory is based on the assumption that:

1        Different countries are differently endowed with resources. The theory assumes two factors and two commodities. This assumption is meant to simplify the model in explaining the international trade. In real situation, international trade is usually between more than two countries, factors of production are more than two and commodities traded are more than two.

2        The two factors are capital and labor. Assumes two commodities X and Y, Y is capital intensive while X is labor intensive. This means that the theory assumes that, Y requires relatively more

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capital to produce in countries A and B. This is to say, the capital labor ratio (k/l) is higher for production of commodity Y as compared to commodity X in country A and B which are assumed to be at the same relative factor prices. On the other hand the labor capital ratio l/k of producing commodity X is relatively high in country A and B as compared to commodity Y.

3        The theory also assumes a production faced by constant to return to scale. This means that production of commodities Y and X faces a constant return to scale. Although in the real situation production may be in three stages, diminishing return to scale, increasing return to scale and constant return to scale, this assumption help in clearly understanding gains and specialization in international trade. In this assumption the constant return to scale means that,  units of labor and capital used in production process will increase the production (output) by the same amount as the proceeding production factors( capital and labor) units used. To elaborate on this point, assume country A increases capital and labor used say by 20% in production of commodity Y, then, the output should increase by 20%. Doubling of the amount of factors of production (capital and labor), should result into doubling of output.

4                    The theory also assumes that the specialization in both nations, A and B, is          incomplete.  This means that both countries produce both commodities despite         the opportunity for free trade. Non the countries is ‘too small’

5                    The theory assumes equal tastes in both countries. The demand preferences derived from indifference curves of both countries are identical. This means that given equal relative commodity prices in A and B, the consumption of X and Y in both countries will be of the same proportion.

6                    The theory also assumes perfect competition both in factor and commodity markets. The means that, economic agents (household and firms) have no power to dictate the prices of Y and X, capital and labor in country A and B.  The prices are determined by forces of demand and supply. The price of commodity X and Y equals the cost of factors of production (with implicit costs included) used to produce it in the long run.  There is also perfect knowledge of prices of commodities and the rewards to factors of production in both nations

7                    The theory assumes that hindrance of free trade such as tariffs, transportation costs do not exist. A and B will specialize until relative commodity prices are equal.

8                    There is perfect factor mobility within the country but factor mobility between the two countries

9                    Assumption that resources are fully employed

10                Balanced international trade between the two countries.

The practical case of H-O model

            Given two countries, Kenya and Uganda, and that the production of two commodities, tea and maize in both countries. Kenya can produce tea at a less cost and thus has a comparative advantage. Uganda has comparative advantage in production of maize. However these two countries will produce two commodities but international trade will take place between the two countries. Kenya will export more tea to Uganda while importing maize from Uganda. On the other hand, Uganda will produce more of maize export some to Kenya and finance tea imports from Kenya.

Ricardo theory of international trade:

The assumptions:

            Theory assumes two commodities and two countries; Free trade where products and commodities market are perfect;  Labor is perfectly mobile within the nation but immobile internationally;  Constant return to scale;  no change in technology;  no costs in transport

Practical case of Ricardo theory

            Given two countries  United States and Kenya, that United states  has a comparative advantage in production of two commodities,  flowers  and  machineries, but greater comparative advantage in production of machineries is obtained in United States as compared to Kenya , and that Kenya has a both comparative disadvantage in production of both commodities, but less comparative disadvantage in production of  flowers, United States will specialize in production of the machineries in which greater comparative advantage is obtained and import the other flowers from Kenya.  On the other hand, Kenya will specialize in production of flowers and import machineries from United States. The production of machineries in United States will increase since all factors of production will be used in production of this commodity. At the same time production of flowers will increase in Kenya since all factors of production will be used in flowers production.  The total production will increase and each country will import the commodity which it is not producing at low cost. The technological innovations achieved in specialization process will lead to more gains from international trade.

The differences between the presentations of international trade by Heckscher-Ohlin

(H-O) and Ricardo theory is that,  the HO model assumes that the production of both commodities occur in both countries while the Ricardo model assumes that each country produces a one commodity where comparative advantage is great or comparative disadvantage is less, and import the other commodity from the other country.

Factors hindering the implementation of free trade

Various arguments have been put forward against free trade

This includes: protection of infant domestic industries. Free trade encourages the influx of cheap high quality commodities which poses stiff competition on domestic industries. Growing industries are therefore threatened and this discourage the implementation of frees trade: Unfavorable terms of trade; free trade may lead to imbalances in terms of trade especially between a stronger economy and a less strong economy. The less strong economy will tend to be reluctant in implementing free trade: The strategic trade policy has also hindered free trade. Government may subsidize the production of domestic companies to discourage competition from foreign companies on markets characterized by imperfect markets (Roberta Piermartini. n.d)

Reference

Roberta Piermartini. (nd).The WTO: Economic Underpinnings. World Trade       Organization.  Retrieved on 6 April 2010, from        <http://www.swisslearn.org/wto/module4/e/start.htm>

 

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