Overview --------------------------------------------------------------------------------- 3 Free Trade versus Interventionist Theories ----------------------------------------- 3 Classical Country-Based Trade Theories --------------------------------------------- 4 Extensions of the Ricardian Model ---------------------------------------------------- 7 The Leontief Paradox ------------------------------------------------------------------- 7 Which Trade Theory Is Dominant Today? ------------------------------------------- 8
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TITLE: INTERNATIONAL TRADE AND INVESTMENT THEORIES
Learning Objectives In this lesson, the learners will be able to: a. Understand international trade. b. Compare and contrast different trade theories. c. Determine which international trade theory is most relevant today and how it continues to evolve.
Learning Activities Read and comprehend the whole concept.
Overview Trade is a voluntary exchange of goods, services, assets, or money between one person or organization and another. Free trade refers to a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country Comparative advantage superior features of a country that provide it with unique benefits in global competition – derived from either national endowments or deliberate national policies. In addition, it is the concept that helps answer the question of all nations can gain and sustain national economic superiority. Mercantilism is an economic theory that advocates government regulation of international trade to generate wealth and strengthen national power. Merchants and the government work together to reduce the trade deficit and create a trade surplus. International trade theories are various theories that analyze and explain the patterns of international trade. These theories explain the mechanism of international trade that is how countries exchange goods and services with each other.
Free Trade versus Interventionist Theories
Smith, Ricardo and Heckscher-Ohlin show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself. International trade allows a country: to specialize in the manufacture and export of products that it can produce efficiently import products that can be produced more efficiently in other countries Smith, Ricardo, and Heckscher-Ohlin promote unrestricted free trade.
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Classical Country-Based Trade Theories A. Mercantilism Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop an economic theory. This theory stated that a country’s wealth was determined by the amount of its gold and silver holdings. In its simplest sense, mercantilists believed that a country should increase its holdings of gold and silver by promoting exports and discouraging imports. Mercantilism suggests that it is in a country’s best interest to maintain a trade surplus -- to export more than it imports. Mercantilism advocates government intervention to achieve a surplus in the balance of trade. It views trade as a zero-sum game - one in which a gain by one country results in a loss by another.
B. Absolute Advantage In 1776, Adam Smith offered a new trade theory called absolute advantage, which focused on the ability of a country to produce a good more efficiently than another nation. Smith reasoned that trade between countries shouldn’t be regulated or restricted by government policy or intervention. He stated that trade should flow naturally according to market forces. Smith attacked the mercantilist assumption that trade is a zero-sum game and argued that countries differ in their ability to produce goods efficiently, and that a country has an absolute advantage in the production of a product when it is more efficient than any other country in producing it. According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods produced by other countries. Smith’s theory reasoned that with increased efficiencies, people in both countries would benefit and trade should be encouraged. His theory stated that a nation’s wealth shouldn’t be judged by how much gold and silver it had but rather by the living standards of its people.
Absolute Advantage Assumption
Assume that two countries, Ghana and South Korea, both have 200 units of resources that could either be used to produce rice or cocoa In Ghana, it takes 10 units of resources to produce one ton of cocoa and 20 units of resources to produce one ton of rice So, Ghana could produce 20 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of rice and cocoa between the two extremes In South Korea it takes 40 units of resources to produce one ton of cocoa and 10 resources to produce one ton of rice So, South Korea could produce 5 tons of cocoa and no rice, 20 tons of rice and no cocoa, or some combination in between Ghana has an absolute advantage in the production of cocoa South Korea has an absolute advantage in the production of rice
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Absolute Advantage Without trade: Ghana would produce 10 tons of cocoa and 5 tons of rice South Korea would produce 10 tons of rice and 2.5 tons of cocoa If each country specializes in the product in which it has an absolute advantage and trades for the other product: Ghana would produce 20 tons of cocoa South Korea would produce 20 tons of rice Ghana could trade 6 tons of cocoa to South Korea for 6 tons of rice After trade: Ghana would have 14 tons of cocoa left, and 6 tons of rice South Korea would have 14 tons of rice left and 6 tons of cocoa Both countries gained from trade
C. Comparative Advantage David Ricardo, an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned that even if Country A had the absolute advantage in the production of both products, specialization and trade could still occur between two countries. Comparative advantage occurs when a country cannot produce a product more efficiently than the other country; however, it can produce that product better and more efficiently than it does other goods. The difference between these two theories is subtle. Comparative advantage focuses on the relative productivity differences, whereas absolute advantage looks at the absolute productivity. Ricardo’s theory of comparative advantage suggests that countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries, even if this means buying goods from other countries that they could produce more efficiently at home.
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Comparative Advantage Assumption Assume: Ghana is more efficient in the production of both cocoa and rice In Ghana, it takes 10 resources to produce one tone of cocoa, and 13 1/3 resources to produce one ton of rice So, Ghana could produce 20 tons of cocoa and no rice, 15 tons of rice and no cocoa, or some combination of the two In South Korea, it takes 40 resources to produce one ton of cocoa and 20 resources to produce one ton of rice So, South Korea could produce 5 tons of cocoa and no rice, 10 tons of rice and no cocoa, or some combination of the two With trade: Ghana could export 4 tons of cocoa to South Korea in exchange for 4 tons of rice Ghana will still have 11 tons of cocoa, and 4 additional tons of rice South Korea still has 6 tons of rice and 4 tons of cocoa If each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain Comparative advantage theory provides a strong rationale for encouraging free trade
Qualifications and Assumptions
The simple example of comparative advantage assumes: only two countries and two goods zero transportation costs similar prices and values resources are mobile between goods within countries, but not across countries constant returns to scale fixed stocks of resources no effects on income distribution within countries
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D. Theories Explaining Trade Patterns: Heckscher-Ohlin Theory Heckscher and Ohlin made 2 basic observations: 1. Factor endowments (or types of resources) vary among countries Based on these observations, Heckscher-Ohlin theorized that a country will have a comparative advantage in producing products that intensively use resources (factors of production) it has in abundance.
2. Goods differ according to the types of factors that are used to produce them. The Heckscher-Ohlin theory predicts that countries will export goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce. In the early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on how a country could gain comparative advantage by producing products that utilized factors that were in abundance in the country. Their theory is based on a country’s production factors—land, labor, and capital, which provide the funds for investment in plants and equipment. They determined that the cost of any factor or resource was a function of supply and demand. Factors that were in great supply relative to demand would be cheaper; factors in great demand relative to supply would be more expensive. Their theory, also called the factor proportions theory, stated that countries would produce and export goods that required resources or factors that were in great supply and, therefore, cheaper production factors. In contrast, countries would import goods that required resources that were in short supply, but higher demand.
Extensions of the Ricardian Model
Resources do not always move freely from one economic activity to another, and job losses may occur Unrestricted free trade is beneficial, but because of diminishing returns, the gains may not be as great as the simple model would suggest Opening a country to trade: might increase a country's stock of resources as increased supplies become available from abroad might increase the efficiency of resource utilization, and free up resources for other uses might increase economic growth
The Leontief Paradox
In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US economy closely and noted that the United States was abundant in capital and, therefore, should export more capital-intensive goods. However, his research using actual data showed the opposite: the United States was importing more capital-intensive goods. According to the factor proportions theory, the United States should have been importing labor-intensive goods, but instead it was actually exporting them. His
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analysis became known as the Leontief Paradox because it was the reverse of what was expected by the factor proportions theory. Which Trade Theory Is Dominant Today? The theories covered in this chapter are simply that—theories. While they have helped economists, governments, and businesses better understand international trade and how to promote, regulate, and manage it, these theories are occasionally contradicted by real-world events. Countries don’t have absolute advantages in many areas of production or services and, in fact, the factors of production aren’t neatly distributed between countries. Some countries have a disproportionate benefit of some factors. The United States has ample arable land that can be used for a wide range of agricultural products. It also has extensive access to capital. While its labor pool may not be the cheapest, it is among the best educated in the world. These advantages in the factors of production have helped the United States become the largest and richest economy in the world. Nevertheless, the United States also imports a vast amount of goods and services, as US consumers use their wealth to purchase what they need and want—much of which is now manufactured in other countries that have sought to create their own comparative advantages through cheap labor, land, or production costs. As a result, it’s not clear that any one theory is dominant around the world. This section has sought to highlight the basics of international trade theory to enable you to understand the realities that face global businesses. In practice, governments and companies use a combination of these theories to both interpret trends and develop strategy. Just as these theories have evolved over the past five hundred years, they will continue to change and adapt as new factors impact international trade.
ACTIVITY: Instructions: Answer the following questions below. Write your answers in a sheet of paper. 1. Enumerate the six theories in international trade and its meaning. 2. Describe how a business may use the trade theories to develop its business strategies. 3. Why trade plays a significant role in the world of business. 4. Cite some advantages and disadvantages in trade.
