SUBJECT- BUSINESS ECONOMICS

Name: Slery Richard Dbritto

Roll No. HTBC0226
Div: B
Class: T.Y. Bcom
Topic: Theories of International Trade
CONTENTS
1. Introduction

2. Research Methods

3. Findings

a. Traditional Theories of international trade

b. Factor Endownment model of trade

c. New trade theory

d. Trade theory for 21st Century

e. Effect of trade on growth

4. Conclusions

INTRODUCTION
One of the traps people often fall into in the area of economics, particularly when it comes to

global economics, is thinking that history always moves in one direction, i.e., the world is getting

more global. But, when we look at history, we find out that international trade has been a story

of ups and downs. It is often assumed that globalization is a new phenomenon and that until

recently, there was very little trade between different parts of the world. It turns out, however,

that there was a tremendous amount of trade between countries even on opposite sides of the
world. People in England, for example, regularly ate lamb and mutton raised in New Zealand.

That globalized economy crashed between World War I and World War II, as restrictions and

wars made trade dangerous. By 1950, the increases in tariffs and import quotas reduced global

trade volume to levels equal to those before the revolution of steamships and railroads. Slowly,

nations began reducing those restrictions. By 1980, trade had recovered to roughly the level it

was in 1913, just before the outbreak of World War I. After the 1990s, trade picked up the pace

as seen in the era of hyper-globalization. These up-downs in the history of international trade

also impacted the various explanations provided till now, explaining the pattern and reason of

trade. This article gives a gist of literature from traditional theories to new trade theories. While

providing details of theories in trade literature through no. of coming sections, this essay

concludes with an account of theories that explain the pattern of trade in the 21st century.

RESEARCH METHODS

This section presents the methodological framework of the study. The theoretical review is

based on available literature on classical as well as modern world trade theories and practices.

The nature of this research is descriptive cum-critical interpretation of trade theories.

Interpretative and descriptive method was used for the present write-up. Further, an analysis of

these theories was done based on merits and demerits and how one theory has advancement over

other theories. This research tells us about the journey of the development of international trade

theories and explained (on what ground) how one theory is different from others.

FINDINGS

International trade theories are simply different theories to explain international trade. Trade is

the concept of exchanging goods and services between two or more countries. Here I have
discussed about traditional trade theories, factor endowment theories, new trade theories,

intra-industry trade, role of technology and FDI, effect of trade on growth, and trade theories in

twenty first century. The detailed interpretation is given in sub-sections as follows:

A. Traditional Theories of International Trade

Looking at the evolution of international trade and theories, we found the origin of trade theories

from Mercantilists, often left out of literature. Mercantilists' work style states a lot about their

theory in practice. Coming from the 17th century, they believed that the best thing to do was

export and avoid import which would give them more bullion, which is the sole measure of gain

and welfare. This implicitly implies that trade was based on a framework of protectionist policies

(Braudel, 1979; McCusker, 2001). The eighteenth-century economists, called ‘physiocrats’

analysed the ‘circular flow of wealth’ in an economy in an aggregative framework. Francois

Quesnay’s Tableau Economique (1758) is regarded as one of the most remarkable

macroeconomic models of the early days. This concept was developed in France and

characterized chiefly by a belief that government policy should not interfere with the

operation of natural economic laws and that land is the source of all wealth. Physiocrats

attacked on mercantilists not only for its mass of economic regulations but also for its emphasis

on manufacturers and foreign trade. Whereas mercantilists held that each nation must

regulate trade and manufacturer to increase its wealth and power, the physiocrats contended

that labour and commerce should be free from all restraints (Charbit & Arundhati, 2002;

Muller, 1978). With the Industrial Revolution, new theories witnessed a major change over

mercantilism and Physiocrats in economic literature. Adam Smith’s publication of Wealth

of Nations (1776) marked the evolution of standardized trade theories. Each country makes the

goods in which it has an absolute advantage over others, which comes from a division of labor
as explained by pin factory, diverted from the view of ‘only export’ with attention drawn to

import. The domestic economy being the source of wealth, the purpose of trade was to export

more so that more could be imported, raising overall welfare. Further development came from

the theory of comparative advantage in David Ricardo’s “On the Principles of Political Economy

and Taxation” (1817). As explained through the famous example of England and Portugal

trading wine and cloth, it was not an absolute advantage but the comparative advantage which

was necessary as well as sufficient condition for trade. According to him, a country has the

comparative advantage in producing a good if the opportunity cost of producing that good in

terms of other good is lower in that country than it is in other country. Hence, trade would be

beneficial for both the trading countries. Smith and Ricardo introduced the notion of using

simplified models for understanding economic issues on trade; they both made a case for free

trade, as opposed to the existing Mercantilist theories of protection. It was proposed that letting

the trade flow, it would make everybody richer. Interestingly, Ricardo neglected to include

aspects of income distribution in his theory. Ricardo knew that if England opened to free trade, it

would benefit the workers who worked in England’s cloth industry but hurt the aristocrats who

owned most of England’s agricultural land. But still, his theories are powerful and

excellent at explaining why trade occurs between countries that specialize in very different types

of products.

B. Factor Endowment Model of Trade

Developed by Heckscher and Ohlin and later Samuelson, (in short, HOS) is two countries, two

commodities, and two factors of the production model, assuming constant returns to scale.

This model has brought factor endowments of the countries to the center of trade theories. By

linking trade patterns to factor endowments and production methods, trade theory has
driven apart from technology-based interpretations of the Ricardian comparative cost model.

The Ricardian model states that countries specialize in goods in which they hold the greatest

relative advantage. The Heckscher-Ohlin model ignores differences in total factor

productivity across industries, and it is assumed that all countries possess the same technology

in a given industry. It predicts that countries will produce relatively more of the goods that use

their relatively abundant factors intensively (Clifton & Marxsen, 1974). With the

assumption of the same preferences across countries, factor endowments of different nations

along with factor intensities of commodities was responsible for setting up the price of

commodities. For example, if country A has a capital abundance and produces capital goods

intensive good X, then the price of good X will be lower compared to other countries. From the

theorem of factor-price equalization of this model, we get to know that as factors are immobile

across countries, trade through the commodity price equalization also leads to the factor price

equalization of countries. A corollary to this theorem relates to protection and real wages. It

stated that under the doctrine of free and factor price equalization trade, scarce factors of trading

nations end up losing more. In other words, capital, considered a scarce factor, will benefit more

from protection than free trade under this model. Despite the wider uses of this model in trade

policies, very little empirical evidence supports this model. This model's assumptions failed to

cope with the realities of the world. Even with the trade, there is no evidence of prices getting

equalized across countries. Leontief's paradox indicated that most of the trade happens between

similar countries. US import substitute goods consisted of capital-intensive goods, while

exports were labor-intensive. After this, various explanations have been given, citing the skilled

labor force of the US, which is in demand compared to its trading partners.

C. New Trade Theory

There was a kind of undercurrent of discontent among people who have worked with trade data.

Traditional theories were insightful but did not provide a complete picture of the trade patterns

observed between countries. A lot of trade was between similar economies, for example, trade

between US & EU, US-Canada trade makes for the case. This led to the rise of new trade

theories, in which trade was driven not only by inherent differences in productivity but also by

the fact that economies of scale favored concentrating production in one place. Increasing

returns internal to firms gave rise to monopoly/oligopoly market structure, which inherently

led to product differentiation. With all these changes mentioned above, the new trade theory

deviates from the critical assumptions of constant return, perfect competition, and homogenous

goods, which were the founding stone of the Ricardian and HOS model (Shiozawa, 2017;

Ranjan, & Raychaudhuri, 2016). With the rise of oligopolistic markets, theories on strategic

trade were also highlighted, drawing the attention of policymakers of advanced countries.

The literature draws a line of difference between national and international economies of

scale. These are further classified into internal and external to a firm. For internal economies at

an international level, the production achieves a global span in terms of location. The emergence

of global value chains ensures the dislocating of production to cost-efficient countries. Increasing

returns to scale has also been seen as a time factor with static and dynamic economies of scale

classifications. So, it is not the current economies of scale. Still, those arising from the process

of learning by doing should also be considered for deciding the industry for specialization and

framing of trade policies by countries (Kenneth Arrow,1956). The major problem that cornered

the new trade theory was the predictive power of the pattern of trade by traditional theories.

Possibilities of multiple equilibria due to increasing returns and strategic patterns adopted by

firms were disruptive in predicting the pattern of trade by new trade theories. Thus, trade can
either result in benefits or a loss, with economies of scale for nations depending on their ability

to reap economies. If a country is stuck with the small market of increasing returns goods, then

there is a high probability of incurring a loss from trade.

D. Trade Theories for the 21st Century

Going through the above models, it is apparent that the new trade theory calls for free trade but

with a few steps of caution. Abuse of power by developed nations has resulted in two different

approaches to trade policies. With developing nations forced to follow the traditional suite of

free trade doctrine through bilateral trade negotiations and multilateral institutions, developed

nations' police are centered on strategic trade. The current economic paradigm's ability to

maintain the inequality gap has supported the asymmetrical combination of policies. This

combination of policies determines trade in the modern world. Your position in the world

makes you fall in either group, forcing you to pursue the respected trade policies. Current models

have used simplified notions to understand this dynamic process in a complex world. We

now need to introduce more realistic models, embedding the issues of political strategies,

macroeconomic view, inequality, etc., in the trade theories.

Effect of Trade on Growth

In both the traditional and new trade theory, the effect of trade on growth did not find any space.

Work in this field was first given by J. R. Hicks, which states that even in the HOS world, due to

different income elasticities of goods in countries, income growth can differ from output growth.

Assuming a technology stimulus, which causes a parallel outward shift of PPC, i.e., the same

increase in exports and imports leads to increased income in the economy. In this case, an

increase in income can be more and less than output depending on the different income
elasticities for exportable and importable. This work was extended by Bhagwati (1958) in

“Immiserizing Growth” model, which explained how technology growth in exportable goods and

lower-income elasticities of exportable goods could negatively impact the terms of trade. In

this scenario, income growth is less than output growth, and income is absolutely less

because of decreased prices. Thus, under this model, technological progress has shifted the terms

of trade against your country. Prebisch and Singer's hypothesis provided a further breakthrough

in this field. Their hypothesis states that there exists a long-run tendency for terms of trade of

primary commodities to deteriorate. It has been observed that countries exporting primary

commodities have seen a decline in their terms of trade. This is consistent with the argument

that global supply is not fixed, and when some resource becomes scarce, its substitute becomes

available in the market. It is the contribution of policies of agriculture protectionism followed by

countries advocating free trade and the decline in demand for intermediate/ primary goods by

developed countries from developing countries that has led to the underdevelopment of

these countries

CONCLUSION

Countries engage in international trade for two basic reasons, each of which contributes to

their gains from trade. Because each country is different from other countries in terms of factor

endowments, technology, geography, natural resources, and human capital and they want to

achieve economies of scale in production (Krugman & Obstfeld, 2003). Hence, trade take place

among the countries. According to classical trade theories, Ricardo knew that if England

opened to free trade, it would benefit the workers who worked in England’s cloth industry

but hurt the aristocrats who owned most of England’s agricultural land. But still, his theories

are powerful and excellent at explaining why trade occurs between countries that specialize
in very different types of products. Heckscher-Ohlin model has widely used in trade policies,

but very little empirical evidence supports this model. This model's assumptions failed to cope

with the realities of the world. Even with the trade, there is no evidence of prices getting

equalized across countries. Leontief's paradox indicated that most of the trade happens

between similar countries. US import substitute goods consisted of capital-intensive goods,

while exports were labor-intensive. After this, various explanations have been given, citing

the skilled labor force of the US, which is in demand compared to its trading partners.

In twenty first century, we now need to introduce more realistic models, embedding the issues

of political strategies, macroeconomic view, inequality, etc., in the trade theories. There is a

major discord between WTO members on issues relating to data flows and data

localization. (Nivedita, 2018). The basis of trade entirely based on the purpose of trade and

economic efficiency of nation in terms of demand and supply. But the comparative cost

theory of international trade is still unchallenged and valid for almost all kinds of

circumstances among trading nations.