ECONOMIC BASIS FOR TRADE

Distribution of Economic Resources Different Technologies and/or Resources Goods are Differentiated as to Quality and other Non-price Attributes Labor-Intensive Goods Land-Intensive Goods

The Economic Basis for Trade

Why do Nations Trade? TRADE ALLOWS nations to consume beyond their maximum domestic production possibility curve. There is an uneven distribution of natural, human and capital resources among nations. Therefore different countries have comparative advantages (NOT absolute) on different products. Efficient production of various goods requires different technologies and combinations of resources. Thus it may be more efficient if countries specialize. Products are differentiated as to quality and nonprice attributes (eg. French wine as opposed to Californian wine). People may prefer imported goods rather than domestic manufactured goods.

Labor Intensive Goods: Goods that require a large amount of people in the labor force to produce. eg. electronics like digital cameras, video game players, DVD players, which require skilled labor (Japan) Land Intensive Goods: Goods that require a large amount of land to produce. eg. crop or harvested goods like coffee, wheat, wool, and meat (Brazil) Capital Intensive Goods: Goods that require a sufficient level of technology to produce. eg. automobiles, agricultural equipment, machinery, and chemicals (Germany, USA) Regardless of labor, land, or capital intesity in a nation, any nation may have a niche in trading certain products based on the unique qualities of those products. Thus, by allowing specialization to occur through trade, in which countries produce goods according to their resource avaliability, each trading country can acquire more goods and services. The distributions, technology, and product distinctiveness can change. As changes occur, the relative efficiency with which a nation can produce specific goods will also change.

Propagated in the 16th and 17th centuries, mercantilism advocated that countries should simultaneously encourage exports and discourage imports. Adam Smiths theory of absolute advantage. Proposed in 1776, Smiths theory was the first to explain why unrestricted free trade is beneficial to a country. Smith argued that the invisible hand of the market mechanism, rather than govt. policy should determine what a country imports and what it exports. Laissez-faire stance is the best for the country. Building on Smiths work there are two additional theoriesone is the theory of comparative advantage, advanced by the 19th century English economist David Ricardo.

Theories of International Trade

Adam Smiths Theory of Absolute Advantage

According to A. Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these for goods produced by other countries. Smith demonstrates that, by specializing in the production of goods in which each has an absolute advantage, both country benefits by engaging in trade. Consider the effects of trade between Ghana and South Korea. Lets assume that both countries have 200 units of resources to produce Rice and Cocoa. Ghana takes 10 resources to produce 1 ton of cocoa ( 20 tons of cocoa and no rice) and 20 resources to produce 1 ton of rice( 10 tons of rice and no cocoa). The different combinations of Ghanas production capacity is shown in the Production Possibility Frontier (PPF) GG.

Similarly, South Korea takes 40 resources to produce 1 ton of cocoa ( 5 tons of cocoa and no rice) and 10 resources to produce 1 ton of rice( 20 tons of rice and no cocoa). The different combinations of South Koreas production capacity is shown in the Production Possibility Frontier (PPF) KK. 20 G Ghana has an absolute advantage 15 in the production of Cocoa whereas A South Korea has an advantage 10 with regard to rice production. 05 K G

Cocoa

2.5 0 5 10

K 15 20

Rice

 Now in a new situation neither country trades with each other. Each country devotes half of its resources to the production of rice and half to the production of cocoa. Each country must consume what it produces. Ghana would be able to produce 10 tons of cocoa and 5 tons of rice while South Korea would be able to produce 10 tons of rice and 2.5 tons of cocoa as shown in the earlier diagram. Without trade, the combined production of both the countries would be 12.5 tons of cocoa and 15 tons of rice. If each country were to specialize in producing the good for which it had an absolute advantage and then trade with the other for the good it lacks, Ghana could produce 20 tons of cocoa, and South Korea could produce 20 tons of rice. Thus by specializing both the counties would benefit.

Resources Required to Produce 1 Ton of Cocoa and Rice Cocoa Ghana 10 20 South Korea 40 10 Production and Consumption without Trade Cocoa Rice Ghana 10 5 South Korea 2.5 10 Total Production 12.5 15= 27.5 Production with Specialization Cocoa Rice Ghana 20 0 South Korea 0 20 Total Production 20 20= 40

Rice

David Ricardos Theory of Comparative Advantage

David Ricardo took Adam Smiths theory one step further by exploring what might happen when one country has an absolute advantage in the production of both the goods. According to Ricardos theory of comparative advantage, it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself. Lets assume Ghana is more efficient in the production of both cocoa and rice; that is Ghana has an absolute advantage in the production of both products. Both countries have 200 units of resources to produce Rice and Cocoa. Ghana takes 10 resources to produce 1 ton of cocoa ( 20 tons of cocoa and no rice) and 13.3 resources to produce 1 ton of rice( 15 tons of rice and no cocoa).

The different combinations of Ghanas production capacity is shown in the Production Possibility Frontier (PPF) GG. Similarly, South Korea takes 40 resources to produce 1 ton of cocoa ( 5 tons of cocoa and no rice) and 20 resources to produce 1 ton of rice( 10 tons of rice and no cocoa). The different combinations of South Koreas production capacity is shown in the Production 20 G Possibility Frontier (PPF) KK.
15 10 05 2.5 0 K B K G 15 C A

Cocoa

3.75 0.5 7.5 10

Rice

 Now without trade, Ghana will produce 10 tons of cocoa and 7.5 tons of rice ( point A in the figure), while South Korea will produce 2.5 tons of cocoa and 5 tons of rice ( point B in the figure). In light of Ghanas absolute advantage in the production of both the goods, why should it trade with South Korea? Although Ghana has an absolute advantage in the production of both cocoa and rice, it has comparative advantage only in the production of cocoa. Ghana can produce 4 times as much cocoa as South Korea, but only 1.5 times as much rice. Ghana is comparatively more efficient at producing cocoa than it is at producing rice. Without trade the combined production of cocoa will be 12.5 ( 10 tons in Ghana and 2.5 in South Korea), and the combined production of rice will also be 12.5 tons (7.5 tons in Ghana and 5 tons in South Korea). Without trade each country must consume what it produces. By engaging in trade, the two countries can increase their combined production of rice and cocoa, and consumers in both nations can consume more of both goods.

Resources Required to Produce 1 Ton of Cocoa and Rice Cocoa Ghana 10 13.33 South Korea 40 20 Production and Consumption without Trade Cocoa Rice Ghana 10 7.5 South Korea 2.5 5 Total Production 12.5 12.5= 25 Production with Specialization Cocoa Rice Ghana 15 3.75 South Korea 0 10 Total Production 15 13.75= 28.75

Rice

Adam Smith in the Wealth of Nations (1776) 1. asserted that trade should be free and nations should specialize in what they could do best so that they could become wealthy and powerful.

2. assumed that international trade was based on absolute advantage that is, on an exporter with a given amount of resources being able to produce a greater output at less cost than any competitor. Such absolute advantage had historically been the basis of international trade and this is still the case in many commodities.

David Ricardo in his Principles of Political Economy and Taxation (1817) demonstrated that international trade is mutually beneficial if it is based on comparative advantage or cost He demonstrated that the flow of trade among countries is determined by the relative costs of the goods produced The international division of labor is based on comparative costs and that countries will tend to specialize in those commodities whose costs are comparatively lowest Specialization in those goods with the lowest comparative costs, while leaving the production of other commodities to other countries, enables all countries to gain more from exchange (international trade is not a zero-sum game but a positive-sum game).

Heckscher-Ohlin Trade Theory

This theory almost completely replaced the classical and neo-classical theories related to international trade. Heckscher-Ohlin have traced the cause of cost differences between countries to relative factor endowments and relative factor intensities. That is why this theory is also known as factor proportions-factor intensity theory. According to this theory, countries which are rich in labour will export labour intensive goods and those rich in capital will export capital intensive goods. ASSUMPTIONS OF THE HECKSCHER-OHLIN THEORY 1. This theory considers a two-country, two commodity and two factor case. 2. The factors of production are perfectly mobile within their respective countries but they are immobile between the countries. 3. There is a state of perfect competition both in the product and factor markets.

4. There is full employment of the factors of production in both the countries. 5. Production functions pertaining to both the commodities are linearly homogeneous. That is constant returns to scale prevails. 6. The techniques of production in both the countries remain unchanged. 7. The taste and preferences therefore the demand remains constant 8. There is absence of transportation costs between countries. Factor Endowments: The term relative factor abundance in H-O model have two different conceptions-(i) the physical criterion of relative factor abundance, and (ii) the price criterion of relative factor abundance. (i) the physical criterion of relative factor abundance: According to this criterion, a country is said to physically relative capital abundant. H-O lays down that country A will produce capital intensive commodity (machines) and country B will have a bias in producing labour intensive commodity (cloth). If both the countries produce machines and cloth in the same proportion and production occurs along OR, the country A would be producing at C and country B at D. The points C and D lie on the respective PPCs PQ and P1Q1 of these two countries.

Since at point C, the slope of country As PPC is more steep than the slope of the PPC of country B at D, this implies that P MC of producing cloth in country A is higher then the MC of producing cloth in Country B. So if the production takes T P1 place at points C and D, machines can be Produced more cheaply in country A and Cloth can be produced more cheaply in O B country.
MACHINES

C D T1 S1 Q CLOTH Q1

Since country A is capital abundant and the production of machines is capital-intensive, country A will tend to extend the production of machines. Country B, at the same time being labour abundant, will tend to extend the production of cloth which is relatively labour intensive.

In this figure, the opportunity cost curves A4 A3 PQ and P1Q1 indicate that country A is A2 Capital abundant and country B is labour S A1 P abundant. The pattern of demand is different B4 C B3 B2 In the two countries. The community ICs S1 B1 T A1, A2, and A3 indicate demand pattern P1 in country A and ICs B1,B2 and B3 indicate the D T1 demand pattern in country B. The iso-revenue curve SS1 related to country O Q Q1 A is steeper than the iso-revenue curve TT1, CLOTH for country B. Thus it indicates that machines are costly in country A while cloth is costly in country B. Therefore, country A may decide to export cloth and country B may export machines. So the pattern of demand may off-set the H-O generalization that capital abundant country will export capital intensive commodity and vice versa.
MACHINES

(ii) the price criterion of relative factor abundance:- This criterion lays down that a country having capital relatively cheap and labor relatively costly is capital abundant and vice-versa. Suppose country A is capital rich A and labour-scarce, the interest rate will be relatively low and wage R K rates are relatively higher when compared with interest rates and M A1 wage rates in country B. Therefore, S1 country A will decide to produce C K1 and export capital-intensive L B L1 B1 commodity (say machine) and LABOUR import labour-intensive commodity (say cloth). This is presented through the graph.
CAPITAL

AB is the factor price line for country A and A1B1 it is the factor price line for country B. as the slope of AB is greater than that of A1B1, capital is relatively cheap in country A and labour is relatively cheap in country B. Now the factor price line AB is tangent to the isoquant M of the capital intensive commodity machine at R. At point R, OK amount of capital and OL amount of labour is required. Similarly at S1, OK1 amount of capital and OL1 amount of labour is required. Therefore, labour is cheap in country B and machine in country A.

The New Trade Theory

The new trade theory began to emerge in the 1970s when a number of economists were questioning the assumption of diminishing returns of specialization used in international trade theory. They argued that increasing returns to specialization might exist in some industries. The new trade theory argues that in industries where there are economies of scale, both the variety of goods that a country can produce and the scale of production are limited by the size of the market. The domestic market may not be big enough to allow producers to realize economies of scale for certain products, and accordingly, those products may not be produced, thus limiting the variety of products available to consumers. Alternatively, they may be produced, but in such low volumes that unit costs and prices are higher. When nations trade with each other and form a single world market that is bigger than individual national markets, individual firms in a nation may be able to better attain scale economies.

The implication, according to new trade theory, is that each nation may be able to specialize in producing a narrower range of products than it would in the absence of trade, yet by buying goods that it does not make from other countries, each nation can simultaneously increase the variety of goods available to its consumers and lower the costs of those goodsthus trade offers an opportunity of mutual gain even when countries do not differ in their resource endowments or technology.

Trade Theories at the Firm Level

The 'new' trade theory has generated a rich body of predictions concerning the effects of commercial policy on price-cost mark-ups, firm sizes, exports, productivity and profitability among domestic producers. It critically assesses the plant- and firm-level evidence on these linkages. Several robust findings are identified. First, mark-ups generally fall with import competition, but it is not clear whether this phenomenon reflect the elimination of market power or the creation of negative economic profits. Second, import-competing firms cut back their production levels when foreign competition intensifies, at least in the short run. This suggests that sunk entry or exit costs are important in most sectors.

 Third, trade rationalizes production in the sense that markets for the most efficient plants are expanded, but large importcompeting firms tend to simultaneously contract. Fourth exposure to foreign competition often improves intraplant efficiency. Fifth, firms that engage in international activities tend to be larger, more productive, and supply higher quality products. However the literature is mixed on whether international activities cause these characteristics or vice versa. Finally, the short-run and long-run effects of commercial policy on exports and market structure can be quite different. Both types of response depend upon initial conditions, sunk entry costs, and the extent of firm heterogeneity.

The rapid and comprehensive tariff reductions-part of an IMF-supported adjustment program with India in 1991 established a causal link between variations in inter-industry and inter country tariffs and consistently estimated firm productivity. Specifically, reductions in trade protectionism lead to higher levels and growth of firm productivity, with this effect strongest for private companies. Interestingly, state-level characteristics, such as labor regulations, investment climate, and financial development, do not appear to influence the effect of trade liberalization on firm productivity.

1) There is evidence of trade-induced productivity gains 2) These gains mainly stem from the intra-industry reallocation of resources among firms with different productivity levels and: 3) they are larger in import competing sectors; 4) There is no evidence of significant scale efficiency gains. Indeed, unilateral trade liberalization is often associated with a reduced scale efficiency; 5) There is evidence of a pro-competitive effect of trade liberalization; 6) There is no evidence either of learning-by-exporting effects or of beneficial spillover effects from foreign owned to local firms; 7) There is evidence of skill upgrading induced either by technology imports, or by trade-induced reallocations of market shares in favor of plants with higher skill-intensity; 8) There is no evidence of trade-induced increases in labor demand elasticities. Direct evidence suggests, however, that trade exposure raises wage volatility; 9) There is no evidence of substantial employment contraction in import competing sectors.

Benefits of Foreign Trade

Countries differ with each other with reference to natural resources, tastes and preferences, technologies, economies of scale, economic and social institutions and capacities for growth and development. There has to imports and exports of required resources between countries for economic growth and development.