Theory of International Trade

Introduction

The theory of trade has a central place in economic analysis, and underpins the doctrine of free trade. Free trade doctrines have a long and fascinating history in Europe. In 1846 Britain repealed the Corn Laws, an historic event which marked the start of the era of free international trade, and lasted until the great depression of the 1870s. The Corn Laws were the duties on imports of grain, which had been in force in England since the middle of the fifteenth century. Other European countries had similar taxes: France, Sweden, Bavaria, Belgium and Holland.

The reasoning behind the Corn Laws was as follows. Grain, chiefly wheat, is a staple foodstuff, especially important in the diets of labouring people. But its price varies greatly from year to year, depending on the size and quality of harvests. Duties on imports were levied on a sliding scale in order to stabilise the price of wheat. When the domestic price was high because of a poor harvest, duties were lowered to permit imports. When the domestic price was low because of a bumper harvest, import duties were raised.

In the decades leading up to the repeal of the Corn Laws in Britain, the system had fallen into disrepute. In fact the sliding scale of duties was tending to increase rather than reduce fluctuations in the price of wheat. When the domestic price was high, traders tended to withhold supply to raise the price even further. They anticipated that import duties would soon be lowered, which was in fact what tended to happen. Then, when duties fell, traders began to import large quantities of grain. As supply rapidly increased, and prices fell dramatically, import duties were quickly increased. The net effect was to amplify market fluctuations through speculation, making a vulnerable market even more unstable, much to the detriment of consumers.

The Corn Laws had another important effect. They benefited agricultural interests at the expense of the newly emerging manufacturing sectors. High prices of grain, maintained through restricting foreign supply, increased the value of land. Landowners, understandably, came to constitute an important pressure group for the maintenance of the Corn Laws. Against these landed interests were ranged the burgeoning manufacturing classes. In Britain, the opposition to the Corn Laws centred on Manchester, the home of the textile industry. The ‘free traders’ as they were called, believed that lower grain prices were needed so that the labouring classes in industrial areas would have access to cheap foodstuffs. Led by Cobden, formerly a manufacturer, the free traders argued for the opening-up of British markets to cheap grain imports from overseas. Manufacturers were also anxious that free trade principles should be reciprocated in other countries, so that foreign markets would be opened up to exports of cheap manufactured goods from Britain.

In Britain free trade principles eventually triumphed. In the twentieth century, with the important exception of the period 1918 to 1939, free trade principles also came to dominate the world economy. In this chapter we explore the economic principles which underpinned the doctrine of free trade, a doctrine which is arguably one of the most robust of any in present-day economics. Chapter 2 starts with the mercantilist thinking which pre-dates the free trade era, and passes on to the writings of Adam Smith and David Ricardo, which formed the basis of the case for free trade. These principles were reinterpreted in terms of modern economics by the economist Haberler in the 1930s.

Finally, a word of warning – the theory of comparative cost, on which everything in this chapter rests, is deceptively simple! In 1996, the world-famous US economist Paul Krugman came to Manchester, UK, to give a paper to mark the 150 years which had elapsed since the repeal of the Corn Laws. He entitled his address ‘Ricardo’s Difficult Idea: Why Intellectuals Don’t Understand Comparative Advantage’. In it he made clear that intelligent people who read, and even those who write about world trade, often fail to grasp the idea of comparative advantage. The aim of this chapter is to ensure that you fully understand the basis of the theory of trade.

Objectives

When you have completed this chapter, you should be able to:

● outline the key features which distinguish mercantilist economic thinking;

● show how Adam Smith’s theory of absolute advantage, in the book Wealth of Nations, broke with the mercantilist tradition;

● define absolute and comparative advantage and show how they constitute a basis for trade;

● understand the theory of comparative advantage when it is stated in terms of the modern concept of opportunity cost;

● describe how factor endowments may constitute an explanation of the basis of trade;

● know the results of formal testing of the Ricardian and Heckscher–Ohlin models of trade;

● relate your knowledge of the theory of trade to real world trade patterns in the nineteenth and early twentieth centuries.

Mercantilism

The theory of trade is part of the classical liberal tradition of economic thought. Classical liberalism is often described as the dominant ideology of capitalism. It is associated with the industrialisation of western Europe, a process which began in the eighteenth century.

Mercantilist economic thinking is a philosophy of political economy which predates classical liberalism. It was characteristic of economic thinking in Europe from the late Middle Ages through to the sixteenth and seventeenth centuries.

It is important to understand the key principles of mercantilist thinking because mercantilist ideas lingered on in international trade even when they had been largely discredited in the domestic context. Indeed in the present day there are many who are still wedded to certain mercantilist philosophies in the international economy, and advocate protectionist policies in foreign trade which might be described as ‘neo-mercantilist’.

Mercantilism emerged in the period between 1300 and 1500, when Europe was experiencing an acute shortage of gold and silver bullion for use as money in domestic and international transactions. Trade was growing but the money supply could not keep pace. To ensure sufficient bullion to meet the rising needs of commerce, monarchs and their advisers discouraged imports of goods since an excess of imports over exports required the export of gold and silver in payment for imports. By the same token, every effort was made to expand exports of goods, since exports would draw in gold and silver from abroad and thus increase the domestic money supply. Of course, since one country’s exports are another’s imports, this could never be a recipe for harmonious international relations. All countries could not enjoy the benefits of an export surplus!

The following features characterised the mercantilist system as it operated in Europe in the centuries before the rise of free trade:

● Extensive regulation of imports and exports. Some imports were prohibited altogether, others were subjected to high rates of import duty. In England the Navigation Acts of 1651 and 1660 aimed to exclude foreign ships from both the import and export trade. Even the export of raw materials (wool, for example) from England was restricted in order to keep input prices low and make the finished product (textiles) more profitable in foreign and domestic markets.

● Trade monopolies flourished. Governments permitted one merchant (or a group of merchants acting together) to operate in domestic and foreign markets. This meant that merchants could sell goods abroad at high prices because there was no price competition among sellers. Merchant capitalists with monopoly power dominated economic activity in England, France, Spain, Belgium and Holland.

● Smuggling flourished. Large profits could be made by traders who were willing to import or export prohibited goods. Smuggling of bullion was especially profitable. Most of the gold from South America flowed into Spain. In Spain there were severe penalties, including death, for merchants who smuggled bullion out of the country. Nevertheless, large quantities of Spanish bullion found its way into all parts of Europe.

● There were significant incentives for European governments to establish colonial empires. England France, Holland, Belgium and Spain established colonies. Colonies enabled the metropolitan country to control trade with weaker countries. The colony was required to provide cheap raw materials for manufacturers in the metropolitan countries. Colonies also provided protected markets for a home country’s manufactured exports.

Even when bullion supplies to Europe increased in the mid-sixteenth century, mercantilist restrictions on international commerce remained. This was because it was widely believed that tariffs were a good way to increase domestic output and employment, and to boost the power of the monarch. Tariffs were a source of revenue for the monarch out of which the army and navy and huge state bureaucracies could be paid. Import restrictions, it was believed, stimulated domestic manufacturing by keeping out foreign competition. To this end there were in place wide-ranging domestic regulations covering manufacturing and commerce. These included patents and monopoly rights, statutes governing apprenticeships, maximum wage rates, and tax exemptions and subsidies.

From the seventeenth century onwards, however, it became increasingly apparent that regulations imposed on domestic output and employment, together with restrictions on international trade, were hindering the growth of enterprise. Writers such as Dudley North (1641– 91) argued that economies would flourish only if restrictive laws which bestowed special privileges were removed. By the beginning of the eighteenth century there was a growing recognition, even in mercantilist writings, that emerging capitalists needed greater freedom to pursue profitable investment opportunities. This was the background against which Adam Smith published the path-breaking book Wealth of Nations in 1776, which is universally regarded as the foundation of modern market economics, and is the starting point for the theory of trade.

Adam Smith and absolute advantage

Adam Smith was a Scotsman, born in 1723, the son of a Scottish Judge Advocate and Comptroller of Customs. He became Professor of Logic and then of Moral Philosophy in the University of Glasgow. This was followed by travels in France as tutor to the young Duke of Buccleuch, with a final appointment as Commissioner of Customs, which he held until his death in 1790. Smith can justifiably be described as the first professional economist! He was also thoroughly familiar with the practicalities of trade and tariffs.

Smith’s Wealth of Nations has been described as the most profound intellectual achievement of classical liberalism. It was conceived as an attack on what Smith called the mercantile system. The basis of Smith’s criticism of mercantilism was that it enabled certain merchants to enrich themselves by exploiting monopoly concessions and other ‘extraordinary privileges’. Such activities did not enhance the material welfare of society. Regulations governing foreign trade, such as bounties, monopoly grants and restrictive trade treaties, though they secured a large stock of bullion and a favourable trade balance, and may have enriched individual merchants, nevertheless conferred no general benefit on society.

What Smith favoured was a free market where hard work, enterprise and thrift would be rewarded. In a free market, without state regulation, monopoly and privilege, entrepreneurs would be encouraged to behave in a competitive, efficient and dynamic manner. In pursuing profit they would contribute to the wider social interest. They would be rewarded for doing things which added to the welfare of society, not for actions that diminished the common good.

Specialisation and exchange

Adam Smith observed that the division of labour increases productivity and wealth. As individuals specialise in certain activities they become more skilful and productive. But they also become more dependent on others for their needs. Specialisation therefore implies exchange ‘where every man may purchase whatever part of the produce of other men’s talents he has occasion for’ (Wealth of Nations, book I).

Specialisation and exchange enable everyone in a community to benefit by purchasing goods and services from low-cost sources of supply. According to Smith, it is ‘the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy’. Smith then extended this principle into the sphere of foreign trade: ‘What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom.’ If commodities could be purchased abroad more cheaply than they could be made at home, then it would be foolish to put obstacles in the way of importing them. Such restrictions could only impede the welfare of the whole community.

The critique of mercantilism, together with the case for free trade, is contained in books III and IV of Wealth of Nations. There are three powerful ideas to bear in mind in the remainder of this chapter:

● A nation’s wealth depends on its productive capacity. Gold and silver do not of themselves constitute a nation’s wealth. Gold and silver can be ‘wasted’ on luxury spending. But if gold and silver are used to purchase materials and tools, or to employ labour, then productive capacity and future wealth is assured.

● Laissez-faire is the best way to increase productive capacity. Governments should remove restrictions and privileges to permit the expansion of industry and trade. Once freed from the burden of the state, social harmony and economic progress will triumph.

● International trade is mutually beneficial for all trading countries. Every country benefits from being able to export those commodities which it produces efficiently, and being able to import those commodities which it produces inefficiently. There are no ‘losers’ from free trade. All are ‘gainers’.

Absolute advantage

Smith claimed that a country should specialise in, and export, commodities in which it had an absolute advantage. An absolute advantage existed when the country could produce a commodity with less labour per unit produced than could its trading partner. By the same reasoning, it should import commodities in which it had an absolute disadvantage. An absolute disadvantage existed when the country could produce a commodity only with more labour per unit produced than could its trading partner.

Table 2.1 is a simple arithmetical example of the principle of absolute advantage. The countries in the table (the UK and the US) are not, of course, the ones familiar to Smith, nor are the commodities (wheat and cloth) the ones which feature in Wealth of Nations, but the principle is universal. To simplify matters, we will continue to use these two commodities and countries whenever we are dealing with the two-country, two-commodity case.

Table 2.1 indicates that the UK has an absolute advantage in cloth production and an absolute disadvantage in wheat production. The US has an absolute advantage in wheat production and an absolute disadvantage in cloth production. Both countries will gain if the UK specialises in cloth and exports it to the US, and the US specialises in wheat and exports it to the UK. In modern terminology, trade is a positive sum game. Everyone gains from specialisation and exchange, though we may note from the outset that there is no reason to expect everyone to gain equally.

Labour theory of value

The classical economists, of whom Smith was the first, regarded labour as the sole source of value. The quantity of labour embodied in a commodity measured the value of that commodity.

The arithmetical example of Table 2.1 is consistent with a labour theory of value, since the exchange value of each commodity is determined by the amount of labour time (output per unit of labour) necessary for its production. The classical writers operated with a labour theory of value. Although Smith had not developed a pricerelated demand schedule in the modern sense he did recognise that demand for acommodity needed to be taken into consideration. Producers in search of profit would not continue to produce commodities for which there was no market. Market demand was needed if producers were to cover their costs of production. Market demand would determine what commodities were to be exchanged and the relative amounts to be produced.

Table 2.1 Absolute advantage (arithmetical example)

Output per unit of labour                UK                        US

Production of wheat                             5                     20

Production of cloth                               10                     6

Smith also recognised that workers differed in aptitudes and abilities. The lazy and unskilled worker would be less productive than the industrious and skilled worker. It is labour, as opposed to the labourer, which is the measuring rod in the labour theory of value. Labour, Smith claimed, was alone ‘the ultimate and real standard by which the value of all commodities can at all times and places be estimated and compared’ (Wealth of Nations, book I).

Political economy

Adam Smith’s demonstration of the gains from specialisation and exchange, based on the principle of absolute advantage, constituted an immensely powerful argument for free trade. At the time of publication of Wealth of Nations, Britain was already the most advanced capitalist country in the world economy. We can imagine even today how appealing Smith’s book was to the newly emerging manufacturing interests in Britain who wished to be freed from state regulation, to import raw materials and to sell goods abroad. Its sentiments also appealed to the labouring poor, who stood to gain from the opening-up of British markets to imports of cheap grain from overseas.

Smith, and other classical economists, regarded themselves as operating in the sphere of political economy. They were in the business of persuading governments what they ought to do. They were concerned with normative, as opposed to positive, economics. The normative implication of Smith’s (and later of Ricardo’s) economics was free trade.

The philosophy of economic liberalism, of which the free trade doctrine is a key element, took strong root in Britain in the early nineteenth century. The repeal of the Corn Laws, which came at the end of decades of pressure from industrialists, consolidated Britain’s lead in the world economy. Economic liberalism was much slower to gain acceptance elsewhere in Europe. In continental Europe protectionism had a firmer grip. The ideas of Friedrich List, the German nationalist economist who died in 1849, had a loyal following. List believed that protectionism was an important defence for Germany against the rapidly growing political and economic power of Britain.

David Ricardo and comparative advantage

Born in 1772, David Ricardo was of Dutch parentage. His family was Jewish and settled in England where his father followed the profession of stockbroker. The younger Ricardo also made his fortune in stockbroking, and then retired from business to embark upon his intellectual journey. His most important work, The Principles of Political Economy and Taxation, was first published in 1817 and contained, in addition to his theory of international trade, work on the theory of value, wages, profit and rent, a theory of accumulation, and a theory of economic development. It is a complete account of the workings of an economic system, much more rigorous and less philosophic than Wealth of Nations. The contribution of David Ricardo was to demonstrate that even though a country may be absolutely more efficient than another in the production of all tradeable goods, nevertheless trade will be mutually advantageous.

Absolute advantage explains a certain proportion of trade taking place in the world economy in the eighteenth and early nineteenth centuries. Britain probably had an absolute advantage in manufactured goods in the early stages of industrialisation and an absolute disadvantage in the production of commodities like sugar and tobacco, which required specific climatic conditions. Sugar, tobacco, raw cotton and tea were significant commodities in Britain’s import bill.

But suppose a country has an absolute advantage over its trading partner in respect of all commodities. Is there any basis for mutually advantageous trade? Adam Smith thought not. If the trading partner had no absolute advantage, then there would be no opportunity to trade.

Consider Table 2.2. The US has an absolute advantage in the production of both wheat and cloth. By 1860, this was a distinct probability. The US was an agricultural economy capable of producing large quantities of low-cost wheat, as the margin of cultivation was extended westwards. But due to high rates of investment, productivity levels were also rising in certain types of manufactured cotton goods. Productivity levels could well have outstripped those in the UK.

Based on Smith’s principle of absolute advantage, Table 2.2 suggests that there is no basis for trade between the UK and the US. The US is absolutely more efficient in the production both of wheat and cloth. But, looking again at Table 2.2, it is clear that the US is relatively more efficient in the production of wheat (four times more efficient than the UK) than it is in the production of cloth, where it is three times more efficient than the UK. The US has a comparative advantage in wheat production. The UK, comparatively speaking, is more efficient in cloth production than wheat.

Ricardo was the first of the classical economists to recognise that it is relative rather than absolute values which are fundamental to the operation of a market economy. This insight was critical to the further development of the theory of trade.

Consider again Table 2.2. The US has a fixed quantity of labour available to produce wheat or cloth. One unit of labour can produce 20 units of wheat or 6 units of cloth. Assume that trade takes place and the US sends 20 units of wheat to the UK. To produce 20 units of wheat the US has sacrificed 6 units of cloth. But the US will be able to obtain 8 units of cloth from the UK in exchange for 20 units of wheat, because within the UK 20 units of wheat trade for 8 units of cloth. In the UK, 1 unit of labour can produce 5 units of wheat or 2 of cloth. Assume now that trade takes place and the UK sends 2 units of cloth to the US. To produce 2 units of cloth, the

Table 2.2 Comparative advantage (arithmetical example)

Output per unit of labour                UK                          US

 Production of wheat                            5                      20

Production of cloth                               2                      6

UK has sacrificed 5 units of wheat. But the UK will be able to obtain 6.6 units of wheat from the US in exchange for cloth because within the US 2 units of cloth trade for 6.6 units of wheat.

Recognition of the principle that it will be beneficial for a country to specialise in the commodity in which it has a comparative advantage, and export it to another country in exchange for a commodity in which it has a comparative disadvantage, is fundamental to the doctrine of free trade. In drawing attention to the principle of comparative cost, Ricardo showed enormous insight. Although absolute advantage provides a basis for trade, it is likely, in practice, to apply to a fairly limited range of goods: trade in foodstuffs and raw materials between tropical and temperate zones, for example. Comparative advantage, on the other hand, can apply whenever there are productivity differences between countries, in respect of two or more commodities.

Opportunity cost and the pure theory of trade

So far in this chapter, the free trade doctrine has been discussed in terms of alabour theory of value in which the value of a commodity is determined by the amount of labour time used in its production. Following on from Smith and Ricardo, economists in the nineteenth century subsequently modified and finally abandoned the labour theory of value. It was replaced with the familiar economics ‘tool-box’ of the present day, in which the value of a commodity is related to its market price, which depends not only on supply and cost conditions, but also on demand.

Neo-classical trade theory

The economists who later overturned the labour theory of value were from continental Europe as well as from Britain. Jean Baptiste Say (1767–1832) was French. Though afirm disciple of Smith, he was the first economist to break away entirely from the labour theory of value. He is generally credited as developing the forerunner of formal equilibrium analysis. Of the three ‘founders’ of the marginal utility school in the late nineteenth century, Jevons was from England, Menger from Austria (Vienna) and Walras from Switzerland (Lausanne).

The ‘neo-classical’ thinkers, led by Jevons, Menger and Walras, developed theories of an economic system based on large numbers of producers and consumers. Given a competitive market economy, prices would guide consumers and bring about the most efficient allocation of resources in order to maximise society’s income. Neo-classical economists also made great use of mathematical and geometric exposition in order to show functional relationships between important variables such as price and quantity demanded. The use of mathematics ensured greater rigour in the development of their theories.

This is the context in which economists have developed the pure theory of trade. The pure theory of trade treats international trade within the framework of neoclassical theory. It carries through to the present day Adam Smith’s belief in the invisible hand of the market, competition and the benefits of laissez-faire policy in relation to international exchange. The pure theory abandons the labour theory of value. Instead it is based on rigorous analysis of consumer and producer behaviour.

The pure theory of trade can be developed through a system of equations and this is the most exact way of presenting it. In this chapter, however, we rely on a simple geometric exposition instead of on equations.

Opportunity cost

The doctrine of free trade holds good even if we discard the labour theory of value. The Austrian economist Gottfried Haberler first demonstrated this in the 1930s, utilising the concept of ‘opportunity cost’. If the concept of the ‘indifference curve’ is also introduced into the analysis, it becomes possible for the first time to demonstrate the gains in real income from trade. What follows here is a simplified form of the pure theory of trade based on Haberler’s Theory of International Trade (1933).

Assume two countries, the US and UK, and two commodities, wheat and cloth. The purpose of the analysis is to demonstrate that the UK gains from specialising in the production of cloth in which it has a comparative advantage, and exporting it to the US in exchange for wheat in which it has a comparative disadvantage. The gains from trade come about because the domestic opportunity cost of cloth in terms of wheat differs from the international opportunity cost of cloth and wheat.

Figure 2.1 shows the UK (country A). The axis Oy represents units of wheat. The axis Ox represents units of cloth. If all resources available in the UK are devoted to producing cloth, On’ units of cloth will be produced. If all the resources available in the UK are devoted to producing wheat, On units of wheat will be produced. Any point on the curve nn’ represents a combination of wheat and cloth production. nn’ is the production possibility frontier for country A. Assuming all resources are fully employed, country A will be producing at some point on the production possibility curve where both wheat and cloth are produced.

Where on the production possibility curve will country A be located? To answer this question we need information

● on the preferences of consumers in country A for wheat relative to cloth, and

● on the relative prices of wheat and cloth. Remember, at this stage we have not introduced the possibility of foreign trade.

Information on relative prices is therefore represented by the domestic price schedule. Information on preferences is represented by the community’s indifference curve.

The indifference curve ii’ in Figure 2.1 shows the two goods, wheat and cloth, and the combinations of wheat and cloth that are equally acceptable to consumers in country A. The price schedule pp’ shows the relative prices of wheat and cloth, the rate at which they can be traded one for another in country A. In effect, the slope of pp’ is the domestic opportunity cost.

The ‘no foreign trade’ or ‘autarky’ equilibrium is at e. Here the marginal rate of transformation in production (the slope of nn’) is equal to the marginal rate of substitution in consumption (the slope of ii’) and is equal to the domestic opportunity cost (the slope of pp’). At e, country A produces Ow of wheat, and Oc of cloth. This equilibrium represents the most efficient use of resources for both producers and consumers and yields the maximum level of real income in country A.

Gains from trade

We now open up country A to foreign trade. To simplify matters, the analysis uses a partial equilibrium approach, showing the effects of trade on country A only. If we were to introduce country B, as in a general equilibrium approach, more sophisticated geometric tools would be needed.

We know that foreign trade is beneficial if the domestic opportunity cost is different from the international opportunity cost of wheat and cloth. A line TT’ is constructed to represent the international terms of trade, i.e. the rate at which wheat trades (exchanges) for cloth in the international economy. Because it differs from the domestic opportunity cost it is constructed with a different slope to pp’. TT’ also indicates how much cloth country A will produce when it is opened up to trade. It must be tangential to nn’ because after trade, country A must still be somewhere on its production possibility curve, producing both wheat and cloth. The location is indicated by the new post-trade equilibrium e*. Country A has moved along the production possibility curve to e*, where it is producing more cloth and less wheat. It has specialised in cloth at the expense of wheat because it is assumed to have a comparative advantage in cloth.

Exports of cloth trade at the more favourable international opportunity cost represented by TT’. TT’ is determined by supply and demand conditions for wheat and cloth in country A and country B. To arrive at the post-trade equilibrium for country A, move out along TT’ until a point of tangency is reached with a higher indifference curve II’, at e’. At this point, country A’s marginal rate of substitution in consumption (slope of II’) is equal to the marginal rate of transformation in production (slope of nn’), and is equal to the relative prices of wheat and cloth in international markets (slope of TT’). II’ represents a higher level of real income for country A. Foreign trade, which has led to specialisation and exchange, results in a higher level of real income at the new post-trade equilibrium e’.

Factor endowments

What is the source or basis of comparative advantage? Eli Heckscher (1919) and Bertil Ohlin (1933) were the two Swedish economists who provided an answer to this question. The answer itself, and the theoretical structure that underpins it, has turned out to be very influential in international economics.

Why are there differences in comparative advantage? Why do domestic opportunity costs differ from international opportunity costs? According to Heckscher and Ohlin it was because of differences in relative factor endowments between nations. Countries like the United States and Canada were relatively abundant in fertile land. Other countries, such as the UK, were relatively abundant in labour. The UK could produce cotton textiles relatively cheaply because large amounts of cheap labour were used in the production process. Wheat was cheap in the US relative to cloth because fertile land was abundant in the US relative to labour. Cotton goods were cheap in the UK relative to wheat because labour was relatively abundant in the UK.

● Countries have a comparative advantage in commodities which use more of their relatively abundant factor of production. A labour-abundant country will export labourintensive goods. A capital-abundant country will export capital-intensive goods.

● Countries have a comparative disadvantage in commodities which use more of their relatively scarce factor of production. A labour-scarce country will import labour-intensive goods. A capital-scarce country will import capital-intensive goods.

The Heckscher–Ohlin theory tells us that questions about a country’s pattern of trade – which goods and services it exports and which goods and services it imports – can be answered in terms of factor endowments. It will become clear later in this chapter that the appeal of the Heckscher–Ohlin explanation of comparative advantage does not lie in its power to explain real world trade patterns. As an explanatory model its present-day relevance is very limited. If it ever applied anywhere, it was probably only in the period 1850–75 when reductions in transport costs opened up vast areas of cheap, fertile land, and made available exports of landintensive agricultural products from North and South America and Australia.

If the Heckscher–Ohlin model has serious limitations in an empirical sense, why is it still important in international economics? The answer is that it is a trade model which has important theoretical qualities. Many of these qualities it shares with the Ricardian approach to comparative cost. But there are key differences. An important difference is that the Heckscher–Ohlin model abandons the classical labour theory of value, and enables several factors of production to be incorporated into the analysis.

Comparing the Ricardian and Heckscher–Ohlin trade models

The economist Jagdish Bhagwati suggested in 1961 a useful schema for comparing the Ricardian and Heckscher–Ohlin models. This schema also plays a role in the ‘testing’ of the Ricardian and Heckscher–Ohlin (H–O) models.

Schema for evaluating Ricardian and Heckscher–Ohlin trade models (following Bhagwati)

Assumptions

Predictions

Empirical evidence

Normative implications

‘Fruitfulness’ in terms of further work

The assumptions and predictions of the two trade models

Table 2.3 shows that the Ricardian and H–O models hold the majority of their assumptions in common.

Both the Ricardian and H–O trade models assume perfect competition, so that the prices of goods entering into international trade perfectly reflect productivity differences (Ricardo) or factor endowments (H–O). There are no monopolistic tendencies which

might undermine the relationship between labour productivity and the price of goods (Ricardo), or factor endowments/factor intensities and the price of goods (H–O).

Both models also assume that costs of production are constant with respect to scale of output. Again, this is necessary to maintain a clear relationship between price and productivity (Ricardo) and price and factor endowments (H–O). There are no economies of scale to complicate the issue.

In both models transport costs are zero. This assumption is highly unrealistic but necessary, again to ensure that international price ratios reflect productivity differentials (Ricardo) or relative factor endowments (H–O), rather than such things as location, distance and other costs of moving goods across national boundaries.

Finally, if factors of production could move between countries, then factor mobility would rule out differences in the prices of goods and factors of production which give rise to trade. It is only because factors of production are immobile internationally that trade in goods and services becomes possible. None of the above assumptions could be regarded as realistic, but in this, as in other areas of economics, they are necessary to the logical development of the model.

The final two categories of assumptions differ between the models, and highlight the difference in approach between the classical model of Ricardo, and the later H–O model which sits more easily in the neo-classical tradition.

First, the Ricardian model assumes only one factor of production, labour. The costs of traded commodities are determined by the amount of labour utilised in production. The H–O model, on the other hand, has several factors of production. The relative prices of traded commodities are determined by the different factor intensities that they display.

Second, in the Ricardian model the relationship between labour inputs and output for the same commodity differs in the two trading countries. In other words, production functions for the same commodity differ internationally in the Ricardian model.

In the H–O model production functions are the same for both countries when producing the same commodity. In producing commodity x, country A and country B both face the same production function. It is the factor intensities which differ between commodities x and y, and factor endowments which differ between countries A and B.

Following Bhagwati’s schema and comparing the Ricardian and H–O trade theories, there are important differences in assumptions which may lead to differences in predictions about likely trade patterns.

If Ricardian theory is selected, then a country’s exports and imports – the pattern of trade – are determined by productivity differences. A country will export those commodities in which its labour productivity is comparatively high, and import those commodities in which its labour productivity is comparatively low.

If H–O theory is followed, then a country’s pattern of trade is determined by relative factor endowments. A country will export commodities which embody its relatively abundant factor, and will import commodities which embody its relatively scarce factor.

Empirical evidence has been kinder to the predictions of the Ricardian model than to the H–O model. The H–O model does not stand up very well to the test of real-world evidence. Why? Reservations about the real-world relevance of the H–O trade model have long been voiced by economists, and they seem to centre on the fact that trading nations usually have very similar factor endowments. The bulk of world trade is between countries which have similarly structured economies. More than this, the trade which takes place between these countries tends to be in commodities which have very similar factor requirements.

Normative implications and further work

There is no difference between the H–O and Ricardian models so far as their normative, i.e. policy, implications are concerned. Both approaches strongly support a policy of free trade. Trade is a positive sum game. All gain by participating in international exchange.

The H–O model is superior to the Ricardian model, however, in that it can be used to tell us something about how the gains from trade will be distributed. There are, potentially, four factors of production in the H–O model and the prices of these factors (rents on land, wages for labour, interest payments on capital and profits for enterprise) are the rewards accruing to the factors, i.e. their real income. The H–O model enables the economist to reach a general equilibrium solution which indicates how the invisible hand of the market determines what exports should be produced, how they are to be produced and how the gains from trade are distributed among the different factors of production in the trading countries.

It is the ability of the H–O model to provide a general equilibrium solution which explains why it occupies a central place in the pure theory of trade, and why economists have found it so useful in stimulating further theoretical work.

Testing the Ricardian and Heckscher–Ohlin models

The Ricardian model

The Ricardian model, in which trade patterns depend on productivity differences, comes out well from empirical investigation. The earliest tests were carried out by G. D. A. MacDougall, and published in the Economic Journal of December 1951 and September 1952.

MacDougall inferred from the Ricardian model that, in comparing US and UK patterns of trade, the ratio of US exports to UK exports would be relatively high in commodities where the ratio of productivity of US workers to UK workers was also relatively high. So, in taking a cross-section of industries, MacDougall found that in industries like textiles where US productivity was very close to UK productivity, the volume of US exports was very close to the volume of UK exports. In industries such as car production, where US productivity was much greater than UK productivity, US exports were much greater in volume than UK exports. This result broadly confirms the Ricardian model in which productivity differences (comparative costs) determine trade patterns.

In MacDougall’s test of Ricardian theory, productivity ratios are measured on the y axis and export ratios on the x axis. Productivity ratios and export ratios are correlated for a range of manufactured goods. There is a clear positive relationship between productivity ratios and export ratios across the commodities, ranging from textiles (low US productivity and low US exports) to motor vehicles (high US productivity and high US exports).

The Heckscher–Ohlin model

The most famous test of the Heckscher–Ohlin model is that carried out by the US statistician Wassily Leontief which was published in 1953. It used what was then a pioneering methodology. The methodology was that of input–output analysis. It was to win Leontief the Nobel Prize in 1973.

Essentially input–output analysis involves representing the output of any product in terms of its input requirements. A simplified example might relate to cotton textiles, which require a certain quantity of fuel (electricity), raw materials (raw cotton), capital equipment (machinery for spinning and weaving) and labour (to produce the final output). Extended to the economy as a whole, it is possible to represent all transactions in the economy in a ‘snapshot’ form, at a particular point in time. The aim is to highlight the interrelationships in the economy, as the output of one sector (say, textile machinery from the capital goods sector) is used as input in other sectors. In an economy such as the Soviet Union before liberalisation, planners could use input–output analysis to avoid bottlenecks, particularly for critical inputs such as energy and raw materials.

It is important to know something about the history of Leontief’s work, because here is an example of a methodology in search of something to test, rather than the other way around! For an economy the number of calculations required to produce a comprehensive input–output table is vast. It is no coincidence that Leontief’s work coincided with the development of computers in the US in the late 1940s, because one of the first uses of the technology was the construction of an input–output table for the US economy for the year 1947.

Having constructed the input–output table, Leontief considered its possible uses. Testing the Heckscher–Ohlin model was just one of these potential uses. It enabled Leontief to compare the factor intensity of US exports with the factor intensity of US import-competing goods. Ideally, Leontief would have wished to look at the factor intensity of actual imports, rather than the factor intensity of US goods which replaced imports. This was not possible because data in the input–output table relate only to the US. However, Leontief was quite justified in using import replacements because of assumption 6 in Table 2.3, i.e. that the same commodity has the same production function in different countries. This means that if, say, cotton textiles are relatively labour-intensive in the US, they are also relatively labourintensive in the UK. If motor vehicles are relatively capital-intensive in the US, they are relatively capital-intensive in the UK.

The Leontief paradox

When Leontief had completed his calculations it emerged that the US exported relatively labour-intensive goods and imported relatively capital-intensive goods – as measured, in the latter case, by the factor requirements of import-competing goods. The results were regarded as paradoxical because, by the end of World War II, the US economy was generally regarded as the most capital-abundant country in the world economy, a position which it has maintained ever since.

Leontief himself re-did the calculations using an input–output table for a later year, but the results were largely the same and it must be admitted that although more refined data and better methods of testing the H–O model have emerged over the past forty years, and even though other countries and even trade blocs have featured in observations and testing, the results for the H–O model have been, at best, mixed.

Faced with the poor empirical performance of the H–O model, the economist has two choices: either

● reject the H–O explanation of differences in comparative advantage, and pursue instead alternative explanations of trade patterns such as the ones discussed in the next chapter; or

● accept that the H–O explanation of differences in comparative advantage may still be valid and look for reasons for the paradox which are consistent with an underlying H–O framework.

Because the H–O model is such a powerful theoretical construct in neo-classical analysis, economists seem reluctant to abandon it altogether! The following reasons for the paradox have been advanced in various research papers, by economists who believe that the H–O explanation of trade patterns is fundamentally correct, despite its poor empirical showing.

Reasons for the Leontief paradox

● Natural resources are neglected. This was one of the earliest explanations of the paradox, and one which initially was favoured by Leontief himself. By concentrating on labour and capital, the test had neglected to take into account the relatively abundant natural resources of the US. On closer investigation, exports may have been natural-resource-intensive rather than capital-intensive.

● Exports are skill-intensive. Labour is not a homogeneous commodity. The US has a relatively skilled labour force. Labour-intensive exports may have embodied relatively large amounts of the abundant skilled labour in the US economy.

● Factor reversals occur. US import-competing goods may be produced in a capitalintensive way in the US, even though actual imports are labour-intensive. Although such factor reversals are ruled out by assumption in the H–O model, they remain a distinct real-world possibility, depending on the relative prices of factors of production.

● Trade policy is responsible for the paradox. The H–O model assumes perfect competition and free trade, but the US has very powerful labour unions which lobby for protection against labour-intensive imports. This means that entrepreneurs in profit-maximising import-competing industries are able to use relatively capital-intensive techniques, even though actual imports may be relatively labour-intensive.

Although all four of these ‘solutions’ to the paradox feature strongly in later empirical research, it appears that economists are no nearer a satisfactory resolution of the paradox. Results have been inconclusive.

The influence of the free trade doctrine

From its early beginnings in the writings of Smith and Ricardo, the pure theory of trade emerged as part of the marginalist revolution led by Jevons in England, Menger in Austria and Walras in Switzerland. It was reinforced in the writings of the important ‘second generation’ of neo-classical thinkers, those whom Haberler acknowledged in his 1933 book: Marshall in England (his paper ‘Pure Theory of Foreign Trade’ (1879)); Wieser and Böhm-Bawerk of the Austrian School; and Pareto from Lausanne.

Smith and Ricardo operated in the sphere of political economy, the art of persuading governments and sectional interests of the mutual benefits of free trade. Political economy was very much an English phenomenon. Even Marshall, trained as a mathematician and fully at home with formal analysis, was anxious to root his enquiries in economic reality. The continental European writers, though no less committed to competitive markets, were more technical in their approach, more mathematical and formalist.

It is also apparent that free trade doctrines were slower to gain a hold on governments in continental Europe than they were in Britain. Britain was the first country to adopt a policy of free trade, ushering in an era of freer trade in the international economy which lasted from 1850 to 1875. Between 1840 and 1880, Britain reduced tariffs by 20 per cent.

It is not clear, however, how much of the free trade movement in Britain was due to the persuasive powers of economists. Economic historians have argued that the reductions in tariffs in Britain were not due to free-trade doctrines, but rather to the fact that government revenues were rising for other reasons, and there was no need to tax imports in order to balance the budget. In particular, income taxes in Britain were coming to represent an increasing proportion of government revenue, helped by rising national income.

France liberalised trade policy after 1860, but this was largely through reciprocal bilateral trade treaties with most favoured nations (MFNs). Often these treaties had a political rather than an economic purpose. When France concluded a trade treaty with Prussia, the aim was to exclude Austria-Hungary rather than to embrace wholeheartedly a free-trade doctrine. The south German states too were protectionist, great supporters of their Zollverein, the free-trade area which maintained a high common external tariff. The Zollverein was not reformed until 1866.

The United States was also slow to convert to free-trade principles. Import duties were increased every year until 1865. Sectional interests continued to lobby successfully for protectionism through to the 1880s. As late as 1880, the import duty on steel in the USA was 100 per cent. Wool had a 35 per cent tariff.

The world depression in output and employment from 1873 onwards resulted in renewed pressure for protection. W. Cunningham, the contemporary historian, remarked of Britain that, ‘the Science of Political Economy speaks with far less authority and receives far less respectful attention than it did some years ago’ (The Rise and Decline of the Free Trade Movement, 1904). Nevertheless, Britain just about held on to free-trade principles, and in 1906 the Conservative Party lost an election fought on protectionist principles. Significant opposition had come from the skilled artisan classes, fearing higher food prices.

In Germany, under the influence of the depression of the 1870s, Bismarck introduced a new German tariff, which was further increased in 1890. In France imports of US wheat were the cause of popular agitation. Rates on a number of agricultural products were raised in the 1890s. By 1892 French tariffs on agricultural products averaged 25 per cent.

The USA had always been more protectionist than Europe and raised tariffs (the McKinley tariff) in 1890. At that point in time the average US tariff was 57 per cent. Interestingly the US tariff was justified by the need to protect US workers from the cheap-labour goods of Europe.

The Depression of 1929 signalled further decisive rounds of protectionist policies. Both nominal tariff levels and trade restrictions, such as quotas, were raised in order to forestall massive price declines. Italy imposed quotas on French exports of wines and perfumes. France retaliated with quotas on Italian fruit and vegetables. In the US tariffs were raised to help farmers and were later extended to non-agricultural products. Barter agreements on a bilateral basis began to feature in international trade. Hungary started to exchange foodstuffs for Czechoslovakian coal. By 1935 world trade had fallen to one-third of its 1929 level. European nations such as Britain, with significant colonial links, tried to ride out the storm by entering into preferential trading agreements with colonies and dominions. Germany entered into bilateral clearing arrangements through the banks with countries such as Yugoslavia and Romania. By 1938, more than half of Germany’s foreign trade was being carried out through bank-based bilateral clearing arrangements.

The experience of the 1930s is a salutary lesson when economists contemplate the triumph of ideas represented in the free trade doctrine. The new liberal economic order which was constructed by the allies at Bretton Woods in 1944 marked the re-emergence and triumph of an intellectual tradition which had faltered in the 1890s and had collapsed altogether by 1939. In Chapter 5 we learn about the painstaking reconstruction of a free trade agenda, beginning with the ill-fated ITO, later GATT, and the successive rounds of item-by-item trade negotiations under GATT which culminated in the Uruguay Round of trade negotiations and the setting-up of the World Trade Organisation. The theory which has underpinned the doctrine of free trade over the last two centuries can truly be described as robust in surviving, among other things, the political and social dislocation of two world wars and economic slumps in two world depressions.

Summary

● The theory of trade is the basis of the doctrine of free trade. Free trade principles emerged in Britain as a protest against the effects of the Corn Laws.

● Mercantilist economic thinking was characteristic of Europe up to the seventeenth century. It featured wide-ranging domestic regulations and restrictions on imports and exports.

● Adam Smith, the founder of modern economics, presented a critique of mercantilism, together with the case for free trade based on the principles of absolute advantage.

● David Ricardo recognised that it is relative or comparative advantages which lead to mutually beneficial trade. Comparative advantage applies whenever there are productivity differences between countries.

● Modern economics replaces the classical labour theory of value with the concept of opportunity cost. This enables the economist to develop the pure theory of trade within the framework of neo-classical theory.

● Heckscher and Ohlin believed that the source of comparative advantage is differences in relative factor endowments between countries. Countries export commodities which embody the relatively abundant factor, and import commodities which embody the relatively scarce factor.

● The Ricardian and H–O models have most assumptions in common, but have two important categories of assumptions that differ. These relate to the number of factors of production, and the properties of the production functions.

● The Ricardian model performs better in empirical investigation than the H–O model. Various explanations have been put forward for the Leontief paradox.

● The theory of trade which underpins the doctrine of free trade is very robust. It has survived and triumphed over many vicissitudes in the world economy.