International Trade Theory – A Dual, General Equilibrium Approach

International trade is a very important phenomenon that exists in today’s world. Without international trade, the world would have been a very different place. The exchange of products, services, and capital across borders are key highlights of international trade. As a source for economic, social, and political growth, international trade fuels economic growth in a country which eventually results in improved standards of living within a nation. Foreign Policy and Economic Policies in terms of tariffs, quotas, and subsidies have a major impact on international trade.

International Trade Theory

The international trade theory aims at explaining the patterns of international trade worldwide and the distribution of the gains from this trade. Classical economists have given varying descriptions to the international trade theory; these include the works of Adam Smith and Dave Ricardo. Adam Smith, in his bestseller “Wealth of Nations (1776)”, described the importance of specialization in international trade theory. It stated that each nation should specialize in the production of a certain product or service it is well-equipped to produce as compared to other countries. This product/service should be exported and those goods/services should be imported which the country cannot bring into being that effectively.

Dave Ricardo, on the other hand, gave this principle a formal title known as comparative advantage. Thus, the crux of international trade theory revolves mainly along the lines of comparative advantage, followed by absolute advantage, endogenous advantage, bilateral trade patterns, and the division of gains.

Comparative Advantage and the Heckscher-Ohlin analysis

Countries earn comparative advantage mainly due to labor productivity differences. Suppose, in France, two hours of labor is required to produce a unit of cloth while in Thailand it takes four hours to produce a unit of cloth. Moreover, it takes three hours of labor to produce a unit of wine in France as compared to eight hours in Thailand. The trade equilibrium as per Ricardo should rest with France exporting wine and Thailand exporting cloth. This is because, exclusive of trade, a unit of wine is worth 1.5 units of cloth in France whereas a unit of wine is worth 2 units of cloth in China. Labor productivity is essential here, notice that France has an absolute labor productivity advantage in both cloth and wine but trade still occurs because labor productivities differ in goods exported by the two countries. E.g. to produce a unit of wine costs Thailand 0.5 more than France. The Heckscher-Ohlin study of the factor proportions model suggests that a country would have a comparative advantage in a good or service which used a factor of production abundantly available in that country. E.g. if France, as compared to Thailand is relatively abundant in labor, then it would have a comparative advantage over Thailand in all those goods whose production is labor-intensive.

The Absolute Advantage Fallacy

The monetary value of a good or service across nations is of extreme importance to both customers and businesses. Absolute cost advantage entails that a country will import goods that are cheaper abroad and would export those goods that are expensive abroad. Let’s come back to our example. If wages in France and Thailand were equal before trade started France would have an absolute advantage over Thailand. It could undersell both wine and cloth to Thailand and exploit the market. This would create problems for Thai businessmen as they would be driven away from the market. Market equilibrium would be attained through price changes in the labor market, with Thai wage rates falling and French wage rates rising until equilibrium strikes.

Endogenous Advantage

At times a country is blessed with an exogenous advantage e.g. some countries have abundant oil resources. Endogenous advantage coexists with comparative advantage and the theory focuses on this resulting from economies of scale. E.g. big oil deposits lead to a lower price in home countries. Economies of scale can also be exploited by developing countries through openness to trade. Moving on, bigger markets also mean newer products and result in gain from trade. E.g. if France were to expand in wine production with scale economies, it would look more attractive to adopt policy measures to promote French Wine. Scale economies can also operate at global levels. An example would be global outsourcing especially popular in India where cheaper labor results in lower costs. Trade also tends to intensify competition and thus reduces the strongholds of monopolies in various industries.

Bilateral Trade Patterns

The world has now shrunk due to more than 150 countries actively engaging in complex trade patterns. Most products and services are differentiated by origin. Clothing in Thailand is different from that available in France. Thus trade becomes attractive as consumers seek variety and diversity.

Division of Gains

The gains from trade can again be explained through the comparative advantage reasoning. Suppose a typical French householder is willing to swap 1 unit of wine for 1.5 units of cloth. He would be indifferent to sacrifice a little to offer the market 1 wine for 1.5 cloths. Similarly, a Thai householder is willing to swap 2 clothes for 1 unit of wine. Now let’s assume trade takes place and a price is set at 1.75 cloths per unit of wine. Before the trade, a unit of wine cost 1.5 units of cloth in France while it cost 2 units of cloth in Thailand. By specializing in cloth production and exchanging it for wine, Thai workers can obtain wine more easily at a cheaper price somewhere between 1.5 and 2. For French workers before the trade, a unit of wine acquired 1.5 units of cloth, and after the trade, a unit of wine now acquires somewhere between 1.5 and 2 units of cloth. Thus both parties are happier with trade taking place.

Thus, to conclude, International Trade is beneficial to every country if handled with care. Through comparative advantage we studied that France will do better if it concentrated on what it produces more efficiently, Thailand should produce what it can produce best in terms of the factor of production employed. To reap the benefits of international trade, Thai wine companies should consider setting up their businesses in France to utilize resources efficiently and vice versa, French wine companies could set up their businesses in Thailand to produce wine more efficiently.

Works Cited

Kemp, Murray C. International Trade Theory – A critical review. Illustrated. London: Routeledge. (2008).

Dixit, Avinash K. International Trade Theory – A dual, general equilibrium approach. Illustrated, Reprint. New Delhi: Cambridge University Press. (1980).

Boston College Anderson, James E. “International Trade Theory” American Economic Review. 2009. Web.

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