The Theory of International Trade

The central question of foreign trade theory is how to determine the pattern of foreign trade: which commodities will be exported and imported and where. The answer provided is based on the work of two Swedish economists, Eli Filip Heckscher (1919) and Bertil Ohlin (1933). Their propositions were later formulated as the Heckscher—Ohlin Theorem (HO). Subsequently three additional theorems have been posited. These four propositions represent the core of the mainstream theory of foreign trade. Of these, two refer to comparisons between two countries (the HO theorem proper and the factor price equalization theorem). The other two deal with relationships within a single country (the Stolper—Samuelson and Rybczynski theorems). The latter two can dispense with the assumption of identical technology.

The scarcity theory suffers from a fatal ambiguity. When it was originally formulated in relation to consumption, scarcity was correctly defined with respect to demand. As the theory was extended to cover production, scarcity came to be defined as a technological relationship. As the ratio of two factors declines, the factor in the numerator becomes relatively scarce. The two concepts of scarcity may coincide, but they need not. They may be made identical by special restrictive assumptions, but this is artificial. If a country is technologically capital abundant (K/L high), it may nevertheless be economically labour-abundant when tastes in the two countries are different or if there is permanently high unemployment. Thus, it will try to export labour, not capital, in terms of commodities. Also, the theory is in difficulties when more than two factors of production are involved. The third main point of confusion is that the scarcity theory with respect to factors of production was developed for single industries. Thus, the composition effect was not noticed. Any real-world economy is composed of different industries that may vary substantially in their capital intensity.

A certain amount of human labour must be invested in order that any object of nature can acquire use value and be appropriated by someone. Even picking readily available fruits requires labour. If two man-made objects are exchanged, their owners will determine the common value by estimating the labour expended. The value of reproducible objects depends exclusively on labour expended; that of nonreproducible ones on scarcity relative to demand. The former value can be measured by the labour time necessary for production; the latter is purely subjective and therefore nonmeasurable. Since most of commodities are reproducible, the objective measure of exchange value is labour-time expended. This is the common sense basis of the labour theory of value.

Even an economy with constant per capita output will produce interest if quantity of labour changes. The source of interest is neither productivity of capital nor the roundaboutness of the production process (Böhm-Bawerk) nor the abstinence nor any other fancy explanation, but the growth of employment. Additional workers must be employed if we are to have full employment, which is a necessary condition for rational (optimal) social production. In this sense, the theory of profit is a normative theory. Pareto optimality and unemployment are, clearly, contradictions. And resources necessary for the establishment of additional working places are obtained from the reduction of consumption (given production), i.e., from the generation of surplus which corresponds to profit. Even with constant labour productivity (no technological progress), mere changes in employment create positive or negative surplus. If technological progress occurs, the surplus will be correspondingly greater. Labour growth increases, while technological progress decreases the amount of labour necessary for the production of the same final output and that must be born in mind. The problem will be reduced to bare essentials.²

Labour input is measured by labour time. If economic systems — similarly to physical systems — move (change) in time, the measuring rod of time itself will change. Dynamic systems involve time in an essential way and so there is no absolute time independent from the rate of change (speed of movement).

If only welfare generating part of final output (i.e. consumer goods) is considered, two dynamic effccts represent two opposing forces. The production of a given basket of consumer goods B requires more social labour time (increased demographic investment) when labour force is increasing under full employment. It also requires les social labour time when the rate of growth is higher because replacement per unit of capital decreases with the rate of growth (1/n for stationary economy, 1/v for the growing one). To disentangle these effects, consider two simple models, one for a stationary and one for a growing economy. Let gestation period of investment be n _g = 1 year and the life span of fixed assets (of constant productivity and scrapped without cost or benefit) n = 3 years.

It might be thought that the ‘free gift of growth’ is really not free because there must be some initial investment somewhere. To find out the traverse from a stationary to a growing economy, consider the following schematic example. Let replacement be rectangular and the life span of fixed assets be n years. Let gestation period of investment be n _g = 1 year. The annual factor of growth is G = 1 + g.

Consider an integrated — and therefore closed — world economy consisting of three industries producing consumption goods X₁, capital goods X₂ and intermediate goods or materials X₃. (X _i denotes the type of the good and its quantity).

The wagc-rental curve (also called wage-profit frontier, wage curve or distribution curve) portrays the relation between real wages and gross profits (cf. Horvat, 1995, pp. 119–26). Since value added consists of wages and gross profits, one would expect that higher profits will cause lower wages and vice versa — given the output possibilities of the economy. The latter are determined by the existing labour force L, installed output capacity represented by fixed capital K and by the known technology (fixed technical coefficients λ_i, K_i; and a _3j .

So far only two models of foreign trade have been developed and fully explored. The classical or Ricardian model is the older one. The neoclassical or Heckscher—Ohlin model is the contemporary one. Following the lead provided by J. Bhagwati and T.N. Srinivasan (1983, pp. 9, 50), I shall describe them in the somewhat modified fashion indicating the essential characteristics in Table 12.1.

Intra-industry trade is trade among countries with similar factor endowments and in commodities with similar factor intensities (Davis, 1995, p. 204). According to the HO theory, such trade must be nonexistent.² Not so in the real world. Trade among countries in the European Union has been developing fast, and intra-industry trade much faster than the rest of the trade. Thus, countries are not only specializing in products of different industries but also in different varieties of the same commodity from within the same industry. What are the reasons for intra-industry trade? The reasons are many and they have nothing to do with factor proportions.

The mainstream trade theory revolves around the four theorems described earlier: (1) the Heckscher—Ohlin theorem determining the pattern of trade, (2) the factor—price equalization theorem, (3) the Stolper—Samuelson theorem on changes in relative factor prices depending on different factor intensities of countries starting to trade with each other and (4) the Rybczynski theorem determining output changes when the supply of a particular factor increases depending on factor intensity of output.

According to (10.18), the price formation in the three industries considered in terms of p₁ (divided by p₁) is given by (15.1).

The gain from trade may be unambiguously defined in two different ways. Technological version requires more of one good and no less of the other for every set of autarkic outputs. In utilitarian version, one consumer must be better off and none of the others worse off. The latter definition is not operational and so we shall concentrate our attention on the former. Generally, it is also not operational. The problem arises when increased quantity of one good is accompanied by reduced quantity of another. Here our labour prices help to solve the problem.

Most of unequal exchange theorizing is based on Marxian schemes of value formation. Value (w = Wert) is composed of constant (c) and variable (v) capital and of the surplus value (m = Mehrwert) Constant and variable capital are advanced at the beginning of the production period and are completely used in production. In the process of production, workers add to the used means of production (c) new value (v + m). The surplus value (m) is that part of value added which is not appropriated by the workers but by capitalists and so may serve as a measure of exploitation.

If tariff is imposed on the import of one commodity, we can ascertain effects as shown in Figure Fig 18.1.

The situation in which the independent political units, called states, and their economic agents compete on the world market, may be denoted as zero economic integration. The liberal epoch of 19th-century Europe corresponds institutionally most closely to such a state of affairs. Although various attempts at integration were made already in the last century, it is only in the second half of this century that the world began to move gradually towards economic integration. Various international agreements are the milestones on this path. Suffice it to mention the General Agreement on Tariffs and Trade (GATT), whose rules are obeyed by all important trading nations. Nevertheless, the world arrangements, just because they are so encompassing, will be taken as a basis from which the various, less general, integration schemes start. Various preferential trading agreements, in the ascending order of economic integration, are: