International Trade: Causes and Consequences

Frontmatter

Chapter 1. Introduction

Abstract

This book is on what, following Alfred Marshall, has come to be known as the pure theory of international trade dealing primarily with the determinants of the pattern of trade, gains from trade, and trade policy. Most textbooks in international economics attempt to cover both the pure theory of international trade and what has come to be known as international money (which deals with balance of payments, exchange rates, etc.). One concomitant consequence clearly is paucity of space, with the inevitable result that some topics in pure theory receive only perfunctory treatment. For example, the neotechnology and neofactor proportions theories are often not discussed or the empirical tests of various theories are either not discussed or discussed only as obiter dicta. Furthermore, often the substantial literature, both theoretical and empirical, dealing with intra-industry trade, imperfect competition and increasing returns to scale, are neither adequately discussed nor systematically assimilated in the existing textbooks. Again, very few textbooks have considered the recent dynamic models dealing with endogenous growth and international trade.

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Chapter 2. International Trade in the Real World and the Theoretical Issues

Abstract

The pure theory of international trade attempts to determine the causes of trade, that is, to determine why one country, for example, imports machinery and exports textiles. It then attempts to analyse the consequences of international trade. First, as trade takes place, a country produces more of the exportables and less of the importables. This transformation of production, in conjunction with international exchange, will change factor prices, commodity prices, income, and income distribution, and hence, consumption. Second, as trade takes place without any impediments of tariffs or quotas, the question is raised regarding whether a country obtains gains from trade, or for that matter, whether the global welfare of the trading world increases. This question raises further issues related to the terms of trade, tariffs and subsidies within a static framework of given endowments of factors of production, and to economic growth in a dynamic framework.

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Chapter 3. Economic Methodology

Abstract

Economic methodology scrutinises the principles which are employed to make scientific enquiries into economic phenomena and attempts to set rules regarding what constitutes a scientific approach. The pure theory of international trade is often derided because of its severe abstract nature and unrealistic assumptions. A brief résumé, therefore, is in order not only because we will be in a better position to carry out critical evaluations of trade theories at a later stage but also because methodological considerations have largely shaped the contents of the present book. Furthermore, familiarity with methodological tenets makes a reader more aware of the strengths and weaknesses of theories so that judgments can be formed in a more informed manner about the robustness of policy conclusions derived from theories.

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Chapter 4. The Classical View: Specialisation and Exchange, Absolute and Comparative Advantage

Abstract

In dealing with a subject in a comprehensive manner, it is imperative to discuss, even if very briefly, how the subject evolved over time, that is, one ought to have a glance at the history of the development of thought, and in this instance, in the theory of international trade. We will begin with the Mercantilist doctrine, as expounded by John Hales and Thomas Mun (1571–1641), which dominated the sixteenth and seventeenth century England of commercial capitalism which itself was the precursor to industrial capitalism. It is during the period of industrial revolution that Adam Smith (1723–90) published his Wealth of Nations in 1776, and the father of economics expounded the doctrine of free trade. Smith was followed by other perspicacious economists: David Ricardo (1772–1823), Robert Torrens (1780–1864), Friedrich List (1789–1846) and John Stuart Mill (1806–73) who made specific contributions to the theory of international trade.

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Chapter 5. Sources of International Trade: An Overall View

Abstract

The objective of this chapter is to give some idea to the reader about the various probable causes of international trade. These notions, it is hoped, will provide a better perspective and enable the reader to appreciate the theories discussed in this book. The various sources of trade are not rigorously discussed but presented here in the simplest possible way.

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Chapter 6. The Ricardian Hypothesis

Abstract

The core idea of the Ricardian hypothesis is contained in the classic numerical example (as discussed in Chapter 4) which not only elucidated the concept of comparative advantage but also demonstrated welfare gains from free international trade. It has often been a matter of debate regarding whether Ricardo’s objective of the three paragraphs in chapter 7 of his Principles was to enquire into the fundamental causes of international trade or to demonstrate the universal benefits of free trade. One view asserts the latter objective and points out in evidence that, in a full enquiry of the pattern of international trade, Ricardo would have taken three factors of production (land, labour and capital) into account as in his model of economic growth. The alternative view asserts the former objective and believes that the celebrated England-Portugal example can be construed as being an explanation of the pattern of international trade. In evidence, it points out that the assumption of labour being the only factor of production is a direct implication of the classical labour theory of value. The role of ‘capital’ is complementary to labour, and ‘capital’ is not defined as ‘capital goods’ but rather as ‘wage fund’ which buys labour services and raw materials during the ‘period of production’. If labour is assumed to be homogeneous so that wage rates are identical between the sectors, then ‘wage fund’ will be proportional to employment of labour in each sector, and hence, total costs are proportional to wage costs. If this argument is valid, then one needs to concentrate only on labour requirements.

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Chapter 7. Empirical Tests of the Ricardian Hypothesis

Abstract

In accordance with the tenets of economic methodology, a hypothesis must be tested by using the real world data to gauge its explanatory power. The Ricardian hypothesis had to wait for 134 years before the first attempts on its empirical corroboration were made. MacDougall’s (1951, 1952) studies were the first attempts to test the Ricardian hypothesis. His work was followed by several other economists. In this chapter, we discuss the methods used to test the Ricardian hypothesis, summarise the important results, and form an overall opinion about whether the hypothesis is empirically valid or not.

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Chapter 8. The Heckscher-Ohlin Hypothesis

Abstract

The notion that a country’s comparative advantage (disadvantage) is determined by the relative abundance (scarcity) of factors of production was first mooted by Eli Heckscher in an article¹ published in 1919 where he concluded the following:

difference in the relative scarcity of the factors of production between one country and another is thus a necessary condition for a difference in comparative costs and consequently for international trade. A further indispensable condition is that the proportions in which the factors of production are combined shall not be the same for one commodity or for another. (p. 278)

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Chapter 9. The Heckscher-Ohlin Model Mathematically Treated

Abstract

It should perhaps be stated that readers who are not keen on mathematical presentation of models may skip this chapter without any loss of knowledge of trade theory. On the other hand, this chapter presents an opportunity to develop mathematical abilities to discuss trade theory. The geometrical analysis of the 2 × 2 × 2 HOS model during the 1940s and 1950s led to the development of the two-sector growth models in the 1960s (e.g., Uzawa, 1961, 1963). These two-sector mathematical models are used to analyse international trade, within the HOS framework, between two countries. This separate mathematical chapter is warranted by the vast amount of work done in this area. In this chapter we first discuss the analytics of a two-good two-factor mathematical model of an economy under autarky and establish the existence of a globally stable equilibrium, and then extend the same to include two countries trading with each other. Here we are concerned only with the static or temporary equilibrium, and the growth equilibrium in the presence of international trade will be discussed in Chapter 19.

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Chapter 10. Some Extensions of the Simple HOS Model

Abstract

Several restrictive assumptions have been made in the chapters which present the HOS theorem as a logically true proposition. The prime focus has been the simple 2× 2×2 model; and the restrictive assumptions include internationally identical tastes and technology, and non-reversibility of factor intensities. Additionally, there are more than two goods, two factors and two countries in the real world. These assumptions clearly are unrealistic. The objective of this chapter is to explore the consequences if these assumptions are eschewed. It is not theoretically possible to do away with all the restrictive assumptions at the same time. Following the usual methodological procedure, the HOS model is examined by changing one assumption at a time. We consider specifically the consequences of internationally non-identical tastes, internationally non-identical technology, the reversal of factor intensities, many goods but two factors and two countries, many factors but two goods and two countries, and many countries but two goods and two factors.

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Chapter 11. Two Comparative Static Theorems

Abstract

The basic theoretical framework, as propounded by Heckscher (1919) and Ohlin (1933), brought forth two famous theorems: the Stolper-Samuelson (SS) theorem and the factor-price equalisation (FPE) theorem. The former theorem, propounded by Stolper and Samuelson (1941), answers the following question: what happens to income distribution (real rewards to the factors of production) if the pattern of production in a country changes, that is, if the production of one good increases and that of the other good (in a two-good case) falls? The latter theorem, propounded by Samuelson (1948, 1949), answers the question: are factor prices internationally equalised if commodity prices are internationally equalised when only commodities are freely traded? Although the SS theorem was originally expounded in the context of international trade, it essentially answers a general equilibrium question about income distribution when, under full employment, the sectoral levels of production change. The proposition put forward by the SS theorem is of immense importance as it has rendered deep insights into the problems of income distribution. The paper by Stolper and Samuelson (1941) is a precursor¹ to the two famous papers by Samuelson (1948, 1949).

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Chapter 12. The Ricardo-Viner Model

Abstract

The Ricardo-Viner model,¹ more commonly known as the specific-factor model, is a somewhat more realistic variant of the HOS model. It retains all the assumptions of the standard HOS model except that one factor, usually capital, is assumed to be sector-specific (at least in the short run) while labour is assumed to be perfectly mobile between the sectors. Jones (1971), Mussa (1974), Mayer (1974) and Neary (1978) have made significant contributions. Specifically, Jones (1971) has analysed some comparative static properties of the short-run Ricardo-Viner model. Neary (1978) has analysed some long-run dynamic properties when capital, the specific factor, moves from one sector to the other in response to higher rental through a process of decreasing capital stock in one sector via capital depreciation coupled with starvation of new investment and increasing capital stock in the other sector via new investment. Such an analytical framework has more relevance to the problems of the real world. If, as a result of international trade, a country produces, say, more of motor vehicles but less of textiles, then clearly capital equipment producing textiles cannot be used to produce more cars. This transformation has to take place over time as described above.

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Chapter 13. Empirical Tests of the HOS Hypothesis: The Factor Content Studies

Abstract

Following the tenets of scientific methodology, the HOS hypothesis has been subjected to quite rigorous tests. Starting with Leontief’s (1954) seminal paper, a vast amount of work has been done to test the empirical validity of the HOS theorem. As we know, the theorem is most robust in its two-good, two-factor, two-country form. One of the fundamental problems has been to apply the simple model to a multi-good, multi-factor, multi-country real world. The HOS theorem postulates a triple relationship between the following variables: (i) relative abundance of internationally homogeneous factors, (ii) factor-intensity determined by internationally identical technology, and (iii) direction of trade (exports and imports). A valid procedure of empirical test should incorporate all the three variables. As we will see, it is not so easy to accomplish this desired goal.

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Chapter 14. Empirical Tests of the HOS Hypothesis: The Cross-Section Studies

Abstract

This chapter presents the cross-section econometric tests of the HOS hypothesis. Cross-section studies include both the cross-industry and the cross-country investigations. We begin with the cross-commodity studies which regress a variable measuring trade performance, usually net trade, on variables which measure determinants of comparative advantage. To test the HOS hypothesis by this method, one would normally regress net exports on capital per worker at the sectoral level on the assumption that there are two generic factors of production (capital and labour). If the results are poor, then a common practice is to bring in additional regressors (such as human capital) in order to obtain some statistically significant results. Within limits, this procedure of including extra relevant explanatory variables can be justified on the basis of a multi-factor approach. However, with the practice of adding explanatory variables ad hoc, a test could degenerate into an empirical search for significant explanatory variables till one finds econometrically acceptable results.

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Chapter 15. Empirical Tests of the HOS Hypothesis: The Tests of Assumptions

Abstract

It is a reasonable methodological procedure to test the empirical validity of the crucial assumptionsassumptions¹ of a model since the conclusions of a hypotheticodeductive model are dependent on the explanans. Notwithstanding the F-twist, Friedman (1953, p.28) clearly states that assumptions facilitate an indirect test of a hypothesis by their implications.

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Chapter 16. Two Theorems in Comparative Statics: The Rybczynski Theorem and the Findlay-Grubert Theorem

Abstract

While discussing the HOS theorem earlier, in Chapter 8, it was assumed (1) that the endowments of capital (K) and labour (L) were given and fixed, and (2) that the state of technology was given and fixed. This chapter discusses the results which are obtained by eschewing these assumptions. Rybczynski (1955), in a classic paper, discusses the impact of a change in the endowment of a factor on the sectoral levels of output and on the inter-industry terms of trade (relative price). The result obtained regarding the levels of sectoral output has come to be known as the Rybczynski theorem. On the other hand, Findlay and Grubert (1959), in another classic paper, discuss the impact of technological progress in one sector on the sectoral levels of output at constant inter-industry terms of trade (relative price). The result obtained regarding the levels of output has come to be known as the Findlay-Grubert theorem. Both these theorems, which have nothing specifically to do with the pure theory of international trade, are direct contributions to the general equilibrium theory although the use of these theorems has enriched trade theory in analysing the impact of capital accumulation and technological progress on international trade.

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Chapter 17. International Trade and Economic Growth

Abstract

This chapter presents an analysis of the relationship between economic growth and international trade — a topic which was introduced first by Hicks (1953). There are three agents of economic growth: capital accumulation, increase in labour supply and technological progress. Historically, economic growth has always been accompanied by invention and innovation of new products — a phenomenon which has only been recently captured in formal growth models. These are discused in Chapter 27. In the last chapter, we have separately analysed the consequences of changes in factor endowments and technological progress on the sectoral levels of output and the relative price in a closed economy. We will now consider a trading world and analyse the impact of economic growth on the volume of trade, the terms of trade and economic welfare.

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Chapter 18. Trade and Growth Mathematically Treated

Abstract

The reader who is not particulary interested in mathematical derivations of various results may wish to skip this chapter without any loss of economic knowledge. However, mathematical equations bring out the interrelationships of endogenous variables into sharper focus. In this chapter we will first discuss the consequences of capital accumulation (that is, an increase in the stock of capital) in one country on the terms of trade and volume of trade. This discussion will be followed by an analysis of the consequences of technological progress in one sector of one country again on the terms of trade and volume of trade. At this stage the reader may benefit by having a quick revision of Section 3 of Chapter 9.

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Chapter 19. A Dynamic Model of Capital Accumulation and International Trade

Abstract

The theory of international trade, till recently, has been notorious for the paucity of dynamic models. The objective of this chapter is to ‘dynamize’ the static HOS model by introducing endogenous capital accumulation through a process of saving and investment and exogenous growth of population or labour supply. Essentially, we here discuss the path-breaking work of Oniki and Uzawa (1965), who have formulated a dynamic model of international trade to analyse the impact of capital accumulation on the patterns of international trade.

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Chapter 20. The Neofactor Proportions Theories

Abstract

The consternation caused by the Leontief paradox led immediately to attempts at finding what the methodologists would call ‘immunising stratagems’. As the reader knows, the first ‘immunising stratagem’ was put forward by Leontief himself when he suggested that American labour was relatively more productive than foreign labour by a factor of three. Leontief’s disconcerting empirical findings also led to a search for sophisticated interpretations and to various attempts at providing alternative or additional explanations. In terms of Lakatos’s MSRP, as the reader may recall,¹the ‘hard core’ of the HOS model is surrounded by a ‘protective belt’ of auxiliary hypotheses from which new explanations emerge.

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Chapter 21. The Neotechnology Theory of International Trade

Abstract

The neotechnology theory, which is sometimes called the ‘technological-gap account’ of international trade, maintains that technological progress, defined in terms of both process and product innovation, is the prime cause of international trade. A country’s comparative advantage (in the case of cost-reducing process innovation) or absolute advantage (in the case of innovating a new product or an improved product) originates in the invention of new technology. This is a dynamic theory for two reasons. First, technological innovations take place in the process of economic growth. Second, and the more important, the monopoly of the new technology is only transitory because, after a lag in time, the other countries imitate the new technology. The general hypothesis is: there is trade among the nations of the world because of a continuous process of creation and diffusion of new technology.

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Chapter 22. Empirical Tests of the Neotechnology Hypothesis

Abstract

The neotechnology theory has been tested in various ways. One obvious method is to analyse the leads and lags of an innovation of a specific product (e.g., synthetic materials or consumer durables) over a substantial period of time. The second method involves estimating the cross-section impact of innovation on export performance at a point in time. Kenen (1970) refers to this procedure as ‘the treadmill dynamics, explaining the trade pattern at each point in time by on-going innovation’ (p. 204). The neotechnology theory is a dynamic theory which predicts that there is trade between the nations of the world because of a continuous process of creation and diffusion of new technology. The cross-section study for a specific year is a snapshot of the economy in a state of flux, as if we ‘freeze’ the economy momentarily. If the creation and imitation of new technology is the prime cause of international trade, then at each moment (or period) the dynamic hypothesis in its ‘frozen’ form must demonstrate that sectoral ‘trade performance’ is a function of ‘technological progress’. It may be noted that sectors are quasi-aggregates of many ‘industries’ producing various distinct products. At a particular period, within a particular sector, some industries introduce new or improved technology, some imitate from the ‘rest of the world’, and some face the situation of their new or improved technology having been imitated by the rest of the world. Thus, the observed trade data bear the full impact of the above-mentioned state of flux.

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Chapter 23. Views on Synthesis of the Neofactor Proportions and Neotechnology Hypotheses

Abstract

An ambivalent attitude seems to have developed towards the neofactor proportions and neotechnology theories. Some consider the empirical specifications of the variables which capture the basic tenets of the neofactor proportions and neotechnology theories, as various facets of the same phenomenon, while others distinguish between two sets of variables emanating from entirely two different phenomena. Among the economists who accept the former perception are those who attempt to interpret R&D in two different ways in order to capture the characterisations of both the neofactor proportions and neotechnology hypotheses, and also those who attempt to establish close statistical relationships between the variables purported to have captured the tenets of the two hypotheses. Economists who accept the latter perception attempt to estimate the relative explanatory power of the two theories, although the empirical specifications of the two theories vary, somewhat in a confusing manner, from economist to economist. For example, Wolter (1977) uses human capital and physical capital as the core explanatory variables to design a test for the neofactor proportions theory and uses R&D and scale-economies as independent variables to do the same for the neotechnology theory. On the other hand, Hirsch (1974) uses R&D, skill-intensity and wages as the core independent variables to design a test for the neotechnology theory, and uses physical capital and value-added as explanatory variables to do the same for the neofactor proportions theory. This chapter attempts to put together various views, and to give a broader perspective of the intrinsic relationships that exist between the various independent variables commonly used to test the two theories.

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Chapter 24. The Linder Hypothesis

Abstract

The Linder hypothesis, which is sometimes called the ‘demand-similarity’ hypothesis, essentially shifts the emphasis from the supply side to the demand side. The traditional Heckscher-Ohlin theory finds the cause of trade in the supply side (mainly in terms of product attributes and country characteristics). It neutralises the effects of demand with the aid of the assumption of homotheticity of internationally identical preferences. Linder (1961) accepts that the HOS theory adequately explains international trade in primary products but claims that it does not explain trade in manufactured products.

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Chapter 25. Intra-Industry Trade: Imperfect Competition, Increasing Returns to Scale, and Product Differentiation

Abstract

In the last chapter we analysed how Linder (1961) emphasised, although without using the term ‘intra-industry trade’, the importance of varieties and differentiated products in determining the volume of trade between countries with similar levels of per capita income. Ever since Grubel and Lloyd (1975) published their book Intra-Industry Trade, a large literature, both theoretical and empirical, has come to exist. Theoretical attempts to demonstrate how intra-industry trade (HT) is generated have broken into new theoretical horizons by incorporating oligopolistic market structure, increasing returns to scale, product differentiation and monopolistic competition. Various economists have put forward various models which incorporate a variety of specific assumptions. All these theoretical models now constitute the bulk of what has come to be known as the ‘new trade theory’. It is true to say that none of the new models in this area has yet attained the theoretical robustness of the HOS model. A general intra-industry trade model has not yet surfaced, but models are gravitating towards four core theoretical approaches (which are discussed later). This chapter discusses models which are representative of the major approaches to intra-industry trade.

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Chapter 26. Empirical Studies in Intra-Industry Trade

Abstract

There are essentially two types of empirical studies in intra-industry trade: the documentary studies and the empirical tests of the IIT models. The documentary studies provide empirical evidence regarding generalised relationships between IIT and certain economic characteristics, e.g., the levels of economic development or the product type. The empirical studies of the hypotheses, spun out by the new theories, attempt to test the explanatory power of the independent variables as suggested or implied by the various theories. But serious problems in testing specific models arise because of diversity in assumed intra-industry trade (homogeneous products, vertically and horizontally differentiated products) and in assumed market structure (oligopolistic, competitive and monopolistically competitive). Separate IIT models focus on the role of separate specific variables, and as yet no single robust IIT theory, combining the various explanatory variable, has emerged. Empirically the various explanatory variables are combined by including these as independent variables in a single linear regression equation. We will turn to these problems again at a later stage in this chapter.

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Chapter 27. Endogenous Growth and International Trade

Abstract

The recent advancement in growth theory is usually referred to as the theory of endogenous growth. Earlier in Chapter 19, we discussed how endogenous capital accumulation in a two-country world leads to changes in a country’s comparative advantage along the path from any momentary equilibrium to the steady-state. In the context of the neotechnology theory, we also discussed how trade is generated by exogenously given process innovation and product innovation, specifically when the technologically advanced country costlessly innovates and the technologically less-advanced country costlessly imitates the new technology with a lag in time. However, the recent work¹ in growth theory emphasises the role of technological progress which takes place endogenously because of either ‘learning by doing’ or deliberate effort to invent new products and new processes by investing in research and development. The title ‘endogenous growth’ owes its genesis to endogenous knowledge creation.

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Chapter 28. Gains from Trade

Abstract

As the reader may have noted, while analysing various trade theories which attempt to establish the cause of international trade, in each case we have stated that the discussion on gains from trade will be delayed until this chapter. There are two reasons for this decision: first, it is deemed useful to put together various theoretical results in one chapter; second, the sources of gains from trade crucially depend on the causes of trade. Our discussion will take into account the Ricardian hypothesis, the HOS model (including the Ricardo-Viner model and the neofactor proportions theory), the neotechnology theory, and the various intra-industry trade models. The general theorem on gains from trade is one of the oldest propositions in trade theory. The theorem fundamentally rests on the proposition that international trade provides an expanded consumption-possibility frontier. One needs also to consider the economic situations when the general theorem need not necessarily hold. Certain problems may arise when, for example, the economy is characterised by domestic distortions or the economy comes to possess temporary monopoly of a newly invented product not yet known in the rest of the world. There are also important considerations regarding dynamic gains from trade which need to be explained. Lastly the reader should note that this chapter assumes full theoretical knowledge of the theories covered in the previous chapters.

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Chapter 29. Trade Policy

Abstract

Despite an intellectually rigorous theoretical case, it may be reiterated, the world has not overwhelmingly accepted the abstract truth of free trade which still remains as the Pareto efficient notional goal. Nations try to achieve or move towards this goal. The Tokyo round or the Uruguay round of trade negotiations (the most recent negotiations under the auspices of GATT) is essentially a part of this move towards freer or, many would say, fairer trade. There is no doubt that the role of trade policy is a significant factor in shaping the pattern of world production and trade. This chapter discusses the impact of the various trade policy instruments on international trade and welfare.

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Chapter 30. Economic Integration

Abstract

In the previous chapter, we discussed trade policy in terms of a country using various instruments against all trade partners uniformly. Economic integration essentially implies differential treatment of different countries with respect to trade policy. If countries A and B have achieved economic integration, then these two countries will treat each other’s imports differentially from imports from other countries. Economic integration represents a movement towards freer trade at least among the members of the trade bloc. More fundamentally economic integration is a process of fusion of economies which were once independent. There are various forms of economic integration depending on the chosen ‘degree’ of integration. During the last four decades, there has been a proliferation of groups of countries forming economically integrated blocs¹in various parts of the world, e.g., ASEAN (Association of South-East Asian Nations) CARICOM (Caribbean Community and Common Market), ECOWAS (Economic Community of West African States), EU (European Union), LAIA (Latin American Integration Association) and NAFTA (North American Free Trade Area), among other blocs. This chapter attempts to discuss the various forms of economic integration and to analyse the trade and welfare consequences of economic integration.

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Backmatter