Studies in the Pure Theory of International Trade

Although the pure theory of international trade has much in common with the micro-economic theory, for obvious reasons trade theory should be and has been treated as a separate discipline. Nevertheless, a clear comprehension of the micro-economic concepts is essential for the exploration of various issues that arise in the field of inter­national trade. Accordingly, the present chapter is devoted to a brief examination of mathematical concepts, definitions and geometric tools which have been utilised quite extensively in the literature and which as an aid to exposition will be used on numerous occasions in subsequent chapters.

One of the elemental, though most important, questions in international trade concerns the determination of a country’s pattern of trade. Stated differently, why are countries induced to import goods if they can produce them at home? The answer to these questions, however, requires a prior comprehension of the structure of production in a closed economy or autarky. It is this latter question with which the present chapter is concerned. Specifically, we wish to determine the factors which influence commodity prices in the absence of trade.

In the last chapter we studied how changes in the commodity-price ratio occur under the thrust of variations in the factor-price ratio, the overall capital/labour ratio and the relative rate of technical advance in the two industries. Any theory attempting to explain the basis of international trade must always commence with the theory of resource allocation and production in a closed economy. This task having been accomplished in the previous chapters, we are now in a position to pinpoint the factors that determine a country’s pattern of trade. The issue is what goods a country will export and import. Stated differently, is it possible to predict a country’s configuration of exports and imports just by examining the characteristics of a closed economy? Seeking a clear-cut answer to this query constitutes the subject-matter of this chapter.

The theory of gains from trade is almost as old as economics itself. Early contributions in trade theory were motivated by the desire to demonstrate the speciousness of protectionist policies advocated by the Mercantilist School. Adam Smith was among the first to point out the beneficial effects of international trade because it provided expanded opportunities for ‘division of labour’, or for what the modern writers call ‘specialisation’.

Because of its long chronicle, the theory of nominal tariffs has earned a pivotal place in the literature on the pure theory of international trade. Historically, the main concern of this theory has been with the implications of tariffs on the imports of final products, and it is only recently that the trade theorist has begun to explore the implications of tariffs on the imports of intermediate products, despite their existence in practice for centuries. The fast-proliferating literature concerned with the latter question is surveyed in the chapter on effective protection; the present chapter is concerned solely with the issues arising from the imposition of nominal tariffs.

The analysis of interrelations between economic expansion and the terms of trade cannot boast of a long, uninterrupted history. Here and there one may come across a few scattered references to terms of trade in studies of the incidence of technological innovations on the growing country’s net gain from growth in the works of Mill [18], Edgeworth [9], Bastable [2] and Ohlin [19]; of the desirability of the policy of protection in the wake of technical improvements in what is known as the German tariff controversy;† of the celebrated transfer problem sparked primarily by Thornton [22] and Hume [14] and subsequently resurrected by Taussig [21] and Keynes [17] (in the famous debate over the German reparations problem); finally, of the impact of international capital movements featuring in the works of Fanno [10], Iverson [15] and Ohlin [19]. But the avowed application of the tools of general equilibrium analysis to the diagnosis of the behaviour of the terms of trade consequent upon growth is only a post-war phenomenon. Whatever ingenuity the problem of shifts in inter-country commodity prices elicited from the economist in the pre-war era was, with a few exceptions,‡ incidental; it arose not because of an interest in the application of economic theory to the problem of economic development, which itself never figured prominently in neo-classical writings, but was due to the economist’s preoccupation with some other issues of current importance wherein considerations of the terms of trade were unavoidable.

Until now we have assumed that goods are produced with the help of primary factors only, but since in practice much of the production activity would come to a halt if there were no intermediate products — goods which are produced to be used as inputs in other goods — this assumption, although a convenient one, is very unrealistic. There is hardly any justification for this assumption, even though the bulk of trade theory has ignored the presence of material inputs which constitute a very large proportion of the total volume of world trade.† It is only recently that trade theorists have come to recognise the importance of intermediate products in the production process, but even here the general tendency has been to defend the neglect of the treatment of material inputs in the earlier literature. In his book on trade theory, for example, Kemp ([7], p. 148), citing Vanek [10], defends the neglect of the incorporation of intermediate goods in earlier trade theory. In some respect, this neglect may be justified. Many properties of the general equilibrium model presented in the previous chapters carry over to the model with intermediate goods. However, there are some crucial differences which have not been recognised before. The analysis of such similarities and differences is the subject-matter of this chapter.

In the previous chapter our analysis focused entirely on the implications of inter-industry flows for various theorems in trade theory. As noted there, most of the trade literature on intermediate products concerns the commodities which serve the dual role of goods used for final consumption and as productive inputs. However, there exists another class of intermediate goods which are produced solely to be used as productive inputs and not for final consumption at all. Such goods may be called pure intermediate goods, and include produced inputs like raw materials, spare parts, steel, etc. The current literature in trade theory pays scant attention to the implications of such products. If the ramifications of pure intermediate products ran closely parallel to those of inter-industry flows, the current neglect of the former could be easily vindicated. However, as will be demonstrated in this chapter, there are important differences between the implications of the two types of material inputs, crucial among them being the fact that, unlike with the inter-industry flows, the gross and net factor-intensity rankings need not be identical in the presence of pure intermediate products. This implies that those traditional theorems in trade theory that depend exclusively on the nature of the differences between the factor intensities in the two final products may no longer be valid in the model that allows for the presence of pure intermediate products, even though these theorems continued to be valid in the model with inter-industry flows.

Why do countries impose tariffs? The main objective of the tariff-imposing country, apart from curbing imports and possibly capturing the advantage of its natural monopoly power in trade, is to encourage the domestic production of the import-competing industries whose survival is threatened by foreign competition. Until recently, the protective effects of a tariff on the imports of a final good were taken for granted. It was generally believed that a higher rate of tariff or a higher nominal rate of protection would lead to a higher output level for the protected commodity. With the recognition by trade theorists of the importance of trade in intermediate goods, a new measure of protection, widely known as the effective rate of protection (E.R.P.), has been evolved to take into account the implications of the entire tariff structure, rather than tariffs on individual imported commodities, for the pattern of output in the economy. In contrast to the theory of nominal protection, which analyses the impact of tariffs on the total value of final goods, the E.R.P. measures the percentage change in the contribution of the domestic primary factors or, what is the same thing, in the value-added of an industry as the economy moves from a free trade situation to one of protected trade.

There is a general agreement among economists that perfect competition is a ‘myth’. Yet the bulk of the analysis in trade theory — and economic theory in general — has been carried out under this ‘mythical’ assumption. Perhaps the best case that can be made for a perfect market is that it provides an ‘ideal’ yardstick to evaluate the efficiency of existing systems which generally fail to satisfy the stringent requirements of competitive conditions. This suggests that the assumption of perfect markets, which up to the previous chapter contributed much to the simplicity of our analysis, stands in need of replacement. Relaxing this assumption in turn permits a wide variety of production systems such as monopoly, oligopoly, imperfect factor markets, etc., all of which, individually or collectively, may characterise the production side of a country. In order to bring the analysis down to manageable proportions, some selectivity in the choice of alternative systems is unavoidable. In this chapter we relax the assumption of perfect factor markets, while product markets continue to be perfect. The discussion of the product market distortions is postponed until the next chapter.

The previous chapter was devoted to the analysis of factor market imperfections in the presence of international trade. The quintessence of the chapter was that the existence of distortions in factor markets could cause reversals in nearly all the results derived from the standard undistorted model. Throughout our analysis there, product markets were still assumed to be perfect. In this chapter we turn to the other side of the exercise and assume that different goods are produced by different monopolists, but that factor markets continue to be perfect. It is worth pointing out here that within the theory of market imperfections it is the distortions in factor markets that have borne the brunt of attack from the trade theorist, whereas the existence of distortions in product markets, perhaps because of the intractability of the problem, has by and large been ignored.

Every country produces goods which cannot be traded at all either because of the nature of the goods, like houses, services, etc., or because of political barriers preventing, for example, the export of certain strategic military equipment, or because of artificial trade barriers like prohibitive tariffs. In all the preceding chapters we ignored the presence of such products, much at the expense of economic reality. The objective of this chapter is to examine how and to what extent the results derived from the two-traded-goods model are modified when a non-traded final good is incorporated into the framework.

The barter theory of international exchange remains incomplete until the complications arising from the presence of international investment are explored in our standard two-good, two-factor model. This is the task assigned to this chapter. In all, this chapter is concerned with two burning issues. First, it turns out that under certain conditions free international movement of capital is a perfect substitute for free inter-country movement of goods. In other words, the hitherto assumed absence of international immobility of factors turns out to have been made not for convenience but for ensuring that trade will in fact take place among countries. However, the conditions under which capital movement becomes a perfect sub­stitute for goods movement are quite stringent, and it is not at all unlikely to encounter the presence of international movement of both goods and capital. This gives rise to our second question, namely, what are the optimal policies in the presence of trade and international investment? The model described below is a natural extension to the case of international investment of the two-good, two-factor model that we have been using in the past several chapters.

Recent years have witnessed a steadily growing application of the standard two-factor, two-good model to the solution of questions that arise in a growing economy, questions that were first raised in a seminal contribution by Oniki and Uzawa [5]. Although some insights as to what happens in the economy under conditions of growing factor supplies and technology were gained in Chapter 6, the nature of our analysis there was essentially comparative statics, for we were concerned primarily with the implications of exogenous and once-for-all growth in factor supplies. In the present chapter, however, our concern will be the development of a dynamic model where labour grows exogenously at a certain given rate, but where capital grows endogenously as a result of the savings habits of the factor owners. Oniki and Uzawa and, following them, otherst have used a technique which, for want of a better substitute, I call the ‘production function’ technique. The mathematical calculations under this technique are quite lengthy and oppressive, and a superficial glance is sufficient to discourage the student from getting seriously involved with the problem. Fortunately, the technique suggested by the activity-analysis approach used in the past chapters cuts down the length of the derivations and makes the issues susceptible to better comprehension.