The Pure Theory of International Trade

The pure theory of international trade is concerned with the fundamental relationships which exist between two trading bodies. In one sense it is a branch of exchange theory, but because the exchanging bodies are, on the whole, countries, additional relationships come into play. It was often debated in the past – although the distinction is readily accepted today – as to why we should have a theory of international trade, i.e. whether there is a distinction between inter-regional trade and international trade. The usual reasons given for distinguishing the two are: (i) international immobility of factors of production; (ii) independent monetary systems; (iii) the existence of political boundaries and controls which go with them; and (iv) greater geographical differences and greater transport costs. However, each of these is a matter of degree only.

In 1776 Adam Smith argued that if a country could produce a good cheaper than a second country, and if the second country could produce a different good more cheaply than the first, it would be to the advantage of both countries if they specialised in the good they could produce cheapest, and traded. For example, the tropics are more suited to growing bananas than the temperate zone and with the same amount of labour the tropics can produce far more bananas than can the U.K. On the other hand the U.K. is more suited to producing machine goods and with the same amount of labour the U.K. can produce more machinery than can a tropical country. It will be of obvious advantage to both countries to employ the division of labour and to produce the good in which each has an absolute advantage and undertake international exchange. The qualification ‘absolute’ is necessary because the question arises, as Torrens and Ricardo pointed out:¹ what if a country can produce both goods in greater amount with the same labour as a second country – will trade cease under these circumstances? Ricardo argued that under these conditions it would be to the (possible) advantage of both countries if they specialised in the good in which they had a comparative advantage.

Classical literature was very much concerned with a country’s wealth by means of international trade – in other words, with the effect of trade on economic growth and development. In the post-Second World War period, the theoretical literature has been largely concerned with the effect of growth on international trade, rather than the converse. Interest in this second direction of causation arose from considerations given to the secular dollar shortage, which led to Hicks’ important inaugural lecture [13]. The classical direction of causation has also returned the attention of economists to a concern for the problems of developing countries. It is helpful, therefore, to divide this section into two parts.

So far we have been concerned essentially with positive economics and have put to one side normative issues. In this section the problems of normative economics are reviewed and consideration is given to the way it has been applied to the problems of international trade. In positive economics it is generally agreed that the conclusions of a theory are to be validated (or falsified) rather than the assumptions. In welfare economics it is important to validate the assumptions rather than the conclusions; moreover, each assumption must be shown to hold in isolation. This partly explains the general concern over the particular welfare criterion adopted. It follows, therefore, that the student who wishes to understand normative issues in international trade – and most of the important problems involve normative issues – must first acquaint himself with the pertinent developments in welfare economics.¹ To see this, consider the following two questions: (i) Can economists pass judgements on international trade policies without invoking ethical judgements about the distribution of income? (ii) Can economists develop useful conclusions on the basis of explicit, generally accepted, ethical norms?

In conclusion, we shall consider briefly a number of extensions and complications which have arisen, and see if any modifications are in order. In this respect we shall consider the introduction of non-tradeable goods, intermediate and capital goods, and the modifications arising from variable returns to scale.

It was pointed out earlier that with more than two factors the concept of factor intensity breaks down; furthermore, in the section on tariffs it was argued that in going from no trade to free trade the wage of the scarce factor is reduced, but this too is dependent upon the concept of factor intensity. The Rybczynski theorem also makes reference to factor intensity, as do many arguments of the Leontief paradox. Growth has been analysed in a 2 × 2 × 2 world. It is most important for the student to be aware that in the field of international trade the generalisation to more than two goods or two factors reduces the significance of many of the former theorems.

The pure theory of international trade has come a long way from Ricardo’s comparative cost doctrine, but we are still a long way from explaining many of the trade phenomena which exist in the world today. Part of the reason for this is that trade theory has remained in the realm of comparative statics with little attention placed on dynamics. This is inevitable in such a complicated interrelated system. Trade theory must explicitly take into account non-economic objectives and place trade theory in a larger socio-politico-economic setting if we wish the theory to be of any practical use. In this sense we would be returning to issues which the classical economists knew were important, but with the difference that our value judgements are made explicit, and with a greater understanding of the economic system.