Introduction International Trade Theory

INTERNATIONAL BUSINESS MANAGEMENT
LESSON 2
INTRODUCTION INTERNATIONAL TRADE THEORY

Learning Outcomes: controlled co-coa marketing board. The board was given the
• Acquaint yourself with various theories propounded by authority to fix prices for cocoa and was designated the sole
various experts in the field of international trade sharing buyer of all cocoa grown in Ghana. The board held down the
their views and experiences by way of theories. prices that it paid farmers for cocoa, while selling the co-coa that
it bought from them on the world market at world prices.
• Theories also help people in the trade to implement them in Thus, it might buy cocoa from farmers at 25 cents. A pound
practical scenario and finding ways and solutions to day to
and sell it on the world market for the world price of 50 cents a
day problems faced in working.
pound. In effect, the board was taxing exports by paying
Case Study farmers considerably less for their cocoa than it was worth on
The Gains From Trade Ghana And South Korea the world market and money was used to fund the government
Living standards in Ghana and South Korea were roughly policy of nationalization and industrialization.
comparable in 1970. Ghana’s 1970 gross national product One result of the cocoa policy was that between 1963 and 1979
(GNP) per head was $250, and South Korea’s was $260. By the price paid by the cocoa marketing board to Ghana’s farmers
1998 the situation had changed dramatically. South Korea had a increased by a factor of 6, while the price of consumer goods in
GNP per head of $8,600 and boasted the world’s 12th largest Ghana increased by factor of 22, and while the price of cocoa in
economy. Ghana’s GNP per capita in 1998 was only $390, while neighboring countries in-creased by a factor of 22,and while the
its economy ranked 96 in the world. These differences in price of cocoa in neighboring countries in creased by a factor of
economic circumstances were due to vastly different economic 36! In real terms, the Ghanaian farm-ers were paid less every year
growth rates since 1970. Between 1968 and 1998, the average for their cocoa by the cocoa marketing board, while the world
annual growth rate in Ghana’s GNP was less than 1.5 percent. price increased signifi-cantly. Ghana’s farmers responded by
In South Korea achieved a rate of more than 8 percent -annually switching to the production of subsistence foodstuffs that
between 1968 and 1998. could be sold within Ghana, and the country’s production and
While no simple explanation addresses the difference growth exports of cocoa plummeted by more than one-third in seven
rates between Ghana and South Korea, part of the answer may years. At the same time, the Ghanaian government’s attempt to
be found in the countries’ attitudes to ward- international trade. build an industrial base through state-run enterprises was a
A now classic study by the World suggests that whereas the complete failure. The resulting drop in Ghana’s export earnings
South Korean government implemented policies that encour- plunged the country into recession, led to a de-cline in its
aged companies engage in international trade, the actions of the foreign currency reserves, and severely limited its ability to pay
Ghanaian- government. Discouraged domestic producers from for necessary imports.
becoming involved in international trade. As a conse-quence, in In essence, what happened in Ghana is that the inward oriented
1980 trade accounted for 18. Percent of Ghana’s GNP by value trade policy of the Ghanaian government resulted in a shift of
compared to 74 percent of South’s GNP. that country’s resources away from the profitable activity of
In1957, Ghana became the first of Great Britain’s West African growing cocoa-where it had an ab-solute advantage in the world
colonies to gain independence. Its first president, Kwame economy and toward growing subsistence foods and manufac-
Nkrumah, influenced the rest of the continent with his theories turing, where it had no advantage. This inefficient use of the
of pan-African socialism. For Ghana this meant the imposition country’s resources severely damaged the Ghanaian economy
of high tariffs on many imports, an import substitution policy and held back the country’s economic development
aimed at fostering Ghana self- sufficiency in certain manufac- In contrast, consider the trade policy adopted by the South
tured goods, and the adop-tion of policies that discouraged Korean government. The World Bank has characterized the
Ghana’s enterprises from engaging in exports. The results were trade policy of South Korea as “strongly outward oriented.”
an unmitigated disaster that transformed one of Africa’s most Unlike in Ghana, the policies of the South Korean government
prosperous is into one of the worlds poorest. emphasize low import barriers on manufactured goods (but
As an illustration of how Ghana’s antitrade policies destroyed not on agricultural goods) and incen-tives to encourage South
the Ghanaian economy, consider the Ghanaian, government’s Korean firms to export. Beginning in the late 1950s, the South -
involvement in the cocoa trade. A combination- of favorable Korean government progressively reduced import tariffs from
climate, good soils, and ready access -to the world shipping an average of 60 percent -of the price of an imported good to
routes has given Ghana an absolute advantage in cocoa less than 20 percent in the mid-1980s. On most nonagricultural
production. Quite simply, it is one of the best places in the goods, import tariffs were reduced to zero. In addition, the
World to grow cocoa. As a conse-quence, Ghana was the world’s number of -imported goods subjected to quotas was reduced
largest producer and ex-porter of cocoa in 1957. Then the from more than 90 percent in the late 19505 to zero by the early
government of the newly independent nation created a state- 1980s. Over the same period, South Korea progressively

© Copy Right: Rai University
11.154 15

reduced the subsidies given to South Korean exporters from an advocated that countries should simultaneously encourage

average of 80 percent of their sales price in the late 1950s to an exports and discourage imports. Although mercantilism is an
average of less than 20 percent of their sales price in 1965 and old and largely discredited doctrine, its echoes remain in modem
down to zero in 1984. Put another way, with the exception of political debate and in the trade policies of many countries.
the agricultural sector (where a strong farm lobby maintained Next we will look at Adam Smith’s theory of absolute advan-
import controls), South Korea moved progressively toward a tage. Proposed in 1776, Smith’s theory was the first to explain
free trade stance. why unrestricted free trade is beneficial to a country. Free trade
South Korea’s outward-looking orientation has been rewarded refers to a situation where a government does not attempt to
by a dramatic transformation of its economy. Initially, South influence through quotas or duties what its citizens can buy
Korea’s resources shifted from agriculture to the manufacture from another country, or what they can produce and sell to
of labor-intensive goods, especially textiles, clothing, and another country. Smith argued that the invisible hand of the
footwear. An abundant supply of cheap but well-educated market mechanism, rather than government policy, should
labor helped form the basis of South Korea’s comparative deter- mine what a country imports and what it exports. His
advantage in labor-intensive manufacturing. More recently, as arguments imply that such laissez-faire stance toward trade was
labor costs have risen, the growth areas in the economy have in the best interests of a country. Building on sumit’s work are
been in the more capita-in--tensive manufacturing sectors, two additional theories that we shall review. One is the theory
especially motor vehicles, semiconductors, consumer electronics, of comparative advantage, advanced by the 19th century
and advanced materials. As a result of these developments, English economist David Ricardo. This theory is the intellectual
South Korea has gone through some dramatic changes. In the basis of the modem argument for unrestricted free trade. In the
late 1950s, 77 percent of the country’s employment was in the 20th century two Swedish economists, Eli Heckscher and Bertil
agricultural sector; today the figure is less than 20percent.Over Ohlin whose theory is known as the Heckscher-Ohlin theory,
the same period the percentage of its GNP accounted for by refined Ricardo’s work.
manufacturing in-creased from less than 10 percent to more The Benefits of trade
than 30 percent, while the overall GNP grew at an annual rate of The great strength of the theories of Smith, Ricardo, and
more than 9 percent. Heckscher-Ohlin is that they identify with precision the specific
Sources: “Poor Man’s Burden: A survey of the third World, benefits of international trade. Common sense suggests that
“The economist, September 23, 1989;World Bank, World some international trade is beneficial. For example, nobody
Development report, 2000(Oxford: Oxford university press, would suggest that Iceland should grow its own oranges.
2000s,) Table 1;J. Whalee, “international Trade, Distortions, and Iceland can benefit from trade by exchang-ing some of the
Long-Run Economic Growth, “International Monetary Fund products that it can produce at a low cost (fish) for some
Staff Papers 40, no. 2 (June 1993), p. 299. products that it cannot produce at all (oranges). Thus, by
engaging in international trade, Icelanders are able to add
Introduction
oranges to their diet of fish.
The opening case illustrates the gains that come from interna-
tional trade. For a long time the economic policies of the The theories of Smith, Ricardo, and Heckscher-Ohlin go
economic policies of the Ghanaian government discouraged beyond this commonsense notion, however, to show why it is
trade with other nations. The result was a shift in Ghana’s beneficial for a country to engage in international trade even for
resources away from productive uses (grow-ing cocoa) and products it is able to produce for itself. This is a difficult concept
toward unproductive uses (subsistence agriculture). The for people to grasp. For example, many people in the United
economic policies of the South Korean government encouraged States believe that American consumers should buy products
trade with other nations. ‘The result was a shift in South produced in the-United States by American companies when-
Korea’s resources away from uses where it had no compara-tive ever possible to help save American jobs from foreign
advantage in the world economy (agriculture) and toward more competition. Such thinking apparently underlay a 1997 decision
productive uses (labor-intensive manufacturing). As a direct by the International Trade Commission to protect the Louisi-
result of their policies toward interna-tional trade, Ghana’s ana crawfish industry from inexpensive Chinese imports (see
economy declined while South Korea’s grew. This chapter has the companying Country Focus).
two goals that are related to the story of Ghana and South The same kind of nationalistic sentiments can be observed in
Korea. The first is to review a number of theories that explain many other countries. However, the theories of Smith, Ricardo,
why it is beneficial for a country to engage in international trade. and Heckscher-Ohlin tell us that a country’s. Economy may gain
The second goal is to explain the pattern of in-ternational trade if its citizens buy certain products from other nations that could
that we observe in the world economy. With regard to the be produced at home. The gains arise because international
pattern of trade, we will be primarily concerned with explaining trade allows a country to spe-cialize in the manufacture and
the pattern of exports and im-ports of products between export of products that can be produced most efficiently in that
countries. We will not be concerned with the pattern of for-eign country, while importing products that can be produced more
direct investment between countries. efficiently in other countries. So it may make sense for the
An Overview of Trade Theory United States to specialize in the production and export of
We open this chapter with a discussion of mercantilism. commercial jet aircraft, since the efficient production of com-
Propagated in the 16th and 17th centuries, mercantilism mercial jet aircraft requires resources that are abundant in the
United States, such as a highly skilled labor force and cutting-
16 11.154

edge technological know-how. On the other hand, it may make petition claimed that Chinese crawfish producers dumping their

sense for the United States to import textiles from India since product; selling at below cost to drive Louisiana producers out
the efficient production of textiles requires a relatively cheap of business, the industry requested that a 200 percent to 300
labor force-and cheap lab-or is not abundant in the United percent import tax be placed on Chinese crawfish. The State of
States. Louisiana appropriated $350,000 from state funds to support
Of course, this economic argument is often difficult for the action.
segments of a country’s pop-ulation to accept. With their future Lawyer representing the Chinese crawfish in-dustry claimed that
threatened by imports, American textile companies and their lower production costs in China were the reason for the low
employees have tried hard to persuade the U.S. government to prices-not dumping. One Louisiana-based importer of Chinese
limit the importation of textiles by demanding quotas and crawfish pointed out that 27 processing plants in China
tariffs. Similarly, as the Country Fo-cus illustrates, with their supplied his company. Workers at these plants were given
future threatened by imports, the Louisiana crawfish indus-try housing and other amenities and paid 15 cents per hour, or $9
succeeded in persuading the government to limit imports of for a 60-hour week. The lawyers also said Chinese crawfish have
crawfish from China. Although such import controls may been I good for American consumers, who have saved money
benefit particular groups, such as American tex-tile businesses and benefited from a steadier supply, and good for Louisiana
and their employees or Louisiana crawfish farmers, the theories cuisine, because it is has be-come less expensive to cock. The
of Smith, Ricardo, and Heckscher-Ohlin suggest that the lawyers pointed out that the action was not in the interests of
economy as a whole is hurt by this kind of action. Limits on Amer-ican consumers, since it was nothing more than an
imports are often in the interests of domestic producers, but attempt by Louisiana producers to reestablish their lucrative
not domestic consumers. monopoly on the production of crawfish, a monopoly that
would enable them to extract higher prices from consumers.
Case study
However, the International Trade Commission was deaf to
Crawfish Wars
such arguments. The commission deemed that China was a
Once upon a time, Louisiana was owned by the French.
“nonmarket economy” since it was not yet a member of the
Napoleon sold the territory to the United States, when Thomas
World Trade organization (something that changed in 2001).
Jefferson was president, but many of the French stayed on,
The commission then used prices in a “market econ-omy,”
over time, their descendants developed the distinctive Cajun
Spain, to establish a benchmark for a “fair market value” for
culture that today is cele-brated in the United States for its
crawfish. Since Spanish crawfish sell for approximately twice the
unique cuisine and -music. At the heart of that cuisine can be
price of Chinese crawfish and about the same price as Louisiana
found the venerable crawfish, as Louisianans call the crayfish.
crawfish, the commission concluded that the Chi-nese were
The crawfish is a fresh-water crustacean native to the bayous of
dumping (selling below cost of production). In August
Louisiana. A central ingredient of crawfish pie, bisque, etouffee,
1997,the commission levied a 110 to 123 percent duty on
and gumbo, the craw-fish is to Cajun Louisiana what wine is to
imports of Chinese crawfish, effectively negating the price
France: a symbol of culinary symbol of its culture. It is also a
advantage enjoy by Chinese producers. In the interests of
major industry that -generates $300 million per year in revenues
protecting American jobs, the commission sided with Louisiana
for Louisiana crawfish farmers-or at least it did until the Chinese
producers and against American consumers, who would now
appeared.
have to pay higher prices for crawfish. Under commission
In the early 1990s, development of the Chinese industry was regulations, the ruling would stay place for five years, after which
encouraged by Louisiana importers to meet the growing the legitimacy of import duty must be reevaluated.
demand for crawfish. In China, the crawfish industry proved to
be attractive for entrepreneurial farmers. Chinese crawfish first The pattern of international trade
started to appear on the Louisiana scene in 1991. Although old- The theories of Smith, Ricardo, and Heckscher-Ohlin also help
time Cajuns were quick to claim that the Chinese crawfish had a to explain the pattern of international trade that we observe in
markedly inferior taste, consumers didn’t seem, to notice the the world economy. Some aspects of the pattern are easy to
difference. More importantly perhaps, they liked the price, which understand. Climate and natural resource endowments explain
ran between $2 and $3 per pound depending on the season, why Ghana exports cocoa, Brazil exports coffee, Saudi Arabia
compared to $5 to $8 per pound for native Louisiana crawfish. exports oil, and China exports crawfish. But much of the
With the significant price advantage, sales of Chinese imports observed pattern of international trade is more difficult to
skyrocketed - from 353,000pounds in 1992 to 5.5 million explain. For example, why does Japan export automobiles,
pounds in 1996. By 1996, Louisiana state officials estimated th- consumer electronics, and machine tools? Why does Switzer-
at 3,000 jobs had been lost in the local indus-try mostly land export chemicals, watches, and jewelry? David Ricardo’s
minimum-wage crawfish peelers, due to markets share gains theory of comparative advantage offers an explanation in terms
made by the Chinese. of international differences in labor productivity. The more
sophisticated Heckscher-Ohlin theory emphasizes the interplay
This was too much for the Louisiana industry to stomach. In between the, proportions in which the factors of production
1996, Louisiana’s Crawfish Promotion and research board filed (such as land, labor, and capita) are available in different
a petition with the International trade Commission, an arm of countries and the proportions in which they are needed for
the U.S. government, requesting an antidumping action. The producing particular goods. This explanation rests on the

11.154 17

assumption that countries have varying endowments of me assertion was gold and silver were the mainstays of national

various factors of production. Tests of this theory, however, wealth and essential to vigorous commerce. At that time, gold
suggest that it is a less powerful explanation of real-world trade and silver were the currency of trade between countries; a
patterns than once thought. - country could earn gold and silver by exporting goods. By the
One early response to the failure of the Heckscher-Ohlin theory same token, importing goods from other countries. The main
to explain the ob-served pattern of international trade-was the tenet of mercantilism was that it was in a country’s to maintain
product life-cycle theory. “Proposed by Ray-mond Vernon, this a trade surplus, to export more than it imported. By doing so, a
theory suggests that early in their life cycle, most new products country would accumulate gold and silver and, consequently,
are produced in and exported from the country in which they increase its national wealth and prestige. As the English
were developed. As a new product becomes widely accepted mercantilist writer Thomas Mun put it in 1630.
internationally, however, production starts in other countries. The ordinary means therefore to increase our wealth and
As a result, the theory suggests, the product may ultimately be treasure is by foreign tread, where we must ever observe this
exported back to the country of its original innovation. rule: to sell more to strangers yearly than we consume of theirs
In a similar vein, during the 1980s economists such as Paul in value.
Krugman of. Massa-chusetts Institute of Technology devel- Consistent with this belief, the mercantilist doctrine advocated
oped what has come to be known as the new trade theory. New government intervention to achieve a surplus in the balance of
trade theory stresses that in some cases countries specialize in. trade. The mercantilists saw no virtue in a large volume of trade
the production and export of particular products not because per se. Rather, they recommended policies to maximize exports
of underlying differences in factor endowments, but because in and minimize imports. To achieve this, imports were limited by
certain industries the world market can support only a limited tariffs and quotas, while exports were subsidized.
number of firms. (This is argued to be the case for the com- The classical economist David Hume pointed out an inherent
mercial air-craft industry.) In, such industries, firms that enter inconsistency in the mercantilist doctrine in 1752. According to
the market first are able to build a competitive advantage that is Hume, if England had a balance-of-trade surplus with France
subsequently difficult to challenge. Thus, the observed pattern (it exported more than it imported) the resulting inflow of
of trade between nations may be due in part to the ability of gold and silver would swell the domestic money supply and
firms within a given nation to capture first-mover advantages. generated inflation in England. In France, however the outflow
The United States dominates in, the export of commercial jet of gold and silver would have the opposite effect. France’s
aircraft because American firms such as Boeing were first movers money supply would contract, and its prices would fall. This
in .the world market. Boeing built a competitive advantage that change in relative prices between France and England would
has subsequently been difficult for firms from countries with encourage the France to buy fewer English goods (because they
equally favorable factor endow-ments to challenge. were becoming more expensive) and the English to buy more
In a work related to the new trade theory, Michael Porter of the Franch goods. The result would be deterioration in the English
Harvard Business School developed a theory, referred to, as the balance of trade and an improvement in France’s trade balance,
theory of nation competitive advantage that attempts to explain until the English surplus was elim-inated. Hence, according to
why particular nations achieve international success in particular Hume, in the long run no country could sustain a surplus OD
industries. Like the new trade theorists, in addition to factor the balance of trade and so accumulate gold and silver as the
endowments, Porter points out the importance of country mercantilists had envisaged.
factors such as domestic demand and do-mestic rivalry in The flaw with mercantilism was that it viewed trade as a zero
explaining a nation’s dominance in the production and export game. (A zero-sum game is one in which a gain by one country
of particular products. results in a loss by another.) It was left to Adam Smith and
The Theory and Government Policy David Ricardo to show the shortsightedness of this approach
Although all these theories agree that international trade is and to demon-strate that trade is a positive sum game, or a
beneficial to, a country, they lack agreement in their recommen- situation in which all countries can benefit. The mercantilist
dations for government policy. Mercantilism makes a crude case doctrine is by no means dead. For example, Jarl Hagelstam, a
for government involvement in promoting exports and director at the Finnish Ministry of Finance, has observed that in
limiting imports. The theories of Smith, Ricardo, and most trade negotiations:
Heckscher-Ohlin form part of the case for unrestricted free The approach of individual negotiating countries, both
trade. The argument for unrestricted free trade is that both industrialized and developing has been to press for trade
import controls and export incentives (such as subsidies) are liberalization in areas where their own comparative competitive
self-defeating and result In wasted resources. Both the new advantages are. The strongest, and to resist liberalization in
trade theory and Porter’s theory of national competi-tive areas where they are less competitive and fear that imports
advantage can be interpreted as justifying some limited govern- Would replace domestic production.
ment intervention to support the development of certain
Hagelstam attributes this strategy by negotiating countries to a
export-oriented industries.
neomercantilist belief held by the politicians of many nations.
Mercantilism This belief equates political power with economic power and
The first theory of international trade emerged in England in economic power with a balance-of-trade surplus; Thus, the
the mid-16th century. Referred to as mercantilism, its principle

18 11.154

trade strategy of many nations is designed to simultaneously country must also consume what it produces. Ghana would be

boost exports and limit imports. able to produce 10 tons of cocoa and 5 tons of rice (point A in
Figure 2.1), while South Ko-rea would be able to produce 10
Absolute advantage
tons of rice and 2.5 tons of cocoa. Without trade, the com-
In his 1776 landmark book The Wealth of Nations, Adam
bined production of both countries would be 12.5 tons of
Smith attacked the mercan-tilist assumption that trade is a zero-
cocoa (10 tons in Ghana plus 2.5 tons in South Korea) and 15
sum game. Smith argued that countries differ in their ability to
tons of rice (5 tons in Ghana and 10 tons in South Korea). If
produce goods efficiently. In his time, the English, by virtue of
each country were to specialize in producing the good for which
their superior manufacturing processes, were the world’s most
it had an absolute advantage and then trade with the other for
efficient textile manufacturers. Due to the combination of
the good it lacks, Ghana could produce 20 tons of cocoa, and
favorable climate, good soils, and accumulated expertise, the
South Korea could produce 20 tons of rice. Thus, by specializ-
French had the world’s most efficient wine industry. The
ing, the production of both goods could be increased.
English had an absolute advantage in the production of
Production of cocoa would increase from 12.5 tons to 20 tons,
textiles, while the French had an absolute advantage in the
while production of rice would increase from 15 tons to 20
production of wine. Thus, a country has an absolute advantage
tons. The increase in production that would result from
in the production of a product when it is more efficient than
specialization is therefore 7.5 tons of cocoa and 5 tons of rice.
any other country in producing it.
Table 2.1 summarizes these figures.
According to Smith, countries should specialize in the produc-
tion of goods for which they have an absolute advantage and
then trade these for goods produced by other countries. In 20 G
Smith’s time, this suggested that the English should specialize

Cocoa
15 Figure 2.1
in the production of textiles while the French should specialize The theory of Advantage
in the production of wine. England could get all the wine it
needed by selling its textiles to France and buy-ing wine in 10 A
exchange. Similarly, France could get all the textiles it needed by
5 K
selling wine to England and buying textiles in exchange. Smith’s B
basic argument, therefore, is that you should never produce 2.5
1
K
goods at home that you can buy at a lower cost from other
countries. Smith demonstrates that by specializing in the
0 5 10 15 20
production of goods in which each has an absolute advantage,
both countries benefit by engaging in trade. Rice
Consider the effects of trade between Ghana and South Korea.
The production of any good (output) requires resources Table 2.1
(inputs) such as land, labor, and capital. Assume that Ghana
Absolute Advantage and the Gains from Trade
and South Korea both have the same amount of resources and
that these resources can be used to produce either rice or cocoa. Resources Required to Produce 1 Ton of cocoa and rice
Assume further that 200 units of resources are available in each Cocoa Rice
country. Imagine that in Ghana it takes 10 resources to produce Ghana 10 20
one ton of cocoa and 20 resources to produce one ton of rice.
South Korea 40 10
Thus, Ghana could produce 20 tons of cocoa and no rice, 10
tons of rice and no cocoa, or some combination of rice and co- Production and Consumption without Tread
coa between these two extremes. The different combinations Cocoa Rice
that Ghana could produce are represented by the line GG’ in Ghana 10.0 5.0
Figure 2.1. This is referred to as Ghana’s production possibility
South Korea 2.5 10.0
frontier (PPF). Similarly, imagine that in South Korea it takes 40
resources to produce one ton of cocoa and 10 resources to Total production 12.5 15.0
produce one ton of rice. Thus, South Ko-rea could produce 5 Production with specialization
tons of cocoa and no rice, 20 tons of rice and no cocoa, or some Cocoa Rice
com-bination between these two extremes. The different
Ghana 20 0.0
combinations available to South Korea are represented by the
line KK’ in Figure 2.1, which is South Korea’s PPF. Clearly, South Korea 0.0 20.0
Ghana has an absolute advantage in the production of cocoa. Total production 20.0 20.0
(More resources are needed to produce a ton of cocoa in South Consumption After Ghana Trades 6 Tons of
Korea than in Ghana.) By the same token, South Ko-rea has an Cocoa for 6 Tons of South Korean Rice
absolute advantage in the production of rice.
Cocoa Rice
Now consider a situation in which neither country trades with
Ghana 14.0 6.0
any other. Each country devotes half of its resources to the
production of rice and half to the produc-tion of cocoa. Each South Korea 6.0 14.0

11.154 19

Increase in Consumption as a Result

of Specialization and Trade 20 G
C
Cocoa Rice 15 Figure 2.2
The Theory of Comparative Advantage
Ghana 4.0 1.0 10 A

Cocoa
South Korea 3.5 4.0
By engaging in trade and swapping one ton of cocoa for one 5
ton of rice, producers in both countries could consume more B 1 1
2.5 K G
of both cocoa and rice. Imagine that Ghana and South Korea
swap cocoa and rice on a one-to-one basis; that is, the price of
0 3.75 5 7.5 10 15 20
one ton of cocoa is equal to the price of one ton of rice. If
Ghana decided to export 6 tons of co-coa to South Korea and In light of Ghana’s absolute advantage in the production of
import 6 tons of rice in return, its final consumption after trade both goods, why should it trade with South Korea? Although
would be 14 tons of cocoa and 6 tons of rice. This is 4 tons Ghana has an absolute advantage in the pro-duction of both
more cocoa than it could have consumed before specialization cocoa and rice, it has a comparative advantage only in the
and trade and 1 ton more rice. Similarly, South Korea’s final production of cocoa: Ghana can produce 4 times as much cocoa
consumption after trade would be 6 tons of cocoa and 14 tons as South Korea, but only 1.5 times as much rice. Ghana is
of rice. This is 3.5 tons more cocoa than it could have con- comparatively more efficient at producing cocoa than it is at
sumed before specialization and trade and 4 tons more rice. producing rice.
Thus, as a result of specialization and trade, output of both
Without trade the combined production of cocoa will be 12.5
cocoa and rice would be increased, and consumers in both
tons (10 tons in Ghana and 2.5 in South Korea), and the
nations would be able to consume more. Thus, we can see that
combined production of rice will also be 12.5 tons (7.5tons in
trade is a positive-sum game; it produces net gains for all
Ghana and 5 tons in South Korea). Without trade each country
involved.
must consume what it produces. By engaging in trade, the two
Comparative Advantage countries can increase their combined production of rice and
David Ricardo took Adam Smith’s theory one step further by cocoa, and consumers in both nations can consume more of
exploring what might happen when one country has an both goods.
absolute advantage in the production of all goods. Smith’s
The Gains from Trade
theory of absolute advantage suggests that such a country
Imagine that Ghana exploits its comparative advantage in the
might derive no ben-efits from international trade. In his 1817
production of cocoa to increase its output from 10 tons to 15
book Principles of Political Economy, Ricardo showed that this
tons. This uses up 150 units of resources, leaving the remain-
was not the case. According to Ricardo’s theory of comparative
ing50 units of resources to use in producing 3.75 tons of rice
advantage, it makes sense for a country to specialize in the
(point C in fig-ure 1.2). Meanwhile, South Korea specializes in
production of those goods that it produces most efficiently and
the production of rice, producing l0 tons. The combined
to buy the goods that it produces less efficiently from other
output of both cocoa and rice has now increased. Before special-
countries, even if this means buying goods from other
ization, the combined output was 12.5 tons of cocoa and 12.5
countries that it could produce more efficiently itself. While this
tons of rice. Now it is 15 tons of cocoa and 13.75 tons of rice
may seem counterintuitive, the logic can be explained with a
(3.75 tons in Ghana and 10 tons in South Korea). The source
simple example.
of the increase in production is summarized in Table 2.2.
Assume that Ghana is more efficient in the production of both
Not only is output higher, but also both countries can now
cocoa and rice; that is Ghana has an absolute advantage in the
benefit from trade. If Ghana and South Korea swap cocoa and
production of both products. In Ghana it takes 10 resources to
rice on a one-to-one basis, with both coun-tries choosing to
produce one ton one ton of cocoa and, 13 1/3 resources to
exchange 4 tons of their export for 4 tons of the import, both
produce one ton of rice. Thus, given its 200 units of resources,
coun-tries are able to consume more cocoa and rice than they
Ghana can produce 20 tons of cocoa and no rice, 15 tons of rice
could before specialization and trade (see Table 2.2). Thus, if
and no cocoa, or any combination in between on its PPF (the
Ghana exchanges 4 tons of cocoa with South Korea for 4 tons
ling GG’ in figure 2.2). In South Korea it takes 40 resources to
of rice, it is still left with 11 tons of rice, which is 1 ton more
produce one ton of cocoa and 20 resources to produce one ton
than it had before trade. The 4 tons of rice it gets from South
of rice. Thus South Korea can produce 5 tons of cocoa and no
Korea in exchange for its 4 tons of cocoa, when added to the
rice, 10 tons of rice and no cocoa, or any combination on its
3.75 tons it now produces domestically, leaves it with a to-tal of
PPF (the link KK’ in figure 2.2). Again assume that without
7.75 tons of rice, which is 25 of a ton more than it had before
trade, each country uses half of its resources to produce rice and
specialization. Similarly, after swapping 4 tons of rice with
half to produce cocoa. Thus, without “trade, Ghana will
Ghana, South Korea still ends up with 6 tons office, which is
produce 10 tons of cocoa, and 7.5 tons of rice (point A in
more than it had before specialization. In addition, the 4 tons
Figure 2.2), while South Ko-rea will produce 2.5 tons of cocoa
of cocoa it receives in exchange is 1.5 tons more than it pro-
and 5 tons of rice (point B in Figure2.2).
duced before trade. Thus, consumption of cocoa and rice can
increase in both countries as a result of specializa-tion and trade.

20 11.154

The basic message of the theory of comparative advantage is 4. We have assumed that resources can move freely from the

that potential’ world pro-duction is greater with unrestricted production of one good to another within a country. In
free trade than it is with restricted trade. Ricardo’s the-ory reality, this is not always the case.
suggests that consumers in all nations can consume more if 5. We have assumed constant returns to scale; that is, that
there are no restrictions on trade. This occurs even in countries specialization by Ghana or South Korea has no effect on the
that lack an absolute advantage in the pro-duction of any good. amount of resources required to produce one ton of cocoa
In other words, to an even greater degree than the theory of ab- or rice. In reality, both diminishing and increasing returns to
solute advantage, the theory of comparative advantage suggests specialization exist. The amount of resources required to
that trade is a positive-sum game in which all countries that produce a good might decrease or increase as a nation
participate realize economic gains. As such, this theory pro-vides specializes in production of that good.
a strong rationale for encouraging free trade. So powerful is
6. We have assumed that each country has a fixed stock of
Ricardo’s theory that it remains a major intellectual weapon for
resources and that free trade does not change the efficiency
those who argue for free trade.
with which a country uses its resources. This static
Qualifications and Assumptions assumption makes no allowances for the dynamic changes in
The conclusion that free trade Js universally beneficial is a rather a country’s stock of resources and in the efficiency with which
bold one to draw from such a simple model. Our simple the country uses its resources that might result from free
model includes many unrealistic assumptions: trade.
1. We have assumed a simple world in which there are only two 7. We have assumed away the effects of trade on income
countries and two goods. In the real world, there are many distribution within a country.
countries and many goods. Given these assumptions, can the conclusion that free trade is
Table 2.2 mutually beneficial be extended to the real world of many
Comparative Advantage and the Gains From Trade countries, many goods, positive transportation costs, volatile
exchange rates, immobile domestic resources, nonconstant
Resources Required to Produce 1 Ton of Cocoa and Rice
returns to specialization, and dynamic changes? Although a
Cocoa Rice detailed extension of the theory of comparative advantage is
Ghana 10 13.33 beyond the scope of this book, economists have shown that
South Korea 40 20 the basic result derived from our simple model can be general-
Production and Consumption without Trade ized to a world composed of many countries producing many
different goods. Despite the shortcomings of the Ricardian
Cocoa Rice
model, research suggests that the basic proposition that
Ghana 10.0 7.5 countries will ex-port the goods that they are most efficient at
South Korea 2.5 5.0 producing is borne out by the data. How-ever, once all the
Total production 12.5 12.0 assumptions are dropped, the case for unrestricted free trade,
while still positive, has been argued by some economists
Production with specialization
associated with the “new trade the-ory” to lose some of its
Cocoa Rice strength.
Ghana 15.0 3.75
Simple Extensions of the Ricardian Model
South Korea 0.0 10.0 Let us explore the effect of relaxing three of the assumptions
Total production 15.0 13.75 identified above in the simple comparative advantage model.
Consumption After Ghana Trades 4 Tons of Cocoa Below we relax the assumption that resources move freely from
for 4 Tons of South Korean Rice the production of one good to another within a country, the
assumption of constant returns to specialization, and the
Cocoa Rice
assumption that trade does not change a country’s stock of
Ghana 11.0 7.75 resources or the efficiency with which those resources are
South Korea -
4.0 6.0 utilized.
Increase in Consumption as a Result Immobile Resources
of Specialization and Trade In our simple comparative model of Ghana and South Korea,
Cocoa Rice we assumed that producers (farmers) could easily convert land
Ghana 1.0 0.25 from the production of cocoa to rice, and vice versa. While this
assumption may hold for some agricultural products, resources
South Korea 1.5 1.0 do not always shift quite so easily from producing one good to
2. We have assumed away transportation costs between another. A certain amount of friction is involved. For example,
countries. embracing a free trade regime for an ad-vanced economy such as
3. We have assumed away differences in the prices of resources the United States often implies that the country will produce
in different countries. We have said nothing about exchange less of some labor-intensive goods, such as textiles, and more
rates, simply assuming that cocoa and rice could be swapped of some knowledge-in-tensive goods, such as computer
on a one-to-one basis.
11.154 21

software or biotechnology products. Although the country as a million active members. All members receive a dividend check at

whole will gain from such a shift, textile producers will lose. A the end of each year that amounts to, about 10 percent of value
textile worker in South Carolina is probably not qualified to of their purchases during the year (one does not have to be a
write software for Microsoft. Thus, the shift to free trade may member to shop at REI). REI also has one of the fastest
mean that she becomes unemployed or has to accept another growing, and most profitable, Internet sites in the retail
less attractive job, such as working at a fast-food restaurant, For industry, which registered revenues of $412 million in 1999, up
an example of how the shift toward free trade can impact an 300 percent from a year earlier.
individual enterprise and its employ-ees, look at the Manage- To supply some of its own product need, REI has two
ment Focus profiling how the outdoor equipment cooperative subsidiaries. One of these, Thaw, has been supplying REI with
REI is adjusting its own production activities to deal with a a range of gear, include tents, backpack, sleeping bags, and
move toward greater free trade in textiles in the U.S. economy. clothing, for 33 years. In recent years, Thaw has concentrated on
Resources do not always move easily from one economic activity producing clothing items made out of fleece for REI’s stores.
to another. The process creates friction and human suffering Unfortunately for thaw’s 200 employees, the economics of
too. While the’ theory predicts that the benefits of free trade mananufacturing garments in the United States have been
outweigh the costs by a significant margin, this is of cold chang-ing for several years. Following passage of the North
comfort to those who bear the costs. Accordingly, political American Free Trade Agreement (NAFTA) in 1993,all tariffs on
opposition to the adoption of a free trade regime typically trade in textile garments between the United states and Mexico
comes from those whose jobs are most at risk. In the United were dropped (a tariff is a tax on imports). In the following
States, for example, textile workers and their unions have long years, an increasing number of textile operations shut down in
opposed the move to-ward free trade precisely because this the United States and moved to Mexico, attracted by lower labor
group has much to lose from free trade Govern-ments often costs. Wage rates for textile workers in Mexico run about $5' to
ease the transition toward-free trade by helping to retrain those $10 a day, compared to $8 to $10 an hour at Thaw’s opera-tion.
who lose their jobs as a result. The pain caused by the move- For a labor-intensive operation such as garment production,
ment toward a free trade regime is a short-term phenomenon, these wage differentials are significant.
while the gains from trade once the transition has been made Given these economics, in mid-2000 REI announced it would
are both significant and enduring. be closing its Thaw subsidiary and sourcing its fleece products
Diminishing Returns from Mexico, by shifting its production to Mexico, REI expects
The simple comparative advantage model developed above to reduce the cost of its fleece items by 20 percent. That means
assumes constant returns to specialization. By constant returns lower prices for REI’s members and other customers and
to specialization we mean the units of resources. Required to bigger profits for REI, which translates into larger dividend
produce a good (cocoa or rice) are assumed to remain constant checks, for REI’s members. It also means that its employees at
no matter where one is on a country’s production possibility the thaw will be out of a job. To assist its former employees at
frontier (PPF). Thus, we assumed that it always took Ghana 10 Thaw, REI has added funds to federal money to assist with job
units of resources to produce one ton of cocoa. However, it is retraining, unemployment benefits, and health insurance,
more realistic to assume diminishing returns to specialization. The events at Thaw are being repeated across the country. Since
Diminishing re-turns to specialization occurs when more units 1993, about 450,000 jobs have been lost in the U.S. garment
of resources are required to produce each additional unit. While industry as production has moved to low wage countries such
10 units of resources may be sufficient to increase Ghana’s as Mexico, for-mer textile workers, most of whom are low
output of cocoa from12 tons to 13 tons, 11 units of resources skilled, have found it difficult to find alternative full-time em-
may be needed to increase output from13 to 14 tons, 12 units ployment. The department of Labor estimates that between
of resources to increase output from 14 tons to 15 tons, and so 1995and 1997, 58 percent of unemployed textile workers failed
on. Diminishing returns implies a convex PPF for Ghana (see to find full-time jobs, while for the 42 percent that did, their
figure 2.3), rather than the straight line depicted in Figure 2.2. average wage dropped by some 20 percent. As painful as this
Case study has been for textile workers, the American consumer has gained
from lower prices, and American companies in many other
Free Trade and REI industries have seen their sales to Mexico boom as trade barriers
Recreational Equipment Inc. (REI) is a buyer’s cooperative that have come down. Thus, while a strong case can be made that
has grown into one of the major suppliers of outdoor NAFTA has benefited the majority of American and Mexicans
equipment in the United States and has a rapidly growing alike, it has inflicted pain on some groups, such as U.S. textile
international business. Started in Seattle in 1938 by Lloyd workers, and forces some companies, such as REI, to make
Anderson, the company provided high-quality climbing gear at difficult managerial decisions.
a low price to members ‘of the cooperative, For its first 37 years,
Sources: R. 1. Nelson, “REI’s Globalization,” Seattle Times,
REI operated a single store in Seattle, but in 1975 the coopera-
May 14, 2000, pp. D1, D2, and E Chabrow, “REI Gets Head
tive started opening stores in other cities. Today REI has
Start in Clicks and Mortar Race, “ Information Week, May 1,
become a $621 million with 60 stores worldwide, 6,600
2000.
employees revenue growth of 8 to 10 percent annually, and a
goal of opening up three to five retail outlets per year. Despite
the growth, REI is still organized as a cooperative with 1.7

22 11.154

G Figure 2.3
Ghana’s PPF under PPF2 Figure 2.4
Diminishing Returns
The Influence of free
Cocoa PPF1 Trade on the PPF

Cocoa
1
G
0 Rice

It is more realistic to assume diminishing returns for two
reasons. First, not all resources are of the same quality. As a 0 Rice
country tries to increase its output of a certain good, it is
increasingly likely to draw on more marginal resources whose Second, free trade might also increase the efficiency with which a
productivity is not as great as those initially employed. The country uses its resources. Gains in the efficiency of resource
result is that it requires evermore resources to produce an equal utilization could arise from a number of factors. For example,
increase in output. For example, some land is more productive economies of large-scale production might become available as
than other land. As Ghana tries to expand its output of cocoa, trade expands the size of the total market available to domestic
it might have to utilize increasingly marginal land that is less firms. Trade might make better technology from abroad
fertile than the land it originally used. As yields per acre decline, available to domestic firms; better technology can increase labor
Ghana must use more land to produce one ton of cocoa. productivity or the productivity of land. (The so-called green
revolution had this effect on agricultural outputs in developing
A second reason for diminishing returns is that different goods
countries.) Also, opening an economy to foreign competition
use resources in dif-ferent proportions. For example, imagine
might stimulate domestic- producers to look for ways to
that growing cocoa uses more land and lass labor than growing
increase their efficiency. Again, this phenomenon is arguably
rice, and that Ghana tries to transfer resources from rice
occurring in the once-protected markets of Eastern Europe,
production to cocoa production. The rice industry will release
where many former state monopolies are increasing the
proportionately too much labor and too little land for efficient
efficiency of their operations to survive in the competitive
cocoa production. To absorb the additional resources of labor
world market.
and land, the cocoa industry will have to shift toward more
labor-intensive methods of production. The effect is that the Dynamic gains in both the stock of a country’s resources and
efficiency with which the cocoa industry uses labor will decline, the efficiency with which resources are utilized will cause a
and returns will diminish. country’s PPF to-shift outward. This is illustrated in Figure 2.4,
where the shift from BPF1 to PPF2 results from the dynamic
Diminishing returns show that it is not feasible for a country to
gains that arise from free trade. As a consequence of this
specialize to the degree suggested by the simple Ricardian
outward shift, the country in Figure 2.4 can produce more of
model outlined earlier. Diminishing returns to specialization
both goods than it did before introduction of free trade. The
suggest that the gain from specialization likely to be exhausted
theory suggests that opening an economy to free trade not only
before specialization is complete. In reality, most countries do
results in static gains of the type discussed earlier, but also
not specialize, but instead produce a range of goods. However,
results in dynamic gains that stimulate eco-nomic growth. If
the theory predicts that it is worthwhile to specialize until that
this is so, the case for free trade becomes stronger.
point where the resulting gains from trade are out weighed by
diminishing returns. Thus, the basic conclusion that unre- Evidence for the link between Trade and Growth
stricted free trade is beneficial still holds, although because of Many economic studies have looked at the relationship between
diminishing returns, the gains may not be as great as suggested trade and economic growth. In general, these studies suggest
in the constant returns case. that, as predicted by the theory, countries that adopt a more
open stance toward international trade enjoy higher growth
Dynamic Effects and Economic Growth
rates than se that close their economies to trade. Jeffrey Sachs
Our simple comparative advantage model assumed that trade
and Andrew Warner created a measure of how “open” to
does not change a country’s stock of resources or the efficiency
international trade an economy was and then looked at the
with which it utilizes those resources. This static assumption
relationship between “openness” and economic growth for a
makes no allowances for the dynamic changes that might result
sample of more than 100 countries for the years 1970 to 1990.
form trade. If we relax this assumption, it becomes apparent
Among other findings, they reported:
that opening an economy to trade is likely to generate dynamic
gains of two-sorts. First, free trade might increase a country’s We find a strong association between openness and growth,
stock of resources as increased supplies of labor and capital both within the group of developing and the group of
from abroad be-come available for use within the country. This developed countries. Within the group of developing countries,
is occurring now in Eastern Europe, where many Western the open economies grew at 4.49 percent per year, and the closed
businesses are investing large amounts of capital in the former economies grew at 0.69 percent per year. Within the group of
Communist countries. developed economies, the open economies grew at 2.29 percent
per year, and the dosed economies grew at 0.74 percent per year.
The message of this study seems clear: Adopt an open
economy and embrace free trade, and over time your nation will

11.154 23

be rewarded with higher economic growth rates. Higher growth of its influence, the theory has been subjected to many empirical

will raise income levels and living standards. This last point has tests. Beginning with a famous study published in 1953 by
re-cently been confirmed by a study that looked at the relation- Wassily Leontief (winner of the Nobel Prize in economics in
ship between trade and growth in incomes. The study, 1973), many of these tests have raised questions about the
undertaken by Jeffrey Frankel and David Romer, found that on validity of the Heckscher- Ohlin theory. 15 Using the Heckscher-
average, a one percentage point increase in the ratio of a Ohlin theory, Leontief postulated that since the united States
country’s trade to its gross domestic product increases income was relatively abundant in capital compared to other nations,
per person by at least one-half percent. For every 10 percent the united States would be an exporter of capital-intensive
increase in the importance of international trade in an economy, goods and an importer of labor-intensive goods. To his
av-erage income levels will rise by at least 5 percent. Despite the surprise, however, ‘he found that U.S. exports were less capital
short-term adjustment costs associated with adopting a free intensive than U.S. imports. Since this result was at variance
trade regime, trade would seem to produce greater economic with the predictions of the theory, it has become known as the
growth and higher living standards in the long run, just as the Leontief paradox.
theory of Ri-cardo would lead us to expect. No one is quite sure why we observe the Leontief paradox.
Heckscher-Ohlin Theory One possible explanation is that the United States has a special
Ricardo’s theory stresses that comparative advantage arises from advantage in producing new products or goods made with
differences in pro-ductivity. Thus, whether Ghana is mare innovative technologies. Such products may be less capital
efficient than South Korea. In the production of cocoa depends intensive than products whose technology has had time to
on how productively it uses its resources. Ricardo stressed mature and become suitable for mass production. Thus, the
Labor pro-ductivity and argued that differences in labor United States may be exporting goods that heavily use skilled
productivity between nations underlie the notion of compara- labor and innovative entrepreneurship, such as computer
tive advantage. Swedish economists Eli Heckscher (in 1919) and software, while importing heavy manufacturing products that
Bertil Ohlin (in 1933) put forward a different explanation of use large amounts of capital. Some more recent empirical
comparative ad-vantage. They argued that comparative advan- studies tend to confirm this. Recent tests of the Heckscher-
tage arises from differences in national factor endowments. By Ohlin theory using data for a large number of countries tend to
factor endowments they meant the extent to which a coun-try is confirm the existence of the Leontief paradox.
endowed with such resources as land, labor, and capital Nations This leaves economists with a difficult dilemma. They prefer the
have varying factor endowments, and different factor endow- Heckscher-Ohlin theory on theoretical grounds, but it is a
ments explain differences in factor costs. The more abundant a relatively poor predictor of real-world international trade
factor, the lower its cost. The Heckscher-Ohlin theory predicts patterns. On the other hand, the theory they regard as being too
that countries will export those goods that make intensive use lim-ited, Ricardo’s theory of comparative advantage, actually
of factors that are locally abundant, while importing goods that predicts trade patterns with greater accuracy. The best solution to
make intensive use of factors that are locally scarce. Thus, the this dilemma may be to return to the Ricardian idea that trade
Heckscher-Ohlin theory attempts to explain the pattern of patterns are largely driven by international differences in
international trade that we observe in the world economy. Like productivity. Thus, one might argue that the United States
Ricardo’s theory the Heckscher-Ohlin theory argues that free exports commercial aircraft and imports automobiles not
trade is beneficial. Unlike Ricardo’s the-ory, however, the because its factor endowments are especially suited to aircraft
Heckscher-Ohlin theory argues that the pattern of international manu-facture and not suited to automobile manufacture, but
trade is determined by differences in factor endowments, rather because the United States is more efficient at producing aircraft
than differences in productivity. than automobiles. A key assumption in the Heckscher-Ohlin
The Heckscher-Ohlin theory also has commonsense appeal. For theory is that technologies are .the same across countries. This
example, the ‘United States has long been a substantial exporter may not to be the case, and differences in technology may lead
of agricultural goods, reflecting in part its unusual abundance to differences in productivity, which in turn, drives international
of arable land. In contrast, China excels in the export of goods trade patterns. Thus, Japan’s success in exporting automobiles
produced in labor-intensive manufacturing industries, such as in the 1970s and 1980s was based not just on the relative
textiles and footwear. This reflects China’s relative abundance of abundance of capital, but also on its development of innova-
low-cost labor. The United States, which lacks abundant low- tive manufacturing technology that enabled it to achieve higher
cost labor, has been a primary importer of these goods. Note productivity levels in automobile production than other
that it is relative, not absolute, endowments that are important; countries that that also had abundant capital.
a coun-try may have larger absolute amounts of land and labor The Product Life-Cycle Theory
than another country, but be relatively abundant in one of Raymond Vernon initially proposed the product life-cycle theory
them. in the mid-1960s.19 Vernon’s theory was based on the observa-
The Leontief Paradox tion that for most of the 20th century a very large proportion
The Heckscher-Ohlin theory has been one of the most of the world’s new products had been developed by U.S. firms
influential theoretical ideas in international economics. Most and sold first in the U.S. market (e.g.mass-produced automo-
economists prefer the Heckscher-Ohlin theory to Ri-cardo’s biles, televisions, instant cameras, photocopiers, personal
theory because it makes fewer simplifying assumptions. Because computers, and semiconductor chips). To explain this, Vernon

24 11.154

Introduction International Trade Theory

Introduction International Trade Theory

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