7.1 Theories of international trade

International trade theories explain why countries engage in trade and how it benefits them. From comparative advantage to new trade theory, these models shed light on trade patterns and their economic impacts.

Trade theories have evolved to account for real-world complexities. They explore how factors like resource endowments, economies of scale, and product differentiation shape global trade flows and economic outcomes.

Comparative Advantage in Trade

Theory of Comparative Advantage

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• Comparative advantage refers to a country's ability to produce a good or service at a lower opportunity cost relative to another country
  • Opportunity cost is the value of the next best alternative foregone when making a decision
• Developed by David Ricardo, the theory suggests countries should specialize in producing and exporting goods for which they have a comparative advantage and import goods for which they have a comparative disadvantage
• Differences in comparative advantage arise from variations in factor endowments (land, labor, capital), technology, or productivity across countries

Benefits and Assumptions of Comparative Advantage

• Trade based on comparative advantage leads to increased efficiency, output, and consumption possibilities for all countries involved as resources are allocated more effectively
  • Countries can consume beyond their production possibilities through trade
• Assumes perfect competition, free trade, and the absence of transportation costs and trade barriers
• Examples of comparative advantage in action:
  • Colombia's climate and soil conditions make it well-suited for coffee production (factor endowments)
  • Japan's advanced technology and skilled workforce give it an advantage in producing high-tech goods (technology and productivity)

Heckscher-Ohlin Model and Trade

Factor Endowments and Trade Patterns

• The Heckscher-Ohlin (H-O) model, also known as the factor-proportions theory, explains the pattern of international trade based on the relative abundance of factors of production in different countries
  • Factors of production include land, labor, and capital
• Countries will specialize in and export goods that intensively use their abundant factor and import goods that intensively use their scarce factor
  • For example, a country with abundant labor will export labor-intensive goods (textiles) and import capital-intensive goods (machinery)
• Factor price equalization suggests that under certain assumptions (identical technologies and no trade barriers), international trade will lead to the equalization of factor prices across countries

Extensions and Paradoxes

• The Leontief paradox, an empirical finding that contradicted the H-O model, showed that the United States, a capital-abundant country, exported labor-intensive goods and imported capital-intensive goods
  • This paradox led to further research and extensions of the H-O model
• The H-O model has been extended to incorporate multiple factors of production (skilled and unskilled labor) and technological differences across countries
  • For example, the Ricardian-Heckscher-Ohlin model combines the insights of comparative advantage and factor endowments

New Trade Theory and Intra-Industry Trade

Economies of Scale and Product Differentiation

• New trade theory emerged to explain the growing prevalence of intra-industry trade, which refers to the simultaneous import and export of similar products within the same industry (automobiles, electronics)
• Economies of scale, which refer to the decrease in average costs as output increases, can give countries a competitive advantage in producing certain goods and lead to specialization and trade
  • For example, the aircraft industry benefits from significant economies of scale due to high fixed costs and learning effects
• Product differentiation allows firms to distinguish their products from those of competitors, leading to trade in similar but differentiated products within the same industry (smartphones, fashion clothing)

Market Structure and Trade Patterns

• Monopolistic competition, characterized by many firms producing differentiated products with some degree of market power, is a common market structure in industries with intra-industry trade
  • Firms in monopolistic competition engage in non-price competition through product differentiation and advertising
• New trade theory helps explain the high volume of trade between similar countries (European Union) and the increasing importance of trade in intermediate goods and services (global value chains)
• Intra-industry trade is more prevalent among developed countries with similar factor endowments and high levels of product differentiation

Trade's Impact on Economic Outcomes

Economic Growth and Technology Diffusion

• International trade can promote economic growth by allowing countries to specialize in their comparative advantages, access larger markets, and benefit from economies of scale
  • Exporting firms often experience faster productivity growth due to increased competition and exposure to foreign technologies
• Trade facilitates the diffusion of technology and knowledge spillovers, which can boost productivity and economic growth in trading countries
  • For example, the transfer of advanced manufacturing techniques through trade and foreign direct investment

Employment and Income Distribution

• The impact of trade on employment depends on the structure of the economy and the flexibility of labor markets
  • Trade can create jobs in exporting sectors (services in developed countries) but may lead to job losses in import-competing sectors (manufacturing in developed countries)
• Trade can affect income distribution within countries
  • The Stolper-Samuelson theorem suggests that trade benefits the abundant factor (skilled labor in developed countries) and hurts the scarce factor (unskilled labor in developed countries), leading to changes in relative wages and income inequality
• The impact of trade on income distribution also depends on the skill level of the workforce and the nature of traded goods (skill-intensive or labor-intensive)
• Policies such as education, training, and social safety nets can help mitigate the adverse distributional effects of trade and ensure that the gains from trade are more widely shared
  • For example, Denmark's "flexicurity" model combines flexible labor markets with strong social protection and active labor market policies