The Microeconomic Theory Of International Trade

Abstract: This paper presents the most critical points covered in the literature on international trade from a microeconomic perspective. The paper looks at the contribution of classical economists, such as Hume, Smith and Ricardo to the theory of international trade. Moreover, it looks at the new trade theory introduced by Heckscher and Ohlin. Then, the paper examines the literature on trade barriers, covering different arguments for introducing trade barriers and the most important tools used by governments to restrict international trade. After that, the paper examines the theory of economic integration and presents the theories regarding the gains of trade under customs unions. Finally, the paper presents a comparison between the three major themes previously examined; namely, the free trade school of thought (adopted by the classical economists) on one hand, the restricted international trade school of thought on the other hand, and between them falls the theory of economic integration that combines the most critical aspects of both schools. The implications for this are….(Not yet finished) Introduction:

The idea of International trade dates back to the fifteenth century, when the philosophy of “mercantilism” emerged. Mercantilism is an economic philosophy that “sought to enrich the country by restraining imports and encouraging exports” in order to “achieve a favorable balance of trade that would bring gold and silver into the country and … maintain domestic employment” (LaHaye). The mercantilists advocated government intervention in all forms; as the government was required to promote exports through supporting new industries; and also ban importation through imposing tariffs (LaHaye). Trade, in the mercantilists’ view was a “zero-sum game” because at a certain point in time “one nation can only gain at the expense of other nations” (Salvatore P.34). The mercantilists’ ideas remained the dominant political and economic system in Europe till the emergence of the Enlightenment philosophy in the eighteenth century. Among the most important economists of the Enlightenment era was David Hume, who advocated foreign trade that achieves the mutual benefits for both countries engaged in it. In the benefits of international trade, Hume stated that “The temptation is stronger to make use of foreign commodities which are ready for use, and which are entirely new to us, than to make improvements of any domestic commodity, which always advance by slow degrees, and never affect us by their novelty.” (Hume, qtd in Miller, Essay on Commerce). Hume refuted the mercantilists’ “jealous fear” that stemmed from their fear of gold and silver going out of the country as a result of importation. Hume believed that welfare is attained via “free communication of exchange” among nations because it causes an automatic adjustment in the prices through the adjusting the money supply, which Hume called the “price-species-flow mechanism” (Hume, qtd in Miller, Essay of the Balance of Trade; and Biography of David Hume).

Classical Theories of International:

Smith’s Absolute Advantage

Like Hume, Smith argued that if two nations engaged voluntarily in trade activities, both of them must gain. For him, international trade is based on “absolute advantage”; that is “if a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it from them with some part of the produce of our own industry, employed in a way in which we have some advantage” (Smith qtd in Allen, P. 54) and as a result, both nations gain. The gains of trade are “opening a more extensive market for part of the produce of labor [that] may exceed the home consumption … [thus] encourages them to improve productive powers… and thereby increase the real… wealth of the society” (Smith, qtd in Allen P. 49). International trade also leads to greater specialization and division of labor; and increasing welfare.

The Ricardian Comparative Advantage

Ricardo argued that for trade to occur between two countries, they do not necessarily have to have an absolute advantage in producing any commodity; but rather what he called the “Comparative Advantage”. Each country may have a relative advantage in the cost of producing a certain commodity, so it specializes in its production and then trade it for other goods. (Hunt, P.120). Ricardo illustrated his theory through the famous example of England and Portugal, whereby Portugal has an absolute advantage in producing both cloth and wine. Ricardo proved that Portugal has a relative advantage over England in producing wine; while England had a relative advantage Portugal in the production of cloth. Thus, Portugal should specialize in the production of cloth “instead of employing a great part of her capital and industry in the production of wines, with which she purchases for her own use the cloth of the other country”; and hence both countries achieves positive gains from trade (Ricardo, P. 126- 127; Hunt P. 121).

Ricardo based his law of comparative advantage on some assumptions, the most critical of which was the “labor theory of value” that indicates that the price of the good is determined solely by the amount of labor embodied in it, which indicates that labor is the only factor of production; and that labor is homogenous. Thus, the comparative advantage cannot be based on the labor theory of value (Salvatore P. 43).

The Heckscher – Ohlin – Samuelson Model

The H-O-S model came to replace the classical Ricardian comparative advantage as a dominant theory for international trade. It encompasses four important theorems; namely H-O theorem, the factor price equalization model, the Stopler Samuelson theorem and the Rybczynski theorem.

First, the H-O theorem is based on the principle that the pre-requisite for international trade is the “Different relative scarcity, i.e., different relative prices of the factors of production in the exchanging countries, as well as different proportions between the factors of production in different commodities”. (Heckscher 1919, qtd in Flam and Flanders P. 48). The role of foreign trade is to even out the scarcity and the prices of factors of production among countries, which results in the “equalization of commodity prices between several regions… [thus] there is a tendency toward interregional equalization of factor prices” (Ohlin 1924, qtd in Flam and Flanders, P. 89, 91. The H-O theorem states: “A country will export goods that are intensive in production in its abundant factors and import goods intensive in its relatively scarce factors”.

The factor price equalization theorem states that “International trade will bring about equalization in the relative and absolute returns to homogenous factors across nations” (Flam and Flanders P. 25; and Salvatore, P.131). In fact, both Heckscher and Ohlin did not accept the “factor price equalization” as an empirical fact because of “specialization”. They believed that specialization prevents both factor price equalization and the use of identical techniques. Rather, “diversification” leads to factor price equalization; and this is referred to as “harmonic equilibrium” (Flam and Flander, P. 9).

The Stopler Sameulson theorem states that “A rise in relative price of a commodity leads to a rise in the real return of the factor used intensively in producing that commodity and to a fall in the real return to the other factor” (Vousden, P. 11).

Finally, Rybczynski theorem states that in a closed economy, “maintenance of the same rate of substitution in production after the quantity of one factor has increased must lead to an absolute expansion in production of the commodity using relatively much of that factor, and to an absolute curtailment of production of the commodity using relatively little of the same factor” (Rybczynski, 1955). Further analysis of consumption patterns and the marginal propensity to consume led to another conclusion stating that assuming that the commodity using relatively much of the abundant factor of production that had been increased is an export commodity, this will lead to deterioration in the terms of trade and vice versa (Rybczynski, 1955). Extending the analysis of Rybczynski to an open economy in within the framework of the Heckscher and Ohlin model, considering taste bias, “Reserve Rybczynski” was concluded. It states that “an increase in the endowment of a factor of production can lead to an absolute curtailment in the production of the commodity using that factor intensively, and an absolute expansion of the commodity using relatively little of the same factor” (Opp, Sonnenschein and Tombazos, 2009).

Trade barriers and Protection

Even though classical trade theories are in favor of free trade that promotes gain for both parties participating in it, policymakers, sometimes, favor imposing trade restrictions for many reasons. Among the reasons surveyed in the literature are increasing government revenues through imposing tariffs, maximizing consumers’ and producers’ welfare, and improving their terms of trade. Also, policymakers may impose restrictions on foreign trade to protect political interest, as restricted trade may “undo harm, or prevent further harm that is perceived to be done to domestic workers” (Dearfroff, 1987). Another well-known argument that favors trade protection by the government is the “infant industry argument”. According to this argument, if the government knows that it has a “potential comparative advantage” in the production of a certain good, but it is still in the initial small level of output, the industry cannot withstand severe competition from foreign firms. Therefore, the government needs to step I and offer a “temporary trade protection” to protect the domestic industry during its infancy until it becomes strong enough to meet foreign competition (Salvatore, P. 303). There are two ways by which governments impose trade restrictions; namely tariffs and quantitative restrictions. Both of them yield equal results under a static perfect competition. However, in real world, they differ greatly because of uncertainty (Vousden).

Tariffs

A tariff is “a tax or duty levied on the traded commodity as it crosses a national boundary” (Salvatore, P. 248). The static effects of tariffs include an increase in domestic prices, a reduction in domestic consumption, and the expansion of domestic production. Tariffs also have an effect on resource allocation and income distribution; as increasing domestic production of a certain good requires the reallocation of factors of production into the industry receiving tariff protection, which creates a dead-weight loss for the whole economy. Moreover, tariffs make producers better off at the expense of consumers by transferring part of the consumer surplus to the producer surplus; and part of the consumers’ income to the government (Gerber, P. 113 – 116). The effect of tariffs on terms of trade, in a multi-commodity world, is undetermined because of the “relations of complimentary and substitution existing between traded goods”, in addition to the nature of the good protected, being normal or inferior; which can make terms of trade move in either direction (Graaff, 1949).

The theory of optimal tariff originated when Charles Bickerdike proposed that “with taxes not exceeding some definite height, there seems to be a theoretical correctness in the methods followed by protectionists”; as the country may improve its terms of trade, and thus its welfare conditions. The condition for benefiting from the “incipient import tax” is the higher elasticity of demand of the taxing country for the goods taxed (Bickerdike, 1906). The optimal tariff rate corresponds to optimum price set by a monopoly in the absence of tariffs. Thus, the introduction of a tariff yields the same effect as the availability of a monopoly power in the domestic economy; and the gains from the tariff depends on the foreign demand elasticity and the foreign country’s ability to retaliate. So, if the other country retaliates, both countries loose compared to the free trade position (Kaldor, 1940). However, Johnson argued against this, claiming that there is a possibility for a country to gain from a tariff, even if retaliation occurred. The condition for that is when “the reciprocal demand curves of the two countries have constant elasticities throughout their length”. So, “the implied community preference system of each country is such as to generate offer curves of the same elasticity, whatever the tariff the country imposes of its imports; consequently each country’s optimum tariff is independent of the other’s…” (Johnson, 1954).

Nontariff trade barriers

Non tariff trade barriers (NTBs) directly influence the quantities of imports rather than their price. Non tariff trade barriers include “heterogeneous policy tools”, such as quotas, voluntary export restraints (the importing country induces another country to reduce its exports of a commodity voluntarily), international Cartel (when suppliers of a commodity located in different nations agree to restrict output and exports of a commodity with the aim of maximizing the total profits); export subsidies (direct payments, or tax relief to exporters and/or low interest loans to foreign buyers to stimulate exports); in addition to many more (Salvatore, P. 288-297; and Deardorff 1987). According to Anderson and Schmitt “governments have no incentive to use quotas or antidumping restrictions when they unilaterally choose from a menu of trade policies that includes tariffs. However, once tariffs are set cooperatively, governments may wish to introduce NTBs… [and] policy makers prefer quotas to antidumping restrictions” (Anderson and Schmitt). Nonetheless, others have argued that in some cases NTBs are more preferred to tariffs. Among the reasons stated are “institutional constraints”, such as the General Agreements on tariffs and trade (GATT) that imposes constraints on the use of tariffs. Furthermore, Deardroff believes that tariffs do not work to achieve welfare for, unlike tariffs, quotas “leave nothing to chance. It foils the invasion of [domestic] markets not just by making it harder [like tariffs] but by making it impossible”. In case of dumping, tariffs are usually absorbed by dumping firms, as they increase the price of the good in domestic market, while quotas discourage dumping completely. Thus, according to Deardroff, NTBs are “capable of preserving the levels of welfare, both of consumers and producers in the importing country…” (Deardroff, 1987).

The theory of Economic Integration, and free trade areas

The theory of economic integration refers to “the commercial policy of reducing or eliminating trade barriers among the nations joining together” (Salvatore P. 340). There are different forms of economic integration; the most important of which are: (1) preferential trade agreements that entails providing lower barriers on trade among participating countries; (2) Customs union that entails the removal of duties among members; in addition to unifying trade policies towards the rest of the world; and (3) common market that allows free movement of factors of production among members (Salvatore, P.240). The analysis of economic integration dates back to J. Viner’s, who believed that welfare results of customs union depend on the two types of consequences; trade creation or trade diversion. Trade creation, the “good” side, represents “a shift from high-cost domestic production to lower-cost production in a partner country”, which increases welfare of participating countries. Trade diversion, on the other hand, reduces welfare as it represents “a shift from the lowest-cost external producer to a higher-cost partner” (Cooper and Massell, 1965). Elaborating on Viner’s work, Harry Johnson (1956) concluded that:

(1) “a country is more likely to gain from creation of trade, the higher the initial level of its tariffs and the more elastic the domestic demand and supply of goods which the partner country [produces]”; and (2)”a country is less likely to lose from trade diversion, the smaller are the initial differences in the cost of production between partner and foreign sources of supply and the less degree of substitutability in consumption between goods from partner and foreign sources” (Johnson, qtd in Bhagwati, Krishna and Panagariya).

Lipsey argued against Viner’s proposition that trade creation is good and trade diversion is bad; as he believed that the effect of customs union on welfare is a combination of both “consumption and production effects”. According to Lipsey, a country can gain an increase in welfare by entering a customs union “whose sole production effect [is] to divert import trade”; as “every consumer moves to a higher indifference curve” (Lipsey, 1957). This is referred to as the “general theorem of the second best”, stated as “if the economy is prevented from attaining all the conditions for maximum welfare simultaneously, the fulfillment of one of these conditions will not necessarily make the country better off than would its non-fulfillment” (Johnson, qtd in Bhagwati, Krishna and Panagariya). Furthermore, Cooper and Massell believed that the welfare effect of customs union can be split into two components; “a tariff reduction component and a pure trade diversion component”, with the tariff reduction component being the cause for increasing consumer welfare. Thus, “whether a customs union is on balance beneficial will depend on whether the tariff-reduction effect outweighs the pure trade diversion effect” (Cooper and Massell, 1965).

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Conclusion section, including the comparative summary and implications for each of the three schools of thought; namely, free trade, restricted trade, and in between them comes the economic integration.