UNIT 8

INTERNATIONAL TRADE

International Trade & Economic Development of a Country

The following points highlight the four main roles of International trade in Economic development of a country.

1. Slow Pace of Primary Commodities:

The foremost difficulty that comes in the path of foreign trade is that the growth of primary commodities which forms principal exports of developing countries has been very slow as compared to world trade.

In 1955, primary commodities accounted for 50% of the total exports which in 1977 came down to 35% and again to 28% in 1990 and so on. The causes responsible for this are the increasing tendency of market economies to protect their agriculture, inadequate increase in demand for primary commodities, development of synthetic substitutes etc.

2. Less Share in World Trade:

It has been noticed that exports of developing economies have been slow to develop. Consequently, the share of developing economies in the total world trade has maintained a downward trend.

Its share which was 31 percent in 1950 came down to 13.9 percent in 1960 and again 5% in 1990. This decline is caused by factors like emergence of trade blocks, restrictive commercial policies and growth of monopolies etc. These trends reflect the fact that developing economies have to face foreign trade as a barrier in the way of development.

3. Worse Terms of Trade:

In developed markets, the low demand for primary products has led the problem of balance of payment on worse trend in developing economies. Whereas prices of manufactured goods have been on the upward trend in the world market, the prices of primary products are gradually declining.

In this regard, UN report advocated that in the past developing countries could got a tractor by exporting two tones of sugar, now the time is that they have to export seven tones of sugar to get the same tractor. According to another estimate 1 to 3 percent of the GNP was lost by the developing countries due to decreasing prices of non-oil raw materials during 1990s.

4. Restrictive Trade Policies:

Restrictive trade policies adopted by industrial countries affect prospects for developing country exports of manufacturers. This is due to the fact that for developing countries markets in industrial countries have become increasingly more important.

For instance, in 1965, industrial countries took 41 percent of developing country exports of manufacturers, by 1990 this had grown to -75%. In 1990 only 3% of world trade in manufacturers was between developing countries.

In short, we may conclude that developing economies face several difficulties in their path of foreign trade. The various multinational initiatives having been mounted to tackle these problems have left them largely resolved. Therefore, in given circumstances, the developing economies have to evolve a suitable trade policy mix that may create export outlets and as well may assure supplies of essential imports.

8.1 CLASSICAL THEORY OF INTERNATIONAL TRADE (RICKARD):

David Ricardo agreed that absolute difference in cost gives a clear reason for trade to take place. He, however, went further to argue that even when a country has absolute advantage in the production of both commodities it is beneficial for that country to specialise in the production of that commodity in which it has a greater comparative advantage. The other country can be left to specialise in the production of that commodity in which it has less comparative advantage. According to Ricardo the essence for international trade is not the absolute difference in cost but comparative difference in cost. Ricardian theory is based on the following assumptions.

Assumptions

There are two countries and two commodities.

There is perfect competition both in commodity and factor markets.

Cost of production is expressed in terms of labour i.e. value of a commodity is measured in terms of labour hours/days required to produce it. Commodities are also exchanged on the basis of labour content of each good.

Labour is the only factors of production other than natural resources.

Labour is homogeneous i.e., identical in efficiency, in a particular country.

Labour is perfectly mobile within a country but perfectly immobile between countries.

There is free trade i.e., the movement of goods between countries is not hindered by any restrictions.

Production is subject to constant returns to scale.

There is no technological change.

Full employment exists in both countries.

There is no transport cost.

On the basis of the above assumptions, David Ricardo explained his comparative cost difference theory, taking England and Portugal as two countries and wine and cloth as two countries.

Portugal requires is less hours of labour for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labour hours as against 120 labour hours required in England. From this it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo however, tried to prove that Portugal  stands to gain by specializing in the commodities in which it has a greater comparative advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.

Cost ratios of producing wine and cloth can be expressed as:

Portugal		England
Wine	Cloth	Wine	Cloth
<		>
0.66  <  0.9		1.5  > 1.11

Portugal has advantage of lower cost of production both in wine and cloth. However the difference in cost, that is the comparative advantage is greater in the production of wine (1.5-0.66=0.84) than in cloth (1.11-0.9-0.21).

Even in terms of absolute number of days of labour Portugal has a larger comparative advantage in wine, that is, 40 labourers less than England as compared to cloth where the difference is only 10, (40>10). Accordingly Portugal specializes in the production of cloth  where its comparative disadvantage is lesser than in wine.

Comparative Cost Benefits Both : Let us explain Ricardian contention that comparative cost benefits both the participants, though one of them had clear cost advantage in both commodities. To prove its, let us work out the internal exchange ratio.

Let us assume these two countries enter into trade at an international exchange rate (Terms of Trade) 1:1.

At this rate, England specializing in cloth and exporting one unit of cloth gets in turn one unit of wine. At home it is required to give 1.2 units of cloth for unit of wine. England thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth.

Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e. England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine.

In this example, Portugal specializes in wine where it has greater comparative advantage leaving cloth at home for England in which it has less comparative disadvantage. The example also validates Ricardian Argument that the base for international trade is the comparative difference in cost and not the absolute difference in cost.

8.2 MODERN THEORY OF INTERNATIONAL TRADE (HECKSHER ONLINE)

Introduction:

The drawbacks of the classical theory of international trade induced the Swedish economist Prof. Heckscher (1919) to develop an alternate explanation of comparative advantage theory. His theory was further improved by his pupil Bertil Ohlin(1933). Hence it is known as Heckscher-Ohlin (H-O)theory.

Hecksher-Ohlin (H-O) theory argues that there is no need for a separate theory to explain international trade. According to it, international trade is but a special case of interregional trade. Factor immobility which was the base for a separate explanation of international trade by classical economists, does not hold true as factors are mobile or immobile even between two regions of the same country and also between the two countries. It is difference in degree rather than in nature.

The Modern or Hecksher-Ohlin (H-O) Theory explains the new approach to comparative advantage on the basis of general value theory. From all the forces that work together in general equilibrium, H-O theory isolates the differences in physical availability or supply of factors of production among the nations to explain the difference in relative commodity prices and trade between the countries. According to this theory “a nation will export the commodity whose production requires the intensive use of the nation’s relatively abundant and cheap factor and import the commodity whose production requires the intensive use of the nation’s relatively scarce and expensive factor”.

H-O theory explains the modern approach to international theory on the basis of the following assumptions:

1. There are two countries, each having two factors ( Labour and capital ) and producing two commodities.
2. There is perfect competitions in both commodity and factor markets.
3. All production functions are homogeneous of the first degree i.e. production is subject to constant returns to scale.
4. Factors are mobile within the country and immobile between countries. In international trade commodities move between the countries instead of factors.
5. The two countries differ in factor supply.
6. Each commodity differs in factor intensity.
7. Factor intensity differ between the commodities but are same in both countries for each commodity i.e. if goods X is labour intensive, it will be so in both countries. However goods X and Y differ in factor intensity in the same country.
8. Full employment of factor exists in both economies.
9. Trade is free i.e. there are no trade restrictions in the form of tariffs or non-tariff barriers.
10. No transport cost.

On the basis of the above assumptions it can be stated that (i) each commodity differ in factor intensity (ii) each country differs in factor endowments leading to differences in factor prices. It is therefore necessary to understand the above terms factors intensity and factor abundance in order to explain H-O theory.

(A) Factor Intensity

In our two country commodity model, commodity Y is capital intensive if the capital-labour ratio (K/L) in the production of Y is greater than K/L used in the proportion of X. To explain with an example, if commodity Y requires 2 units of capital (2K) and 2 units of labour (2L), the capital-labour ratio (K/L) for producing commodity Y is 2/2 = 1. For commodity X, if the required inputs are 1K and 4L, the capital-labour (K/L) ratio ¼.

The ratios can be stated as :

For commodity Y, the K/L = 2K /2L = 1

For commodity X, the K/L = 1K/4L =1/4

Here commodity Y is capital intensive and X is labour intensive

Capital or labour intensity is not measured in absolute terms but by the ratio i.e. units of capital per labour or units of labour per capital. In our example, K/L ratio for Y is 1 and for X is ¼.

Instead, if units of capital and labour used in the production of Y are 2K and 2L where as for X, 3K and 12L, commodity Y still remains capital intensive through X requires more capital in absolute terms i.e. 3K. Capital used per labour in the production of X is 3K/2L i.e. 3/12 = ¼. Where as for Y it is 2K/2L = 1 as shown in table.

Factor intensity, therefore is measured by the factor ratios and not by absolute units.

In our example of two commodities, two factors and two countries, we say commodity Y is capital intensive if capital-labour ratio (K/L) of Y is greater than the K/L ratio of X. To illustrate the point let us say that production ofone unit of Y requires two units of capital (2K) and 2 unit labour (2L).the capital-labour ratio (K/L) of Y is2/2 =1. Similarly, if the production of X requires 3K and 12L, the capital-labour ratio of X is ¼. Here we say Y is capital intensive and X is labour intensive.

It is to benoted that goods are not not categorized based on absolute quantity or units of capital and labour used in the production of a unit of good Y or X but the ratio of capital-labour of each c6K and 24L, here good X requires more capital in absolute number than Y. Yet in terms of ratio, it is Y which is capital intensive (5/5 =1) where as X is labour intensive (6/24 = ¼).

(B) Factor Abundance

Factor Abundance in Physical Terms

Nations differ in factor endowments. Some have more natural resources, some have more of labour and others more of capital. A given county’s factor abundance can be defined either in physical terms or in terms of relative factor prices. In our two country model, country I is capital abundant, if in physical terms the ratio of total amount of capital (TK) to the total amount of labour (TL) that is (TK/TL) in nation 1 is greater than nation 2 i.e. > . It should be noted that it is not the absolute amount of capital and labour but the ratio of the total amount of capital to the total amount of labour. Country 1 may have a lesser quantity of capital than country 2, yet country 1 will be capital abundant if TK to TL in country 1 is greater than in country 2.

Factor abundance in physical terms can also be explained with the help of production possibility curve OR production frontier, as shown in fig.

In the diagram below, country I is capital abundant, therefore, its production possibility curve is skewed towards Y-axis. Country II is labour abundant, accordingly its production possibility curve is skewed towards X-axis.

• Commodity Y is capital intensive.
• Commodity X is labour intensive.

Country I can produce OA of Y i.e. CA quantity more than country II. Similarly country II can produce OD of X, i.e. BD quantity more than country I. Country II can produce more of X which is labour intensive because it is capital intensive due to its abundant capital.

The domestic price lines are PP1 and PP2 in countries I and II. The points E and Q are the respective equilibrium points of production and consumption. The price lines P1 and P2 indicate that commodity Y is cheaper in country I and X in country II, providing the basis for trade.

Factor Abundance in Terms of Factor Price

The cause of international trade is the difference in commodity prices. Price of commodity differs because of cost of production which in turn depends on factor prices. It is therefore necessary to explain factor abundance theory in terms of factor prices.

A nation is capital abundant if the ratio of the capital price to the labour price (PK/PL) is lower in it than in the other.

The two definitions give us the same meaning. The physical abundance explains the supply side. The price ratios are based on the price of factors determined by the demand for and supply of factors. The demand for factors derived demand i.e. derived from the demand for commodities produced with the help of factors. In our two nations model, demand is assumed to be the same in both the nations. In a country where the supply of physical units of capital (K) is more, its price has to be lower in comparison to the other factor(L). If in nation 1, the price of capital i.e. interest (r) is less than the price of labour i.e. wage (w) and in nation 2, r is more than w, then we have . Here nation 1 is a capital abundant country.

From our above analysis we can derive the following conclusions:

1. Each country differs in factors endowments, some have abundant labour, some possess plenty of land and others have huge amount of capital and so on.
2. Each country specializes in the production of that commodity which requires more of its abundant factor.
3. Abundance of a factor makes it cheaper in terms of its price.
4. Low factor prices result in low cost of production and in turn low commodity prices.
5. Low commodity price is the basis of international trade.

8.3 Concepts of free trade

1. Classical and Neoclassical

Classical Political Economy, as well as Neoclassical theory, embraces free trade. This is mostly because of the theory of comparative advantage first developed by David Ricardo. Broadly speaking, Ricardo’s theory postulates that free trade is advantageous as it allows nations to specialize in production that requires relatively fewer factor inputs. This reasoning is based on the concept of opportunity cost and postulates that even nations that are worse in producing any good stand to gain something from trade. As a consequence of trade, nations would be able to reach consumption (and thereby utility) that goes beyond the possibilities that could be reached by producing all required goods in an autarch manner. The neoclassical theory later refined Ricardo’s assumptions by introducing increasing marginal costs when shifting production factors from one good to another, thereby explaining why there is no complete specialization in countries.

A theory that seeks to explain why different countries specialize in different goods is the Heckscher-Ohlin theory. This theory says that countries will tend to export goods that require more inputs from a production factor (capital, land, labour) they have in abundance and vice versa import goods that require more input from a production factor that is scarce. Also, due to trade both the prices of goods as well as the returns to production factors will reach an equilibrium or a world price.

The political implications of these insights are to repeal restrictions on trade such as quotas, tariffs or national subsidies wherever possible, since they reduce the overall welfare of the world and lead to inefficient production. Historically, free trade proponents’ first great victory was the mobilization against the “Corn Laws” in 19th century Britain. Contemporarily the different rounds of the GATT and the WTO are promoting trade by reducing tariffs as well as non-tariff barriers (such as regulations and bans on certain goods).

2. Institutionalist

Institutionalists have a more ambiguous stance about free trade. This is mostly because they embrace a more active role for state management of economic development and fear that opening up national economies to world trade (too soon) might interfere with those plans. Also, most of the times a different normative metric for welfare or goodness is applied. Friedrich List, in particular, eschewed the classicals’ preoccupation with the utility of individuals or welfare of the world as a whole. Instead, he places an emphasis on the nation as the locus of collective identity. Consequently, national indicators like, for example, the balance of payment, the share of the manufacturing (or any other nationally relevant) industry or the exchange rate of the nation’s currency would become more important issues than consumers’ welfare gains. Another prominent contribution of List is the “kicking away the ladder” metaphor. He argued that the British economy had actually relied on protectionist tariffs and interventionist policies before embracing free trade and that prescribing other nations to go directly from underdevelopment to free trade would be the equivalent of kicking away the ladder. Contemporary institutionalists might not necessarily share List’s strong attachment to economic nationalism. Still, institutionalists are wary of the consequences for political and cultural consequences that might arise due to free trade i.e. when production patterns are shifted.

3. Marxian and Developmentalist

Marx did stress the necessity of international trade for the sake of capital accumulation in his analysis. Others working in the Marxian tradition such as Karl Kautsky, Rosa Luxemburg, J.A. Hobson and V.I. Lenin subsequently developed theories of imperialism whereby the conquest of new markets was a function of the capitalist mode of production in the industrialized economies. Consequently, capital needed to expand ruthlessly and violently in order to realize its surplus value and therefore bring all parts of the world not yet subjected to capitalist production under its aegis. It is noteworthy that free trade here is seen as a zero sum game, where value is transferred from the powerless to the powerful, often under the use of (physical) force i.e. in the form of colonial armies, foreign backed dictators or economic and financial pressure.

A variant of imperialist theorizing is World Systems Theory developed by Immanuel Wallerstein, in which a “core” set of nations exploits the “periphery.” In this model, the core imports cheap raw materials from the periphery and sells expensive manufactured goods back to the periphery market. As a consequence of this structure, the core is able to maintain its wealth by keeping the most profitable sectors of economic production within its boundaries, while the periphery is unable to move out of impoverishment (even though transitions towards a semi-periphery are possible).

Somewhat connected to this strand of thinking is the developmentalist school. Developmentalists, however, instead of embracing revolution against capitalism as a policy prescription are closer to the early institutionalists in the sense that they advocate for national strategies such as infant industry protection or the development of import substitution industries that are seen to be able to increase their power in the world trade system in the long term. The political implications from this theory were, for example, the proposal of the New International Economic Organization (NIEO) in the UN in the 1970s, which however failed, and national economic strategies pursued by various states in Latin America roughly from the 1930s until the 1970s.

4. Ecological

Ecological economists take issue with free trade for a variety of reasons. Firstly, they contend that the negative externalities from the shipping of goods around the globe are not sufficiently accounted for (i.e. CO2 emissions from transport, environmental damages from shipwrecks, destruction of the biosphere for transport routes, …). So from an environmentalist view, it might actually be preferably to produce and consume locally sidestepping global production chains, which have a high and often not even clearly measurable impact on the environment. Secondly, free trade agreements are criticized as a means to break local or national environmental protection laws. This concern is related to the reduction of non-tariff barriers, which might include environmental protection laws and also the inclusion of international trade arbitration courts, which could fine states for introducing future protection laws. Yet another concern related to trade is that states might “green” their economies not by altering production and consumption patterns but by outsourcing environmentally harmful production to other parts of the world and then import goods, whose production entails, for example, high levels of CO2