Why countries engage in international trade?

This article at explaining why countries engage in international trade.

Now days it is not uncommon to find that the main objective of a trade policy of almost all countries is to promote international trade. Countries have gone ahead to engage in trade negotiations all in the interest of enabling international trade. But then, why do countries engage in international trade? Why are there global attempts to liberalize international trade rather than promote autarky-a situation of no international trade? Does engaging in international trade contribute to income distribution, factor employment and poverty reduction? In short, must a country engage in international trade in order to develop? This article delves into theories of trade so as to understand why countries engage in international trade.

Economist believes that if countries engage in international trade, they can mostly benefit under a free international trade environment. To get a clear perspective to this claim, I will glance though five major main theories on international trade-the Ricardian Comparative advantage Model on gains from specialization and opportunity cost theory, Heckscher-Ohlin model who believes that factor proficiency differences are the reasons why countries engage in international trade because of the gains from specialization and income distribution effects, the new international trade theory which examines the economies of scale and the Heterogeneous firms theory which explains why countries engage in international trade basing on a firm level perspective.

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Gains from Specialization by David Ricardo

According to David Ricardo (1817), countries engage in international trade because they stand to gain if they specialize in the production of products with low opportunity cost.

To Ricardo countries should understand their factor endowments then direct production to the best alternative in utilizing the available resources. A country undertaking such specialization would then enage in international trade with others countries to get those products which are of second best alternative in utilization of resources.

Ricardo emphasizes his point using the opportunity cost theory. Noting that resources are scarce, a country has to give up production of one product in order to produce the other. To know which one to give up, a country has to determine where it would have higher output if the same resource available was utilized in the production of either product. A country would specialize in production of that product whose utilization of the available resource produces the most output. In opportunity cost terms, a country should specialize in production of that product whose cost for failure to produce it is higher than that of the second alternative.

To Ricardo countries are endowed differently and so they have different opportunity costs. The difference in opportunity cost is what would enable countries to enage in international trade with each other so as to get the disdvantaged products. Ricardo sums up the above with the use of what he called the absolute and comparative advantages. To him even if a country would produce more of the two products than the other country (the absolute advantage), it should specialize in producing that product in which it has an advantage in utilization of the available resources (comparative advantage). Let us now examine this theory using the following example. The theory assumes;

1. There are two countries to enage in international trade-We will use Rainlands and United Parkland
2. There are two products produced- i.e. Coffee and Computers
3. One factor of production exists- i.e. Labour
4. Factor productivity is constant
5. Perfect competition exists in the market
6. Homogeneous of factors-They have fixed and same abilities and productivity levels
7. Factors are perfectly mobile within country and between sectors –Can be shifted from production of one product to another and from one region to another
8. Factors are immobile between countries –Endowments in one country cannot move to another country.
9. Fixed level of technology
10. Full employment
11. Comparison is between no international trade and perfectly free why countries engage in international trade trade (no tariff or non-tariff barriers)
12. Transport costs are ignored

The table below indicates the quantities of coffee and computers that would be produced by Rainlands and Parklands when a unit of labor is allocated in the production process. This table also indicates the situation pertaining in each country before the countries enage in international trade.

From the table Rainlands has an absolute advantage in the production of both coffee and computers per unit of labour employed.Let us analyze opportunity costs so as to determine their respective comparative advantages. We achieve this by looking at the cost (foregone benefit) of not producing one product so as to produce the other. In the absence of international trade the opportunity cost is calculated as the ratio of the produced product to the foregone alternative. In a situation of autarky (i.e.no trade), the (relative) price of a good equals the opportunity cost of producing that good in a country. Under free trade however, world (relative) prices are determined by world supply and demand across countries (i.e. they fall between the opportunity costs of the two countries)

If Parklands specializes in coffee, it will have to forego 50/50,000 = 0.001 units of computers for each unit of coffee produced. If however Parklands decides to specialize in computers, it would forego 50,000/50 = 1,000 units of coffee for every unit of computers produced. Likewise, if Rainlands specializes in coffee, it will have to forego 400/100,000 = 0.004 units of computers for each unit of coffee produced. If however Rainlands decides to specialize in computers, it would forego 100,000/400 = 250 units of coffee for every unit of computers produced. The table below summarizes the opportunity costs for both Rainlands and Parklands if they specialized in production of one of the products Summary the opportunity costs for specializing

From the table we can conclude that Parkland has a comparative advantage in the production of coffee and Rainlands has a comparative advantage in production of computers. For this reason, Rainlands should specialize in production of computers and Parklands in coffee and the two countries should engage in international trade and exchage the commodities in which they have a comparative advantage with those in which they are disadvantaged.

If the opportunity cost (relative price) of coffee is higher in Rainlands than in Parklands, it is profitable for the two countries if Parklands exports coffee to Rainlands and imports computers from there.

Now let us examine the effect of transferring one unit of labor to specialize in production of a product where each country has a comparative advantage. As one unit of labour is specialized in production of coffee, Parklands foregoes (loses) 50 units of units of computers to gain 50,000 units of coffee. Likewise, as one unit of labor is transferred from the production of coffee to the production of computers, Rainlands loses 100,000 units for a gain of 400 units. As the countries specialize in their respective comparative advantages, the changes in their outputs will look as follows;

Changes in outputs due to specialisation

But each country will still need the products it has not produced. Rainlands will demand for the 100,000 units of coffee from Parklands. Parkland to be able to produce that amount will have to allocate 2 units of labor. The effect of this labor transfer is that Parklands will forego production of 100 units of computers so as to meet the demand for coffee by Rainlands. Rainlands still using its one unit of labor will have to exchange its 50 units of computers with the 100,000 units of coffee from Parklands. The table shows the international trade related changes in output as countries utilize their respective labor resource in the best alternative; Changes in production with specialisation so as to engage in international trade

Due to specialization and trading based on comparative advantage, additional 250 units of computers are produced and consumed without reducing the quantities of coffee produced and traded in the international market. In general, countries gain from free trade because the output and consumption possibilities of both countries expand as opposed to no trade. Let us try to analyze the mechanism allowing countries to gain from trade. If the world price of coffee is equal to $1and the price of a computer equals $500, Parklands can buy 200 units of computers from the Rainlands by exporting 100,000 coffee units. As both countries engage in international trade, they end up consuming more computers and the same amount of coffee than in the situation without trade.

Therefore enabling countries to specialize their resources in the economic activities in which they have a comparative advantage and then engage in international trade to get products in which they have a comparative disadvantage does not only expand the size of global production, it allows for expanded “ global consumption possibilities”. The downside of the comparative advantage as advanced by David Ricardo The theory has been criticized mainly because of its assumptions which to some economists are not realistic.

Below are some of the areas that the theory ignores.

1. Free international trade is beneficial not only to that country with a more productive sector than foreign countries but also to those countries that are able to avoid the high costs for goods that they would otherwise have to produce domestically.
2. The theory is not complex enough to examine income distributional issues within a country. For example free trade with countries that pay law wages can hurt high wage countries. Even though consumers benefit because they can purchase goods more cheaply, international trade may reduce wages for some workers, thereby affecting the distribution of income within a country. In effect internatioanl trade with such low wage countries erodes the incomes of the producers/workers that are earned using resources more efficiently and through higher prices/wage.
3. The assumption that all countries are identical except for their differences in technologies is farfetched. Countries differ in their endowments of important factors of production (inputs). Does that matter for trade?
4. The theory ignores the nature and form of transport in the different countries and the effect this has on the relative price for one good to any other. Transport costs differ in terms of cost, swiftness and appropriateness in delivery mechanisms. These differences have a bearing on the price of the product and do influence the terms of trade. In other words, a country with a comparative advantage say in using labor to produce coffee could find itself disadvantaged in the international market, if its transport sector is not well developed.
5. Free international trade does not exist in the real world since governments will always come up with obstacles (trade blocks) in the interest of meeting their development challenges including ensuring safety for their citizens, developing the skills of the people, ensuring security and developing infrastructure among others. So even though the general results still hold, economies cannot reach the most efficient allocation of resources, in situations where there are obstacles such as tariffs and non-tariff trade barriers. Even some obstacles meant to correct market failures such as restrictions on production due to environmental concerns do lower the volume of trade.
6. The assumption of constant cost of production is irrelevant in situations where increasing output due to employment of an additional resource will lead to diminishing returns. This limits the expected benefits of specialization.
7. Free international trade can actually lead to long-run continued poverty for small poor countries especially where complete specialization has been attained by the developed countries.Developing countries are not able to compete in the global market including even in their own countries in situations where a developed is able to decrease cost of production as output increases.
8. Technology have since been varied and differently by different countries. Although the general idea of gains from trade still holds in changing technology, comparative advantage attained as a result seems to have been underestimated by the theory. Unless technology change is allowed to move freely across nations, countries with this advantage are able to again, higher productivity and competitiveness thus enabling them to earn better incomes to the detriment of the disadvantaged countries
9. With advancement in technology, immobility of factors of production cannot hold in a free trade environment. If the principal of efficient utilization of resources is to be upheld, then gains can be best made when labour and capital are enabled to move not only within but also across countries. But this can result in increased capital flight and brain drain as capital and labor moves to where returns are higher, instead of producing at home for export.
10. Factors of production are not necessarily homogeneous. Because they are not the same, they cannot necessarily move from the production of one good to another.

The Heckscher-Ohlin Theory of International trade

As we noted, the Ricardian model left out a number of important factors. The model is not complex enough to examine how international trade affects income distributional within a country, it never highlighted on specific terms for the winners and losers. It assumes all countries are identical except for their differences in resource endowment, although in reality we know that countries differ not only in factors of production but also in how they achieve productivity out of those endowments.

Well, Heckscher-Ohlin based his model on these reasons. He does not water down Ricardian model rather he builds on it by putting into consideration some of these factors. In other words, Heckscher-Ohlin model, assumes 2 countries and 2 goods, one fixed factor endowment, domestic mobility, international immobility, perfect competition and constant returns to scale. There are however two important elements that were added to Ricardian Model. Heckscher-Ohlin model assumes also that countries have factor differences in a way that one country has higher proficiency levels than the other. The second and most important assumption is that countries are identical except with regard to endowments. The tests and preferences are the same and technology is a constant in the two countries.

According to Heckscher-Ohlin even if countries have same factor endowment, its productivity in respect to production of a particular product differs between two countries. As such, a country should specialize in the production of a product in which factor productivity is higher. In other words, each country has a comparative advantage in the production that requires relatively less of the factor with which it is well endowed.

Through international trade, there is tendency towards equalization of factor prices across the two nations. In this sense, international trade and factor movement are substitutes. Intuition: Trade in goods implies trade in embodied factors.

Let us look at the example of how the Heckscher-Ohlin model works. We assume two countries, one which a developed country-USA and another less developed like Sudan. The two countries are can produce textiles and pharmaceuticals but Sudan is more endowed in unskilled labour while USA has more of skilled labour. Textiles unskilled labour intensive while pharmaceuticals is skilled labour intensive.

Under autarky textiles will be relatively expensive and pharmaceuticals cheap in USA while the reverse will be true in Sudan. Under international trade it pays USA to export pharmaceuticals to Sudan and import textiles from there. Sudan will of course benefit from this arrangement if it exports textiles to USA and import pharmaceuticals.

If the two countries decide to engage in international trade, Sudan which has relatively more low skilled workers will have more of its skilled labour laid off by the contracting pharmaceuticals sector as more of low skilled workers are demanded by the expanding textiles sector. On the other hand, USA which has relatively more high-skilled workers will have increased layoffs of her unskilled labour by the contracting textile sector as more of skilled workers are demanded by the expanding pharmaceuticals sector.

The factor prices will respond to the international trade engagements in that salaries of high skilled workers in USA will increase relative to those of the low skilled workers. Meanwhile salaries of the low skilled workers in Sudan will increase compared to those of high skilled workers. In the long-run as the two countries specialize and trade in sectors in which their labour is more proficient, they will register increased welfare in their respective labour segments. In USA, high-skilled workers will gain and the low skilled workers loose. In Sudan the low skilled workers will gain while the high skilled workers loose.

Looking closely at Heckscher-Ohlin model, it is clear that factor price equalization can be achieved if there is absence of complete specialization, similar technology and convergence of free trade relative prices which in turn requires absence of trade restrictions.

But does every individual gain from international trade? The answer is NO – within each country owners of the abundant factor gain while owners of other factors lose from trade liberalization. However, aggregate welfare increases in both countries –the sum of the gains exceeds the sum of individual losses. In principal, losers could be compensated at the national level. However, this requires separate redistribution policies to make everyone better off.

Heckscher-Ohlin however failed to explain why there is inequality in highly open countries. He predicted that owners of abundant factors will gain from trade and owners of scarce factors will lose. But, while this mechanism might be at work, the evidence shows that it is not the dominant factor that matters. Empirical literature seems to have converged to the view that trade contributed to about 20% of raising wage inequality. Changes in income distribution occur with every economic change, not only international trade. Changes in technology, changes in consumer preferences, and exhaustion of resources and discovery of new ones all affect income distribution. Economists put most of the blame on the bias of technology transfer and the resulting premium paid on education as the major cause of increasing income inequality in developing countries. In any case trade liberalization may trigger technological change which, in turn affects inequality.

The New Trade Theory On Why Countries Engage In International Trade New trade theory takes a different approach from the Ricardian and the Heckscher-Ohlin models on why countries engage in international trade. Both Ricardo and Heckscher assumed constant returns to scale where to them if all factors of production are doubled then output will also double. But a firm or industry may have increasing returns to scale or economies of scale in way that when all factors of production are doubled, output more than doubles which will necessitate a bigger market and thus forcing firms to engage in international trade where there is a larger market. The New Trade Theorist noted that the bigger the size of a firm or industry the more the efficiency of its operations in that the the cost per unit of output falls as a firm or industry increases output. The increase in output must however be met with an increase in the market size if it has to be sustainable.

The New Trade Theorist noted that the existence of economies of scale makes large firms to be vmore efficient than small firms, and the industry may consist of a monopoly or a few large firms. Production may be imperfectly competitive in the sense that excess or monopoly profits are captured by large firms. In other words New Trade Theory on why countries engage in international trade is opposed to the assumption made in the Ricardian and Heckscher models that there is perfect competition in the market in that all income from production is paid to owners of factors of production and there is no “excess” or existence of monopoly profits. To New Trade Theorists countries engage in international trade because of the notion of economies of scale. To them the presence of scale economies leads to a breakdown of a perfect competition and creates more efficient firms which continue to expand on the markets because of increased outputs.

The New Trade Theorists explained that because engaging in international trade increases market size, this decreases the average cost in an industry described by monopolistic competition. They also noted that when countries engage in international trade variety of goods those consumers can buy also increases thus increasing their welfare. As average costs decrease, consumers also benefit from a decreased price. Two types of economies of scale were considered in explaining that countries engage in international trade because of economics of scale. The first one is the internal economies in which average costs of individual firms will fall as they produce more output and become larger and the second one is the external economies of scale in which average costs of the industry in a country will reduce as it produces more output and grows larger. Below is an example of economies of scale are derived

Costs are measured by C = F +McQ, where; F represents fixed costs, independent of the level of output and, Mc represents a constant marginal cost: the constant cost of producing an additional unit of output Q In other words the average costs (AC) of the firms can be expressed AC= F/Q + Mc This means that a larger firm is more efficient because average cost decreases as output Q increases (fixed costs spread across larger output). The increase in output must be met with an equivalent market if it has to be sustainable and thus the reasons why a firm or a country will engage in international trade so as to enjoy the benefits of economies of scale.