BUSI 303 - INTERNATIONAL BUSINESS
THE GROWTH OF GLOBAL TRADE- THEORIES AND TRENDS
International trade has a long history, dating back to exchanges between
regions such as India and Java. However, formal theories analyzing global
trade have developed more recently. Understanding the evolution of
international trade theories provides insight into current thinking on the
drivers and impacts of globalization.
Interdependence of Countries
No country can produce everything it needs. The interdependence among
nations stems from several key factors:
Uneven Distribution of Resources
Natural resources like oil, metals, and agriculture vary dramatically by
region. These uneven endowments create surplus and deficient areas,
driving trade flows from resource-rich lands to importing nations. For
example, Gulf countries export oil but buy products they lack.
Technology Differences
The Industrial Revolution began in England in 1760, then spread globally
at varying paces. Leading technology producers like the U.S., Germany,
and Japan trade innovations for imports from developing nations.
Information Technology
Modern communication channels like the internet, satellite networks, and
e-commerce connect the world. Consumers mimic lifestyles seen in media
and advertising, raising demand for new products.
Specialization and Trade
Certain nations are relatively better at making some products due to
favorable conditions like climate, expertise, and access to inputs. They
export surpluses in exchange for other goods per the principle of
comparative advantage.
Classical Trade Theory
Classical economists saw key differences between domestic and
international trade, centering their analysis on comparative cost gaps.
Assumptions
The classical model assumes just two countries producing two goods in a
simple full employment economy with no barriers to commerce. Labor is
the sole input, available in perfectly elastic supply at a fixed wage rate.
Absolute Advantage
Adam Smith stated countries trade if one has an absolute cost edge in one
good and the other nation leads in producing something else.
Specialization in those absolute advantage goods raises total output. But
this theory fails to explain trade if one land lacks any production
advantage.
Comparative Advantage
David Ricardo's clever insight was that lands still benefit by exporting
products with comparative advantage, namely where they are relatively
more efficient. A nation imports where it faces comparative disadvantage.
Even if Portugal outpaces England in all areas, both gain through trade if
Portugal specializes in its higher edge sector of winemaking, exporting it
in return for English cloth.
Determining Terms of Trade
The terms of trade or rate of exchange for wine and cloth will be
negotiated between Portugal's opportunity cost ratio of 0.89 units of cloth
per unit of wine and England's alternative price of 1.2 units of cloth. Gains
arise for Portugal if it trades one wine unit for over 0.89 cloth units while
England benefits receiving one wine unit for less than 1.2 cloth units. At a
hypothetical 1:1 wine/cloth swap, Portugal would gain over producing that
cloth domestically while England would save effort compared to its
winemaking cost.
Expressing Comparative Advantage in Monetary Terms
Frank Taussig specified arbitrary dollar wage rates for American and
German workers to show comparative advantage expressed in dollar
prices rather than labor hours. If U.S. workers earn $1.50 per hour versus
$1.00 in Germany, America's unit cost of $0.75 for wheat beats Germany's
$1.00 while Germany's $0.66 linen bests the $0.75 U.S. rate. So each
nation specializes per comparative advantage.
Critique of Classical Theories
The strict assumptions of two lands, two goods, no trade costs, and fixed
coefficients limit applicability. And the theories give no insight into
determining actual terms of trade. But the powerful core concept of
mutually beneficial trade driven by comparative advantage remains
relevant today.
International Trade Theories: Evolution and Critique
Theoretical explanations for global commerce have developed over time,
with pioneering classical economists like Adam Smith and David Ricardo
followed by modern thinkers like Bertil Ohlin. Their models rely on
assumptions like fixed resources, perfect competition, and production
determined solely by labor inputs. International trade flows when
countries specialize along the lines of comparative advantage.
Classical Trade Theory
Classical scholars sought to differentiate foreign from domestic trade,
citing key variations like currency flows, policy differences, and resource
immobility across borders. Trade occurs due to absolute and comparative
cost gaps.
Key Assumptions
The strict classical model assumes just two countries producing two goods
in a simplified full employment economy without impediments to
commerce. Labor constitutes the only input, available in perfectly elastic
supply at a fixed wage rate.
Absolute Advantage
Adam Smith stated nations should specialize in goods with absolute
physical output edges, exporting the surplus. But this fails to explain two-
way trade if one nation lacks any absolute advantage.
Comparative Advantage
David Ricardo’s clever theory says countries benefit by exporting products
in which they are relatively more efficient. A nation imports where it faces
comparative disadvantage. Even if Portugal produces more wine and cloth
than England, both gain if Portugal specializes in its higher edge wine
sector, exporting it for English cloth.
Determining Terms of Trade
The relative price of Portuguese wine and English cloth depends on
opportunity cost ratios in each land. Mutual benefits arise if Portugal
trades wine above its alternative cloth cost while England ships cloth
below its winemaking price.
Expressing Comparative Advantage in Monetary Terms
Frank Taussig specified arbitrary dollar wage rates to express labor cost
gaps revealing comparative advantage in dollar prices, not just hours.
America’s lower wheat price and Germany’s cheaper linen unit cost due to
wage differences prompt specialization.
Critique of Classical Theories
While the core concept of mutually beneficial trade driven by comparative
advantage remains relevant, strict assumptions about two lands, two
goods, no trade costs, and fixed coefficients limit real-world applicability.
The theories also fail to predict terms of trade.
Modern Trade Theory
Ohlin’s general equilibrium framework says comparative cost differences
stem from differing resource endowments and production functions across
countries. Nations export goods utilizing their abundant factors.
Assumptions
The model assumes two countries producing a capital-intensive and a
labor-intensive good under constant returns to scale, perfect competition,
and factor mobility within but not between nations.
Explanation
Trade flows due to commodity price differences caused by divergent factor
prices resulting from different factor endowments. Capital-abundant
Country X has cheaper capital driving specialization in capital-intensive
goods exported to labor-abundant Country Y in return for its cheaper
labor-intensive products.
Impact of Exchange Rates
Bilateral exchange rates help determine whether factors are cheaper in
one land versus another by revealing absolute price differences, shaping
trade patterns. As currency prices adjust, comparative factor and
commodity cost advantages shift producing changes in specialization and
trade flows.
Increasing Complexity
Ohlin extended his model to: • Multi-country, multi-good scenarios •
Increasing/decreasing cost conditions • Imperfect competition •
Qualitative factor differences • Transport costs and product differentiation
• Tariffs and other barriers
Critique of Modern Theory
While an improvement over classical models, the strict assumptions of the
Ohlin framework limit real-world applicability. Moreover, factor prices
depend on both supply and demand, not just endowments. And trade
based on differentiated products can occur without factor proportion
differences. The theory seems too static to capture shifting global
commerce patterns.
Classical Trade Theory
Classical scholars sought to differentiate foreign from domestic trade,
citing key variations like currency flows, policy differences, and resource
immobility across borders. Trade occurs due to absolute and comparative
cost gaps.
Key Assumptions
The strict classical model assumes just two countries producing two goods
in a simplified full employment economy without impediments to
commerce. Labor constitutes the only input, available in perfectly elastic
supply at a fixed wage rate.
Absolute Advantage
Adam Smith stated nations should specialize in goods with absolute
physical output edges, exporting the surplus. But this fails to explain two-
way trade if one nation lacks any absolute advantage.
Comparative Advantage
David Ricardo’s clever theory says countries benefit by exporting products
in which they are relatively more efficient. A nation imports where it faces
comparative disadvantage. Even if Portugal produces more wine and cloth
than England, both gain if Portugal specializes in its higher edge wine
sector, exporting it for English cloth.
Determining Terms of Trade
The relative price of Portuguese wine and English cloth depends on
opportunity cost ratios in each land. Mutual benefits arise if Portugal
trades wine above its alternative cloth cost while England ships cloth
below its winemaking price.
Expressing Comparative Advantage in Monetary Terms
Frank Taussig specified arbitrary dollar wage rates to express labor cost
gaps revealing comparative advantage in dollar prices, not just hours.
America’s lower wheat price and Germany’s cheaper linen unit cost due to
wage differences prompt specialization.
Critique of Classical Theories
While the core concept of mutually beneficial trade driven by comparative
advantage remains relevant, strict assumptions about two lands, two
goods, no trade costs, and fixed coefficients limit real-world applicability.
The theories also fail to predict terms of trade.
Classical Trade Theory
Classical scholars sought to differentiate foreign from domestic trade,
citing key variations like currency flows, policy differences, and resource
immobility across borders. Trade occurs due to absolute and comparative
cost gaps.
Key Assumptions
The strict classical model assumes just two countries producing two goods
in a simplified full employment economy without impediments to
commerce. Labor constitutes the only input, available in perfectly elastic
supply at a fixed wage rate.
Absolute Advantage
Adam Smith stated nations should specialize in goods with absolute
physical output edges, exporting the surplus. But this fails to explain two-
way trade if one nation lacks any absolute advantage.
Comparative Advantage
David Ricardo’s clever theory says countries benefit by exporting products
in which they are relatively more efficient. A nation imports where it faces
comparative disadvantage. Even if Portugal produces more wine and cloth
than England, both gain if Portugal specializes in its higher edge wine
sector, exporting it for English cloth.
Determining Terms of Trade
The relative price of Portuguese wine and English cloth depends on
opportunity cost ratios in each land. Mutual benefits arise if Portugal
trades wine above its alternative cloth cost while England ships cloth
below its winemaking price.
Expressing Comparative Advantage in Monetary Terms
Frank Taussig specified arbitrary dollar wage rates to express labor cost
gaps revealing comparative advantage in dollar prices, not just hours.
America’s lower wheat price and Germany’s cheaper linen unit cost due to
wage differences prompt specialization.
Critique of Classical Theories
While the core concept of mutually beneficial trade driven by comparative
advantage remains relevant, strict assumptions about two lands, two
goods, no trade costs, and fixed coefficients limit real-world applicability.
The theories also fail to predict terms of trade.
