Trade agreements and economic theory
Clarke Ricks School of Business,
Liberty University
BUSI 690: Policy and Strategy in Global Competition
Dr. Hicks
May 7, 2022
Trade agreements and economic theory
Almost all Western economists today believe in the desirability of free trade, and this is
the philosophy advocated by international institutions such as the World Bank, the
International Monetary Fund, and the World Trade Organization (WTO). And this was the view
after World War II, when Western leaders launched the General Agreement on Tariffs and
Trade (GATT) in 1947.
However, economic theory has evolved substantially since the time of Adam Smith, and it
has evolved rapidly since the GATT was founded. To understand U.S. trade agreements and
how they should proceed in the future, it is important to review economic theory and see how
it has evolved and where it is today.
In the seventeenth and eighteenth centuries, the predominant thinking was that a
successful nation should export more than it imports and that the trade surplus should be used
to expand the nation’s treasure, primarily gold and silver. This would allow the country to have
a bigger and more powerful army and navy and more colonies.
One of the better-known advocates of this philosophy, known as mercantilism, was
Thomas Mun, a director of the British East India Company. In a letter written in the 1630s to his
son, he said: “The ordinary means therefore to increase our wealth and treasure is by Foreign
Trade, wherein wee must ever observe this rule; to sell more to strangers yearly than wee
consume of theirs in value…By this order duly kept in our trading,…that part of our stock which
is not returned to us in wares must necessarily be brought home in treasure.”[1]
Mercantilists believed that governments should promote exports and that governments
should control economic activity and place restrictions on imports if needed to ensure an
export surplus. Obviously, not all nations could have an export surplus, but mercantilists
believed this was the goal and that successful nations would gain at the expense of those less
successful. Ideally, a nation would export finished goods and import raw materials, under
mercantilist theory, thereby maximizing domestic employment.
Then Adam Smith challenged this prevailing thinking in The Wealth of Nations published in
1776.[2] Smith argued that when one nation is more efficient than another country in
producing a product, while the other nation is more efficient at producing another product,
then both nations could benefit through trade. This would enable each nation to specialize in
producing the product where it had an absolute advantage, and thereby increase total
production over what it would be without trade. This insight implied very different policies than
mercantilism. It implied less government involvement in the economy and a reduction of
barriers to trade.
The Theory of Comparative Advantage
Thirty-one years after The Wealth of Nations was published, David Ricardo introduced an
extremely important modification to the theory in his On the Principles of Political Economy and
Taxation, published in 1817.[3] Ricardo observed that trade will occur between nations even
where one country has an absolute advantage in producing all the products traded.
Ricardo showed that what was important was the comparative advantage of each nation
in production. The theory of comparative advantage holds that even if one nation can produce
all goods more cheaply than can another nation, both nations can still trade under conditions
where each benefits. Under this theory, what matters is relative efficiency.
Economists sometimes compare this to the situation where even though a lawyer might
be more proficient at both law and typing than the secretary, it would still pay the lawyer to
have the secretary handle the typing to allow more time for the higher-paying legal work.
Similarly, if each country specializes in the products where it is comparatively more efficient,
total production will be higher and consumers will have more goods to utilize.
Smith and Ricardo considered only labor as a “factor of production.” In the early 1900s,
this theory was further developed by two Swedish economists, Bertil Heckscher and Eli Ohlin,
who considered several factors of production.[4] The so-called Heckscher-Ohlin theory basically
holds that a country will export those commodities that are produced by the factor that it has in
relative abundance and that it will import products whose production requires factors of
production where it has relatively less abundance. This situation is often portrayed in
economics textbooks as a simplified model of two countries (England and Portugal) and two
products (textiles and wine). In this simplified portrayal, England has relatively abundant capital
and Portugal has relatively abundant labor, and textiles are relatively capital intensive whereas
wine is relatively labor intensive. With these conditions, both nations would be better off if they
freely traded, and under such a situation of free trade, England would export textiles and
import wine. This would maximize efficiency, resulting in more total production of textiles and
wine and cheaper prices for consumers than would be the case without trade. Through
empirical studies and mathematical models, economists almost universally believe that this
model holds equally well for multiple products and multiple countries.
In fact, economists consider this law of comparative advantage to be fundamental. As
Dominick Salvatore says in his basic economics textbook International Economics, the law of
comparative advantage remains “one of the most important and still unchallenged laws of
economics. …The law of comparative advantage is the cornerstone of the pure theory of
international trade.”[5]
The law of comparative advantage also holds equally well for many factors of production.
In addition to labor and capital, other factors of production include natural resources such as
land and technology, and these can be subdivided. For example, land can be land for mining or
land for farming, or technology for making cars or computer chips, or skilled and unskilled
labor. Additionally, over time factor endowments may change. For example, natural resources,
such as coal reserves, may be used up, or a country’s educational system may be improved,
thereby providing a more highly skilled labor force.
Furthermore, some products do not utilize the same factors of production over their life
cycle.[6] For example, when computers were first introduced, they were incredibly capital
intensive and required highly skilled labor. Over time, as volume increased, costs came down
and computers could be mass produced. Initially, the United States had a comparative
advantage in production; but today, when computers are mass produced by relatively unskilled
labor, the comparative advantage has shifted to countries with abundant cheap labor. And still
other products may use different factors of production in different countries. For example,
cotton production is highly mechanized in the United States but is very labor intensive in Africa.
The fact that factors of production may change does not nullify the theory of comparative
advantage; it just means that the mix of products that a nation can produce relatively more
efficiently than its trade partners may change.
Traditional economic theories expounded by Ricardo and Heckscher-Ohlin are based on a
number of important assumptions, such as perfect competition with no artificial barriers
imposed by governments. A second assumption is that production occurs under diminishing or
constant returns to scale, that is, the costs of producing each additional unit are the same or
higher as production increases. For example, to increase his wheat crop, a farmer may be
forced to use less-fertile land or pay more for laborers to harvest the wheat, thereby increasing
the cost of each additional unit produced.
Another key assumption of traditional economic theory is that basic factors of production
—such as land, labor, and capital—are not traded across borders. Although Ohlin believed that
such basic factors of production were not traded, he argued that the relative returns to factors
of production between countries would tend to be equalized as goods are traded between the
countries. Subsequently, Samuelson argued that factor prices would in fact be equalized under
free trade conditions, and this is known in economics as the factor price equalization theorem.
[7] This might mean, for example, that international trade would cause wage rates for unskilled
workers to fall in the high-wage country in relation to the rents available from capital and to the
same level as wages in the low wage country, and for wages to rise in relation to the rents
available from capital in the low-wage country and equal to the level of the country where
labor was less abundant. (The implications of this are important and are explored further in
chapter 8.)
In static terms, the law of comparative advantage holds that all nations can benefit from
free trade because of the increased output available for consumers as a result of more efficient
production. James Jackson of the Congressional Research Service describes the benefits as
follows: Trade liberalization, “by reducing foreign barriers to U.S. exports and by removing U.S.
barriers to foreign goods and services, helps to strengthen those industries that are the most
competitive and productive and to reinforce the shifting of labor and capital from less
productive endeavors to more productive economic activities.”[8]
Many economists, however, believe that the dynamic benefits of free trade may be
greater than the static benefits. Dynamic benefits, for example, include the pressure on
companies to be more efficient to meet foreign competition, the transfer of skills and
knowledge, the introduction of new products, and the potential positive impact of the greater
adoption of commercial law. Thus trade can affect both what is produced (static effects) and
how it is produced (dynamic effects).
Terms of Trade
Another important concept in international trade theory is the concept of “terms of
trade.” This refers to the amount of exports needed to obtain a given amount of imports, with
the fewer amount of exports needed the better for the country. The terms of trade can shift,
either benefiting a country or reducing its welfare.
Assume that the United States exports aircraft to Japan and imports televisions, and that
one airplane can purchase 1,000 televisions. If one airplane now can purchase 2,000 televisions,
the United States will be better off; alternatively, its welfare is diminished if it can only purchase
500 televisions with a single airplane.
A number of factors can affect the terms of trade, including changes in demand or supply,
or government policy. In the example given just above, if Japanese demand for aircraft
increases, the terms of trade will shift in the United States’ favor because it can demand more
televisions for each airplane. Alternatively, if the Japanese begin producing aircraft, the terms
of trade will shift in Japan’s favor, because the supply of aircraft will now be larger and the
Japanese will have alternative sources of supply.
Under certain conditions, improvements in a country’s productivity can worsen its terms
of trade. For example, if Japanese manufacturers of televisions become more efficient and
reduce sale prices, Japan’s terms of trade will worsen as it will take more televisions to
exchange for the airplane.
A country can also adopt a beggar-thy-neighbor stance by deliberately turning the terms
of trade in its favor through the imposition of an optimum tariff or through currency
manipulation. In his economics textbook, Dominick Salvatore defines an optimum tariff as that
rate of tariff that maximizes the net benefit resulting from the improvement in the nation’s
terms of trade against the negative effect resulting from reduction in the volume of trade. . . .
As the terms of trade of the nation imposing the tariff improve, those of the trade partner
deteriorate, since they are the inverse. . . . Facing both a lower volume of trade and
deteriorating terms of trade, the trade partner’s welfare definitely declines. As a result, the
trade partner is likely to retaliate. . . . Note that even when the trade partner does not retaliate
when one nation imposes the optimum tariff, the gains of the tariff-imposing nation are less
than the losses of the trade partner, so that the world as a whole is worse off than under free
trade. It is in this sense that free trade maximizes world welfare.[9]
If both countries play this game, both will be worse off. However, if only one country
pursues this strategy, it can gain at its partner’s expense.
