International Trade
Introduction
Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and services. Later one side of the barter were the metals, precious metals (poles, coins), bill, and paper money.
International trade is the exchange of capital, goods, and services across international borders or territories. In most countries, such trade represents a significant share of gross domestic product (GDP). While international trade has been present throughout much of history its economic, social, and political importance has been on the rise in recent centuries.
Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system. Increasing international trade is crucial to the continuance of globalization. Without international trade, nations would be limited to the goods and services produced within their own borders.
International trade among different countries is not a new a concept. History suggests that in the past there were several instances of international trade. Traders used to transport silk, and spices through the Silk Route in the 14th and 15th century. In the 1700s fast sailing ships called Clippers, with special crew, used to transport tea from China, and spices from Dutch East Indies to different European countries.
The economic, political, and social significance of international trade has been theorized in the Industrial Age. The rise in the international trade is essential for the growth of globalization. The restrictions to international trade would limit the nations to the services and goods produced within its territories, and they would lose out on the valuable revenue from the global trade.
Internal and International Trade
Internal trade, also known as Domestic trade or home trade, is the exchange of domestic goods within the boundaries of a country. This may be sub-divided into two categories, wholesale and retail. Wholesale trade is concerned with buying goods from manufacturers or dealers in large quantities and selling them in smaller quantities to others who may retailers or even consumers. Wholesale trade is undertaken by wholesale merchants or wholesale commission agents. Retail trade is concerned with the sale of goods in small quantities to consumers. This type of trade is taken care of by retailers. In actual practice, however, manufacturers and wholesalers may also undertake retail distribution of goods to bypass the intermediary retailer, by which they earn higher profits.
Features of Internal Trade
v The buying and selling of goods takes place within the boundaries of the same country.
v Payment for goods and services is made in the currency of the home country.
v It involves transactions between the producers, consumers and the middlemen.
v It consists of a distribution network of middlemen and agencies engaged in exchange of goods and services.
v International Business (IB) deals with the nature, strategy and management of international business enterprises and their effects on business and national performance (e.g., efficiency, growth, profitability, employment).
v IB is interdisciplinary. It draws, among others, on economics, politics, sociology, marketing, management (human resources, strategic).
Models
Ricardian model
The Ricardian model focuses on comparative advantage, perhaps the most important concept in international trade theory. In a Ricardian model, countries specialize in producing what they produce best, and trade occurs due to technological differences between countries. Unlike other models, the Ricardian framework predicts that countries will fully specialize instead of producing a broad array of goods.
Also, the Ricardian model does not directly consider factor endowments, such as the relative amounts of labour and capital within a country. The main merit of Ricardian model is that it assumes technological differences between countries. Technological gap is easily included in the Ricardian and Ricardo-Sraffa model
The Ricardian model makes the following assumptions:
- Labour is the only primary input to production (labour is considered to be the ultimate source of value).
- Constant Marginal Product of Labour (MPL) (Labour productivity is constant, constant returns to scale, and simple technology.)
- Limited amount of labour in the economy
- Labour is perfectly mobile among sectors but not internationally.
- Perfect competition (price-takers).
The Ricardian model applies in the short run, so that technology may vary internationally. This supports the fact that countries follow their comparative advantage and allows for specialization.
For the modern development of Ricardian model, see the subsection below: Ricardian theory of international trade.
Heckscher-Ohlin model
In the early 1900s an international trade theory called factor proportions theory was developed by two Swedish economists, Eli Heckscher and Bertil Ohlin. This theory is therefore called the Heckscher-Ohlin theory (H-O theory). The H-O theory stresses that countries should produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply. It differs from the theories of comparative advantage and absolute advantage since those theories focus on the productivity of the production process for a particular good. On the contrary, the Heckscher-Ohlin theory states that a country should specialize in producing and exporting products that use the factors that are most abundant, and thus are the cheapest to produce.
The Heckscher-Ohlin model was produced as an alternative to the Ricardian model of basic comparative advantage. Despite its greater complexity it did not prove much more accurate in its predictions. However from a theoretical point of view it did provide an elegant method of incorporating the neoclassical price mechanism into international trade theory.
The theory argues that the pattern of international trade is determined by differences in factor endowments. It predicts that countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce. Empirical problems with the H-O model, such as the Leontief paradox, were exposed in empirical tests by Wassily Leontief who found that the United States tended to export labour-intensive goods despite having an abundance of capital.
The H-O model makes the following core assumptions:
- Labour and capital flow freely between sectors
- The amount of labour and capital in two countries differ (difference in endowments)
- Free trade
- Technology is the same among countries (a long-term assumption)
- Tastes are the same.
The problem with the H-O theory is that it excludes the trade of capital goods (including materials and fuels). In the H-O theory, labour and capital are fixed entities endowed to each country. In a modern economy, capital goods are traded internationally. Gains from trade of intermediate goods are considerable, as emphasized by Samuelson (2001).
Reality and Applicability of the Heckscher-Ohlin Model
Many economists prefer the Heckscher-Ohlin theory to the Ricardian theory, because H-O makes fewer simplifying assumptions. In 1953, Wassily Leontief published a study in which he tested the validity of the Heckscher-Ohlin theory. The study showed that the U.S was more abundant in capital compared to other countries, therefore the U.S would export capital-intensive goods and import labour-intensive goods. Leontief found out that the U.S's exports were less capital intensive than its imports.
After the appearance of Leontief's paradox, many researchers tried to save the Heckscher-Ohlin theory, either by new methods of measurement, or either by new interpretations. Leamer emphasized that Leontief did not interpret H-O theory properly and claimed that with a right interpretation, the paradox did not occur. Brecher and Choudri found that, if Leamer was right, the American workers' consumption per head should be lower than the workers' world average consumption.
Many other trials followed but most of them failed. Many textbook writers, including Krugman and Obstfeld and Bowen, Hollander and Viane, are negative about the validity of H-O model. After examining the long history of empirical research, Bowen, Hollander and Viane concluded: "Recent tests of the factor abundance theory [H-O theory and its developed form into many-commodity and many-factor case] that directly examine the H-O-V equations also indicate the rejection of the theory."
Heckscher-Ohlin theory is not well adapted to the analyze South-North trade problems. The assumptions of H-O are less realistic with respect to N-S than N-N (or S-S) trade. Income differences between North and South is the assumption that third world cares about most. There is not much evidence of factor price equalization [a consequence of H-O theory. The H-O model assumes identical production functions among countries, although this is highly unrealistic. Technological gaps between developed and developing countries are the main reason why the latter are poor.
Specific factors model
In the specific factors model, labour mobility among industries is possible while capital is assumed to be immobile in the short run. Thus, this model can be interpreted as a short-run version of the Heckscher-Ohlin model. The "specific factors" name refers to the assumption that in the short run, specific factors of production such as physical capital are not easily transferable between industries. The theory suggests that if there is an increase in the price of a good, the owners of the factor of production specific to that good will profit in real terms.
Additionally, owners of opposing specific factors of production (i.e., labour and capital) are likely to have opposing agendas when lobbying for controls over immigration of labour. Conversely, both owners of capital and labour profit in real terms from an increase in the capital endowment. This model is ideal for understanding income distribution but awkward for discussing the pattern of trade.
New Trade Theory
New Trade Theory tries to explain empirical elements of trade that comparative advantage-based models above have difficulty with. These include the fact that most trade is between countries with similar factor endowment and productivity levels, and the large amount of multinational production (i.e. foreign direct investment) that exists. New Trade theories are often based on assumptions such as monopolistic competition and increasing returns to scale. One result of these theories is the home-market effect, which asserts that, if an industry tends to cluster in one location because of returns to scale and if that industry faces high transportation costs, the industry will be located in the country with most of its demand, in order to minimize cost.
Gravity model
The Gravity model of trade presents a more empirical analysis of trading patterns. The gravity model, in its basic form, predicts trade based on the distance between countries and the interaction of the countries' economic sizes. The model mimics the Newtonian law of gravity which also considers distance and physical size between two objects. The model has been proven to be empirically strong through econometric analysis.
Ricardian theory of international trade (modern development)
The Ricardian theory of comparative advantage became a basic constituent of neoclassical trade theory. Any undergraduate course in trade theory includes a presentation of Ricardo's example of a two-commodity, two-country model.
This model has been expanded to many-country and many-commodity cases. Major general results were obtained by McKenzie and Jones, including his famous formula. It is a theorem about the possible trade pattern for N-country N-commodity cases.
Contemporary theories
Ricardo's idea was even expanded to the case of continuum of goods by Dornbusch, Fischer, and Samuelson this formulation is employed for example by Matsuyama and others. These theories use a special property that is applicable only for the two-country case.
Neo-Ricardian trade theory
Inspired by Piero Sraffa, a new strand of trade theory emerged and was named neo-Ricardian trade theory. The main contributors include Ian Steedman (1941- ) and Stanley Metcalfe (1946-). They have criticized neoclassical international trade theory, namely the Heckscher-Ohlin model on the basis that the notion of capital as primary factor has no method of measuring it before the determination of profit rate (thus trapped in a logical vicious circle). This was a second round of the Cambridge capital controversy, this time in the field of international trade.
The merit of neo-Ricardian trade theory is that input goods are explicitly included. This is in accordance with Sraffa's idea that any commodity is a product made by means of commodities. The limitation of their theory is that the analysis is restricted to small-country cases.
Ricardo-Sraffa trade theory
John Chipman observed in his survey that McKenzie stumbled upon the questions of intermediate products and discovered that "introduction of trade in intermediate product necessitates a fundamental alteration in classical analysis." It took many years until Y. Shiozawa succeeded in removing this deficiency. The Ricardian trade theory was now constructed in a form to include intermediate input trade for the most general case of many countries and many goods. This new theory is called Ricardo-Sraffa trade theory.
The Ricardian trade theory now provides a general theory that includes trade of intermediates such as fuel, machine tools, machinery parts and processed materials. The traded intermediate goods are then used as inputs to production in the importing country. Capital goods are nothing other than inputs to the production. Thus, in the Ricardo-Sraffa trade theory, capital goods move freely from country to country. Labour is the unique factor of production that remains immobile in its country of origin.
GAAT and WTO
The General Agreement on Trade and Tariffs (GATT) was enacted as an attempt to reduce the number of tariffs and trade barriers and to foster international trade in the years following World War II. It was signed in 1947 by over 100 countries and has served the international community for decades. Under the auspices of GATT there have been numerous rounds of trade negotiations on a variety of issues. Beginning in 1986, the Uruguay Round negotiations included the areas of tariffs, services and intellectual property. Over seven years of negotiations, the GATT agreements evolved into their current state. The Uruguay Round concluded in 1994 with numerous agreements to reduce trade barriers and institute more enforceable world trade rules. One of the major results of the Uruguay Round was the creation of the World Trade Organization (WTO), which officially began operations on January 1, 1995. The WTO is a multilateral organization with the mandate to establish enforceable trade rules, to act as a dispute settlement body and to provide a forum for further negotiations into reducing trade barriers. According to the WTO website, there are 147 WTO member countries and observer countries. For a complete list of the member countries, visit the WTO webpage (see description below). Beginning in 2001 and proceeding through at least 2005, the Doha Agenda represents the current round of negotiations.
The World Trade Organization (WTO) is an organization that intends to supervise and liberalize international trade. The organization officially commenced on January 1, 1995 under the Marrakech Agreement, replacing the General Agreement on Tariffs and Trade (GATT), which commenced in 1948. The organization deals with regulation of trade between participating countries; it provides a framework for negotiating and formalizing trade agreements, and a dispute resolution process aimed at enforcing participants' adherence to WTO agreements which are signed by representatives of member governments and ratified by their parliaments. Most of the issues that the WTO focuses on derive from previous trade negotiations, especially from the Uruguay Round (1986–1994).
The organization is currently endeavouring to persist with a trade negotiation called the Doha Development Agenda (or Doha Round), which was launched in 2001 to enhance equitable participation of poorer countries which represent a majority of the world's population. However, the negotiation has been dogged by "disagreement between exporters of agricultural bulk commodities and countries with large numbers of subsistence farmers on the precise terms of a 'special safeguard measure' to protect farmers from surges in imports. At this time, the future of the Doha Round is uncertain."
The WTO's predecessor, the General Agreement on Tariffs and Trade (GATT), was established after World War II in the wake of other new multilateral institutions dedicated to international economic cooperation — notably the Bretton Woods institutions known as the World Bank and the International Monetary Fund. A comparable international institution for trade, named the International Trade Organization was successfully negotiated. The ITO was to be a United Nations specialized agency and would address not only trade barriers but other issues indirectly related to trade, including employment, investment, restrictive business practices, and commodity agreements. But the ITO treaty was not approved by the U.S. and a few other signatories and never went into effect. In the absence of an international organization for trade, the GATT would over the years "transform itself" into a de facto international organization.
Conclusion
International trade is, in principle, not different from domestic trade as the motivation and the behaviour of parties involved in a trade do not change fundamentally regardless of whether trade is across a border or not. The main difference is that international trade is typically more costly than domestic trade. The reason is that a border typically imposes additional costs such as tariffs, time costs due to border delays and costs associated with country differences such as language, the legal system or culture.
Another difference between domestic and international trade is that factors of production such as capital and labour are typically more mobile within a country than across countries. Thus international trade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital, labour or other factors of production. Trade in goods and services can serve as a substitute for trade in factors of production.
Instead of importing a factor of production, a country can import goods that make intensive use of that factor of production and thus embody it. An example is the import of labour-intensive goods by the United States from China. Instead of importing Chinese labour, the United States imports goods that were produced with Chinese labour. One report in 2010 suggested that international trade was increased when a country hosted a network of immigrants, but the trade effect was weakened when the immigrants became assimilated into their new country.
