Chapter 4 Outline

An Overview of Trade Theory

We open this chapter with a discussion of mercantilism. Propagated in the 16th and 17th centuries, mercantilism advocated that countries should simultaneously encourage exports and discourage imports. Although mercantilism is an old and largely discredited doctrine, its echoes remain in modern political debate and in the trade policies of many countries. Next we will look at Adam Smith's theory of absolute advantage. Proposed in 1776, Smith's theory was the first to explain why unrestricted free trade is beneficial to a country. Free trade occurs when a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country. Smith argued that the invisible hand of the market mechanism, rather than government policy, should determine what a country imports and what it exports. His arguments implied that such a laissez-faire stance toward trade was in the best interests of a country. Building on Smith's work are two additional theories that we shall review. One is the theory of comparative advantage, advanced by the 19th century English economist David Ricardo. This theory is the intellectual basis of the modern argument for unrestricted free trade. In the 20th century, Ricardo's work was refined by two Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the Heckscher-Ohlin theory.

The Benefits of Trade

The great strength of the theories of Smith, Ricardo, and Heckscher-Ohlin is that they identify with precision the specific benefits of international trade. Common sense suggests that some international trade is beneficial. For example, nobody would suggest that Iceland should grow its own oranges. Iceland can benefit from trade by exchanging some of the products it can produce at low cost (fish) for some products it cannot produce at all (oranges). Thus, by engaging in international trade, Icelanders are able to add oranges to their diet of fish.

The theories of Smith, Ricardo, and Heckscher-Ohlin go beyond this commonsense notion, however, to show why it is beneficial for a country to engage in international trade even for products it can produce for itself. This is a difficult concept for people to grasp. Many people in the United States believe that American consumers should buy products produced in the United States by American companies whenever possible to help save American jobs from foreign competition. Such thinking apparently underlay a recent decision by the International Trade Commission to protect the Louisiana crawfish industry from inexpensive Chinese imports (see the accompanying "Country Focus").

The same kind of nationalistic sentiments can be observed in many other countries. However, the theories of Smith, Ricardo, and Heckscher-Ohlin tell us that a country's economy may gain if its citizens buy from other nations certain products that could be produced at home. The gains arise because international trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, while importing products that can be produced more efficiently in other countries. So it may make sense for the United States to specialize in the production and export of commercial jet aircraft, since the efficient production of commercial jet aircraft requires resources that are abundant in the United States, such as a highly skilled labor force and cutting-edge technological know-how. On the other hand, it may make sense for the United States to import textiles from India since the efficient production of textiles requires a relatively cheap labor force--and cheap labor is not abundant in the United States.

This economic argument is often difficult for segments of a country's population to accept. With their future threatened by imports, American textile companies and their employees have tried hard to persuade the US government to impose quotas and tariffs to restrict importation of textiles. Similarly, as the Country Focus illustrates, the Louisiana crawfish industry succeeded in persuading the government to limit imports of crawfish from China. Although such import controls may benefit particular groups, such as American textile businesses and their employees or Louisiana crawfish farmers, the theories of Smith, Ricardo, and Heckscher-Ohlin suggest that the economy as a whole is hurt by this action. Limits on imports are often in the interests of domestic producers, but not domestic consumers.

The Pattern of International Trade

The theories of Smith, Ricardo, and Heckscher-Ohlin also help to explain the pattern of international trade that we observe in the world economy. Some aspects of the pattern are easy to understand. Climate and natural resources explain why Ghana exports cocoa, Brazil exports coffee, Saudi Arabia exports oil, and China exports crawfish. But much of the observed pattern of international trade is more difficult to explain. For example, why does Japan export automobiles, consumer electronics, and machine tools? Why does Switzerland export chemicals, watches, and jewelry? David Ricardo's theory of comparative advantage offers an explanation in terms of international differences in labor productivity. The more sophisticated Heckscher-Ohlin theory emphasizes the interplay between the proportions in which the factors of production (such as land, labor, and capital) are available in different countries and the proportions in which they are needed for producing particular goods. This explanation rests on the assumption that different countries have different endowments of the various factors of production. Tests of this theory, however, suggest that it is a less powerful explanation of real-world trade patterns than once thought.

One early response to the failure of the Heckscher-Ohlin theory to explain the observed pattern of international trade was the product life-cycle theory. Proposed by Raymond Vernon, this theory suggests that early in their life cycle, most new products are produced in and exported from the country in which they were developed. As a new product becomes widely accepted internationally, production starts in other countries. As a result, the theory suggests, the product may ultimately be exported back to the country of its innovation.

In a similar vein, during the 1980s, economists such as Paul Krugman of the Massachusetts Institute of Technology developed what has come to be known as the new trade theory. New trade theory stresses that in some cases countries specialize in the production and export of particular products not because of underlying differences in factor endowments, but because in certain industries the world market can support only a limited number of firms. (This is argued to be the case for the commercial aircraft industry.) In such industries, firms that enter the market first build a competitive advantage that is difficult to challenge. Thus, the observed pattern of trade between nations may in part be due to the ability of firms to capture first-mover advantages. The United States dominates in the export of commercial jet aircraft because American firms such as Boeing were first movers in the world market. Boeing built a competitive advantage that has subsequently been difficult for firms from countries with equally favorable factor endowments to challenge.

In a work related to the new trade theory, Michael Porter of the Harvard Business School has developed a theory, referred to as the theory of national competitive advantage, that attempts to explain why particular nations achieve international success in particular industries. Like the new trade theorists, in addition to factor endowments, Porter points out the importance of country factors such as domestic demand and domestic rivalry in explaining a nation's dominance in the production and export of particular products.

Trade Theory and Government Policy

Although all these theories agree that international trade is beneficial to a country, they lack agreement in their recommendations for government policy. Mercantilism makes a crude case for government involvement in promoting exports and limiting imports. The theories of Smith, Ricardo, and Heckscher-Ohlin form part of the case for unrestricted free trade. The argument for unrestricted free trade is that both import controls and export incentives (such as subsidies) are self-defeating and result in wasted resources. Both the new trade theory and Porter's theory of national competitive advantage can be interpreted as justifying some limited and selective government intervention to support the development of certain export-oriented industries. We will discuss the pros and cons of this argument, known as strategic trade policy, as well as the pros and cons of the argument for unrestricted free trade in Chapter 5.