Theories of International Microeconomics

1. Introduction

Economic theory can be considered as a system of ideas that contains a set of models designed to explain economic outcomes and make predictions for future events. The choice of the model will depend principally on the explanatory value and the certainty of the model in explaining current situations and predicting future outcomes.

International trade is the difference between production and consumption. The theory of international trade has heavily been influenced by the works of classical economists. According to David Ricardo, trade occurs between countries because of differences in technology. For Eli Heckscher and Bertil Ohlin, trade arises mainly due to differences in factor endowments and factor intensities of respective countries.

2. Ricardian Model

The Ricardian Model was developed in 1817 by David Ricardo (1817) with two goods, two countries and a single input as components of the model. This model assumes differences in technology between countries as basis of trade. Ricardo stated that both countries could benefit from trade on the condition that labor input of countries should be different, irrespective of the fact that one country might has an absolute advantage in the production of both goods. Being a one factor model, the Ricardian Model is not the appropriate model to study the effects of technology on trade patterns because of its simplicity.

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3. The Heckscher – Ohlin Model

The Heckscher – Ohlin (HO) theory holds two assumptions; countries have different factor endowments and factor intensities as sources of differences in opportunity costs of production. Trade is restricted between 2 countries, 2 factors of production and 2 goods traded. This model generates 4 predictions: (a) The Heckscher – Ohlin theorem, whereby the capital abundant country will export the capital intensive good, (b) The Factor Price Equalization Theorem, with production of different goods, international trade will equalize factor prices, (c) The Stopler-Samuelson Theorem, with production of different goods, an increase in the price of a labor intensive good will reduce the real and relative return to capital and will increase the real and relative return of the labor intensive good, (d) The Rybczynski Theorem, with production of different goods, a rise in the endowment of labor, will lead to a more than proportionate increase in the output of the labor intensive good and a fall in the capital intensive good.

3. 1 The Heckscher – Ohlin Theorem

The Heckscher – Ohlin theorem implies that a country will export those goods that are produced through intensive use of factors of production found locally in an abundant amount. In a 2 2 2 model, countries produce the same pair of commodities, engage in free trade in a competitive environment with countries benefitting from constant returns to scale in accordance with technology. The supply of factors of production is perfectly inelastic in both countries. These conditions are present when there is relative factor abundance. A second situation can arise where autarkic factor prices are present in both countries. Demand and supply conditions dictate autarkic factor prices. Despite a country being relatively abundant in labor, it may nonetheless impose autarkic wage rate if domestic preferences pattern strongly favors the labor intensive produced good relative to the foreign produced good. The trade pattern will reflect the factor price comparison between countries.

3.2 The Factor Price Equalization Theorem

This theorem assumes a situation where there are 2 countries in free trade; they have different factor endowments but have the same level of technologies. If both countries are diversified and Factor Intensity Reversal (FIR) does not occur, factor price equalization will happen in these countries. For Heckscher, identical production techniques were prerequisite for the equalization of factor prices. Different factor prices can be a sufficient cause for international trade to happen. However, Heckscher did not account for the number of factors and international markets. The initial model was a 3 2 classical model with 3 factors such as land, labor and capital, and two goods: textile and machinery.

3.3 The Stopler-Samuelson Theorem

The Stopler-Samuelson Theorem was developed as a 2 2 model, with two traded goods and two non – traded factors. It sets forth that an increase in the relative price of a good will lead to an increase of real return of that factor used intensively in producing that good and will reduce real return to the second factor. Four possible interpretations arise from this theorem: (a) winners and losers corollary; If a relative price change occurs, there will be a minimum of one loser ans one winner (b) Factor – industry detachment corollary; external price changes will have an impact on the return to a factor irrespective of which industry the factor is employed (c) scarce factor corollary 1; trade barriers will help a scarce factor; an abundant factor is hurt (d) scarce factor corollary 2; depending on the scarcity of the factors, trade barriers will help.

3.4 The Rybczynski Theorem

The two – factor two – good Rybczynski Theorem posits that if there is an increase in factor endowment of an industry that uses that factor fully, an increase in output is likely to occur compared to a decrease in output in the other industry. There are 4 levels of interpretation that can be observed from the Rybczynski Theorem: (a) a minimum of one Rybczynski derivative will be negative, (b) a homothetic relationship exists between output and factor supplies, (c) the relationship will be a linear one, (d) the total amount of current factor supplies is important.

4. International Trade: The Evidence

International microeconomics seems little affected by empirical evidence. Despite trade flows being measured with the greatest accuracy, the data obtained has not been really reliable and to certain extent inaccessible. Empirical studies based on this data can hardly be reviewed or taken seriously as a proper revaluation of the theories proposed by classical economists.

Attempts to bridge the gap between the trade patterns and the theoretical assumptions made by the various classical and neo classical models have been made and several problems arose. The first problem that rises is that international trade is arbitrage. This is principally due to price discrepancies governing the international markets. Autarkic prices differences have not been observed and these discrepancies are hypothetical in nature. There is no solid evidence as international trade gets rid of these discrepancies. Another difficulty linked to this is causality. Whatever the consequence, the human mind has always hoped that a single cause must be behind its initial inception. The Ricardian Model and the Heckscher Ohlin model are unicausal. Everything has a single root. For arbitrage in international trade, autarkic prices discrepancies cannot be the only explanation as to why there is arbitrage in the first place. Changes in factor endowments, tastes and preferences or differences in technologies can form part of the supplementary explanations.

In the last 4 decades, there have been 3 types of empirical studies on international trade. These are tests of the Ricardian and HO models, studies trying to find a link between bilateral trade, national incomes and geographical distances between trading countries, and finally, a number of informal accounts yet to be tested and accounted for.

MacDougall (1951, 1952) carried out a study using 1939’s data for a UK-US comparison to find whether exports of good of different countries were correlated in pairs with third markets as the Ricardian model presumed. Results were positively and significant. Later empirical studies provided additional support to these results (MacDougall et al., 1962, Stern, 1962; Balassa, 1963)

The assumption that consumers have homothetic preferences has been empirically refuted. Following studies carried out by Prebisch (1950) and Singer (1950), results have showed that the terms of trade for poor countries has been deteriorating continuously. As world economy experiences economic growth, the relative demand shifts from the South to the industrialized North, a region that specializes in goods with higher income elasticity. The South benefits little from improvement in production in exports sectors, principally because the extra purchasing power generated by lower southern commodities will be spent on purchase of northern commodities.

Studies carried out by scholars affected significantly the reliability of the HO theorem. Patterns of trade were examined between US, West Germany, Japan and Canada with the rest of the world. Results obtained were not in consensus with the HO theorem whereas results of East Germany and India showed support (Bharadwaj, 1962; Leontief, 1953, 1956; Roskamp, 1961; Stolper and Roskamp, 1961; Tatemoto and Ichimura, 1959; and Wahl, 1961). Another study carried out by Clifton, Jr and Marxsen (1984) obtained relatively the same results. They used a multi-commodity, two-country, and two factor model to test for trade based on profit and wages instead of using capital and labor as factors of production. Results obtained show trade patterns for the year 1968 of Australia, Ireland, Japan, Korea, New Zealand, and the United States support the theorem while results of UK, Kenya and Israel do not.

In his study to discover the sources of the success of the American industry for the years 1879, 1899, 1909, 1914, 1928, and 1940, Wright (1990) concluded that the capital to labor ratio was an important source of comparative advantage in the early years but it soon became a comparative disadvantage by 1940. Natural resources did not contribute to exports success in the 19th century but in the 20th century it impacted exports significantly. The reasons provided by the HO theorem that difference in capital and labor endowments are the primary reasons for trade is wrong and thus a need for further study in this area.

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The most important study of trade patterns through use of HO models was carried out by Leontief (1953). The results showed that in 1947, U.S imports were more capital intensive compared to labor than the ratio in U.S exports. This paradox exists if U.S is well endowed in capital. This paradox can be solved through 2 ways: (a) by creating demand or factor intensity reversals (FIRs), (b) the introduction of international technological differences. By introducing these solutions, the American labor intensive industries benefited from significant advantage in terms of costs arising due to factor endowments.

Linnemann (1966) using data from more than 40 countries carried out a study to find a link between bilateral trade, national incomes and geographical distances between trading countries. He wanted to find answers relating to the bilateral trade volumes and trade size with different trading partners. Results illustrated that the volume of trade depends much on the geographical proximity of trading partners inclusive of transport costs. The importing country’s national income and the exporting country’s national income also had an impact on the size of tradable commodities.

Minhas (1963) carried out a study to question the applicability of the FPE theorem due to the presence of Factor Intensity Reversals (FIRs). Minhas came to the conclusion that when elasticity of substitution differs between countries, FIRs are likely to occur. Through trade, equality of commodity prices will not guarantee a price equalization of factor prices in respective countries.

Conclusion

Trade occurs simply because of the price discrepancies that exist in the markets. Technological differences and factor endowments are the main reasons for these discrepancies. The numerous and complex literature on the Ricardian Model and Heckscher Ohlin Model have outlines various faults of these models but they nonetheless remain healthy. However, additional modifications need to be done. The models need to account for technological differences, multiple cones of diversification and home bias.

References:

Ronald Winthrop Jones. A, 1979, ‘International Trade: Essays in Theory’, Oxford North Holland Publishing Co, Amsterdam, New York

Ronald Winthrop Jones. A and Kenen Peter B. (Eds.), 1984, Handbook of International Economics 3, North Holland

Balassa, B. 1963, ‘An Empirical Demonstration of Classical Comparative Cost Theory’, The Review of Economics and Statistics, Aug, Vol. 45, No. 3, pp. 231-238

Mac Dougall, G. D. A, 1951, ‘British and American Exports: A Study Suggested by the Theory of Comparative Costs. Part I’, The Economic Journal, Dec, Vol. 61, No. 244, pp. 697-724

Mac Dougall, G. D. A, 1952, ‘British and American Exports: A Study Suggested by the Theory of Comparative Costs. Part II’, The Economic Journal, Aug, Vol. 62, No. 247, pp. 487-521

Feenstra Robert, C. 2002, ‘Advanced International Trade: Theory and Evidence’, University of California, Davis, and National Bureau of Economic Research, Aug.

Prebisch, R. 1950, ‘The Economic Development of Latin America and Its Principal Problems’, New York: United Nations, Econ. Comm. Latin America

Clifton, D. S, Jr and William B. Marxsen, 1984, ‘An Empirical Investigation of the Heckscher-Ohlin Theorem’, The Canadian Journal of Economics / Revue canadienne d’Economique, Feb, Vol. 17, No. 1,pp. 32-38

Matsuyama, K., 2000, ‘A Ricardian Model with a Continuum of Goods under Nonhomothetic Preferences: Demand Complementarities, Income Distribution, and North‐South Trade’, Journal of Political Economy, Dec, Vol. 108, No. 6, pp. 1093-1120

Redding Stephen J., 2006, ‘Empirical Approaches to International Trade’, Oct, London School of Economics and CEPR