In: Economics
How has the study of trade patterns evolved over time, and in the light of empirical testing of trade models
Over the last two centuries trade has grown remarkably, completely transforming the global economy. Today about one fourth of total global production is exported. Understanding this transformative process is important because trade has generated gains, but it has also had important distributional consequences.
Initially trade pattern was based on Adam Smith's Absolute advantage where two nations trade with each other when both must gain. However, absolute advantage theory had some limitations as it was able to explain only a very small part of world trade. Moreover, trade between developed countries couldnot be explained by it.
David Ricardo's comparative advantage removed the absolute advantage inherent limitation and helped in explaining trade patters i.e. basis and gains from trade. Comparative advantage can be defined as the “low relative cost of a good compared to other countries in autarky. It indicates that it is impossible by definition for a country to have a comparative disadvantage in every good. In practice, every country will have a comparative advantage in something. The comparative advantage theory gave birth to many trade models such as Ricardian model, the Heckscher-Ohlin model.
The Ricardian model assumes that labour is the only factor of production. Under this assumption, the only possible source of comparative advantage is differences between countries in labour productivity.The ricardian model's empirical test was conducted by Macdougall(1951), Balassa, Golub etc and concluded that comparative advantage is based on a difference in labor producitivity or costs, as postulated by Ricardo.
Then came the Heckscher-Ohlin model which provided an alternative explanation of trading patterns. Because it take into account more than one factor. The gains from trade in the Heckscher-Ohlin framework, however, were of the same nature as in the Ricardian model. They are gains from specialization that arise because of differences between countries. Later, Models with economies of scale, imperfect competition and differentiated products were considered. Leontief (1953) was the earliest and probably the best known attempt to confront the Heckscher-Ohlin model with data. His result was known as Leontief paradox. Leontief found that US exports were less capital intensive than US imports which was opposite of H-O Model prediction. Later, most of the empirical work that attempted to test or estimate Heckscher-Ohlin models used inappropriate methods and were therefore largely irrelevant.
Later, new theories have been developed to account for new forms of trade and for new information on trade. For example, New trade theory by Krugman (1980), Heterogenous firms model (Melitz, 2003) etc. These recent theories have provided further causes for trade, identifying gains that can explain trade flows left unexplained by the traditional model. The new theories dealt with Intra-industry trade and the volume of trade between similar countries, Imperfect competition and trade (Krugman’s monopolistic competition model), Gravity Model etc.
Recent empirical work by Hummels and Levinsohn (1995), Evenett and Keller (2002), Bernard et al. (2007a)confirms that beyond differences in technology and differences in endowments, other factors play an important role in the explanation of trade patterns.
Thus, most trade theories in the economics literature focus on sources of comparative advantage. The empirical evidence shows that comparative advantage is indeed relevant; but it is not the only force driving incentives to specialization and trade.