Question

International trade theory implies that international trade is beneficial to all trading countries. However, casual observation leads to the conclusion that official obstruction of international trade flows is widespread. How might you reconcile these two facts?

Answer 1

The theory of international trade is that branch of economic theory concerned with trade between nations and, more broadly, with all aspects of the economic relations between nations. The concept of a nation in this context is somewhat ambiguous and a matter of degree rather than of kind, but not so much so as to cause serious difficulty. To the classical economists, the distinguishing characteristic of a nation was the combination of internal mobility and international immobility of factors of production, an approximation that is, if anything, more appropriate to the twentieth than to the nineteenth century and still dominates the theory of international trade. It has, of course, long been recognized that a theory constructed on these assumptions is equally applicable to trade between geographic regions, whether these are contained within a larger national unit or themselves contain several nations. The theory can also be extended to the analysis of economic relations of groups in the economy between which mobility is restricted or absent, such as skilled and unskilled workers or (a recent application) white and colored workers where color discrimination exists.

The theory of international trade is the application of general value theory and monetary theory to a special case in which the microeconomic decision units (households and firms) are grouped into subunits (countries or regions) of the macro-economy differentiated from one another in the way just described. This special case emphasizes certain problems and approaches that are usually given much less prominence in general economic theory.

the theory of international trade has been historically developed largely in response to national concern with particular problems of international economic policy. One consequence has been that although in its early stages the theory contributed much to general economics, in modern times it has progressed mainly by refining and elaborating analytical techniques originating in general economic theory; an important exception, however, is the recently originated “theory of second best,” a generalization from customs union theory capable of wide application in other branches of economics. Another consequence is that much of the literature of the subject is ad hoc and unsystematized.

The theory of international trade is customarily divided into two major branches: the “pure,” or “real,” theory of international trade equilibrium (”the theory of international values”) and the “monetary” theory of balance-of-payments adjustment (”the theory of the mechanism of adjustment”). The former is concerned with the determination of relative prices and real incomes in international trade, abstracting from the intervention of money. The implicit assumption that whatever adjustments of money wage and price levels or exchange rates required to preserve international monetary equilibrium do actually take place is a potent source of difficulty and confusion in applying the theory to actual problems. International monetary theory, in its classical formulation, was concerned with the automatic mechanism by which international monetary equilibrium was attained or preserved under the gold standard and, subsequently, with the automatic mechanisms of adjustment under fixed and floating exchange rate systems.

The classical economists developed the basic concepts of the theory in two steps: Ricardo contributed the theory of comparative costs, which explained both the cause and the mutual beneficiality of international trade by international differences in relative costs of production; and John Stuart Mill added the principle that the relative prices of the goods exchanged must be such that the quantities demanded in international trade are equal to the quantities supplied. The theory of comparative costs is most easily understood from Ricardo’s example: in England a gallon of wine costs 120 and a yard of cloth 100 units of work, while in Portugal the costs are 80 and 90 units of work, respectively. England has an absolute cost disadvantage in both goods but a comparative advantage in cloth, since the production of a yard of cloth involves sacrificing production of 1⅛ gallons of wine in Portugal but only ⅚of a gallon in England, these being the prices of cloth in terms of wine that would rule in the two countries if labor in each is perfectly mobile and prices accurately reflect labor costs. Ignoring transport costs, a price of cloth in terms of wine anywhere between ⅚ and 1⅛ would make it profitable for England to export cloth and import wine and for Portugal to export wine and import cloth. By so doing, each could obtain more of each of the goods with the same amount of work or consume the same amounts with less expenditure of labor. This example conveys the fundamental point that the beneficiality of international trade depends in no way on the absolute levels of economic efficiency or “stages of economic development” of the trading partners but only on differences in their relative costs of production in the absence of trade. It has been reformulated here so as to bring out the essential point that what matters is differences in the alter-native opportunity costs of commodities in the absence of trade. Ricardo’s own formulation, with its assumption of a single factor of production producing goods at constant costs and its concept of a fundamental unit of real cost (hours of work), unnecessarily tied trade theory to the labor theory of value. The result of his successors’ attempts to abandon the simple labor theory of value while retaining the real cost concept was an increasingly cumbersome theoretical structure, which was ultimately abandoned in favor of the opportunity cost approach. This, the modern approach, can incorporate theories of production of any desired degree of complexity and specifically allows alternative opportunity cost to vary with changes in the production pattern. However, as soon as more than one factor of production is introduced, the analysis of the effects of trade on economic welfare becomes more complex than in the classical system, and the demonstration of gain from trade requires considerably more conceptual sophistication.

The modern theory. The modern approach to the question of the gains from trade recognizes that the inauguration of trade or a change in the conditions of trade, such as that involved in the erection or removal of tariff barriers, will have differential effects on the welfare of individuals—either by changing the relative prices facing them as consumers (affecting differentially individuals with different tastes) or by changing the relative prices paid for the factors of production (affecting differentially the incomes of individuals who own the factors in different ratios). The evaluation of gain or loss therefore necessitates interpersonal welfare comparisons, which must be excluded as illegitimate. In their absence, welfare conclusions can only be derived either on the (unrealistic) assumption that a social judgment of the desirable distribution of real income exists and is implemented consistently or in terms of potential welfare, that is, in the sense that in one situation everyone could be made no worse off and some be made better off than they would be in the alternative situation, by means of appropriate compensations through transfers of income.