Question

Classical and Modern Theories of International Trade: Which approaches the current reality?

Make a comparative table of theories and models indicating the most important postulates.

Set the differences of country-based or business-based theories.

Discuss the importance of economic models in international trade and establish at your discretion which or which approach the current reality. Be specific. You can present examples.

Answer 1

The law of Absolute advantage and comparative advantage are Classical or Traditional theories of trade.

a) The law of Absolute Advantage

This law was given by Adam Smith. It states that a nation should export a commodity in which it has absolute advantage and import the commodity in which it has comparative disadvantage. This considered one of the classical theories of trade.

An example of Absolute advantage

Commodity       UK         USA

   Cheese              4           5

   Wine                 6           4

It is seen that in UK, one hour of labor can produce 6 units of Wine and 4 units of Cheese, whereas in US, one hour of labor in US can produce 5 units of Cheese and 4 units of wine, Thus US has absolute advantage in Cheese and UK in Wine.

b) The law of comparative advantage

This law was given by David Ricardo. David Ricardo states that the trade is still possible if a country does not have an absolute advantage but has Comparative Advantage. The comparative advantage is illustrated in the following example.

Commodity     UK       USA

Cheese   3          2

Wine              6          3

It is seen that UK has absolute advantage in both Cheese and Wine. The comparative advantage is determined by opportunity cost. It can be observed that in UK, to produce one unit of Cheese it has to give up 2 units of wine and to produce 1 unit of wine it has to give up half a unit of cheese, hence UK should produce and export wine, and US should specialize in production of cheese.

c) Heckscher-Ohlin Theorem

This theory went beyond the classical theories, and tried to provide the explanations to the existence of comparative or absolute advantage. According to this theory the comparative advantage arises due to factor endowments of the country. If the country is labor abundant and capital scarce, it should export the goods which are labor intensive (uses the labor more intensively than capital) and import capital intensive goods. According to this theory, the country should export the commodity which uses its abundant factor intensively. Hence, this theory is also called as the Factor Endowment Theory.

Some of the modern theories of Trade, which determine the international trade are

i) Linder Hypothesis: This theory states that countries which have similar tastes and preferences or demand or similar levels of income tend to trade more with each other.

ii) Natural Trading Partners hypothesis: This theory states that if Trading agreements are formed between natural trading partners, the economic outcomes to both parties will be higher. Some of the criterion for categorizing natural trading partners are Distance between the two countries, Trade complementarities etc.

Although, these theories are the prominent theories in international trade literature, the trade in real world scenario is determined by several things, one of the important things being institutional arrangements or Trade agreements. Countries are increasingly entering into Trade agreements which are mostly reciprocal in nature. The trade agreements give liberalized or tariff free access to the member countries. One of the most successful example of such trade agreements is formation of Custom Unions among the European countries which is known as European Union. Hence, it can be said that the current approach to trade comes largely from Modern theories of institutional arrangements or formation of trade agreements.