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Modern theory of international trade

December 12, 2022

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This article is written by Hariharan Y of Christ (Deemed to be University), Bangalore. It provides a detailed overview of the modern theory of international trade, also known as the Heckscher-Ohlin Theory. The aspects that are covered in this article are the features, essentials, assumptions, and criticisms of the theory.

It has been published by Rachit Garg.

Table of Contents

Introduction

International trade has become a vital part of any economy. With increasing globalisation and the opening up of world markets, trade between countries has grown exponentially. Such trade is needed since countries are not completely self-sufficient. They need to depend on other countries for certain goods and services. However, trade is not a novel concept. It dates back to the barter system, in which goods were traded for goods. With the growth of mercantilism in the 16th and 17th centuries, the barter system was phased out. Later, in the 18th century, liberalism became popular, allowing for the free flow of goods across borders. Liberalism thus paved the way for international trade to take place between countries.

International trade has a massive impact on the GDP of an economy. Today, we are trading more goods and services than we previously used to. Global goods exports have increased drastically since 1983, from $1.8 trillion to $18.4 trillion. The trade-in services are around $5.9 trillion. Globally, we trade around $7000 per person per year. International trade has thus become inevitable today.

International trade as a concept is based on certain theories. These theories help explain the patterns of the trade from different perspectives. Currently, there are two schools of thought – the classical theory and the modern theory. The modern theory of trade, also known as the Heckscher-Ohlin theory or the factor endowment theory, states that the exports of a country depend on its factor endowments. If a country has plenty of labour, it will produce labour-intensive products, whereas if it has an abundance of capita, it will produce capital-intensive products. Factors here mean the labour or capital that a country possesses.

This article will discuss the theory of international trade and why there was a change from the classical theory of mercantilism to the modern theory. The modern theory is based on certain fundamental assumptions and theorems, such as the existence of perfect competition, similar technology in both countries, etc. Further, the limitations of the theory will also be discussed.

What is trade

Trade means the exchange of goods or services between two different parties. Hence, it is a concept where one person sells his goods or services, for which he receives compensation from the other party. The Merriam-Webster dictionary defines it as “the buying and selling or bartering of commodities.” Trade can either be domestic trade or international trade. Domestic trade refers to the trade that happens within a nation, and trade between nations is called international trade.

Trade is a vehicle or an engine that helps create employment, reduce poverty rates, and increase the economic prosperity of a country. Trade based on its types can be classified as wholesale trade or retail trade. Wholesale trade refers to trade in large quantities and generally happens between the manufacturer and the distributors, while retail trade is the selling of goods or rendering of services directly to the consumer.

What is international trade

International trade, as the name suggests, is the trade that happens between different nations. Every country is not endowed with all the resources it needs to sustain itself. Hence, trade becomes necessary to ensure that domestic requirements are met. While trading initially happened only with goods, trade in services among nations has also increased by a significant amount in the areas of banking, telecommunications, and information technology, among other service-based sectors.

According to Wasserman and Haltman, international trade is defined as the transactions between residents of different nations. It is based on the concept of resource surplus and shortage. The biggest exporting industry in 2022 was the pharmaceutical and medical manufacturing industry.

Classification of International Trade

International trade can be classified into the following –

Import trade

Import means the purchasing of goods or availing services from another country. A country imports goods either because it does not have the resources to manufacture such goods domestically or because there are certain difficulties to procure such goods within the country.

Export Trade – Export means the sale of goods outside the territory of a country. Here, the goods are produced domestically and sold to another country. Exporting brings foreign exchange into the country.
Entrepot Trade – In this kind of trade, the goods are imported from one country to export to another country. Hence, the goods are imported not for domestic consumption but for resale in another country.

World Trade Organisation

The World Trade Organization is the central body that facilities and regulates international trade today. It was established through the Marrakesh Agreement also known as the Agreement Establishing the World Trade Organization. Before the WTO, there was no central body to regulate trade. The General Agreement on Tariffs and Trade (GATT), 1947 was the only document that regulated international trade for around 50 years until the WTO was established. The GATT underwent many amendments through these years to facilitate trade among nations.

The WTO is headquartered in Geneva, Switzerland, and was founded on 1st January 1995. Currently, it has 164 members, out of which there are 160 UN Member States along with the European Union, Macau, Taiwan, and Hong Kong. The purpose of this organisation is to reduce tariffs and other barriers to trade such as technical barriers, strict regulations, discriminatory and favourable policies etc.

The fundamental principles that govern WTO are as follows –

Principle of Non-Discrimination

This principle states that the Members must not discriminate among other Members unless specifically permitted through the WTO regulations. It has two components – the Most Favoured Nation (MFN) principle and the National Treatment policy. The MFN principle states that any kind of favourable treatment given to one Member must be given to all the other Members also. The National Treatment policy mandates identical treatment of domestic goods and imported goods.

Principle of Reciprocity

Negotiations form the bedrock of the WTO. These negotiations must lead to material results for both the nations which are trading. It essentially means mutual concessions between the Members.

Binding Commitments

The tariff and other commitments are binding documents on the Members and they are obliged to follow the same. Any dispute that arises during such trade would be handled by the Dispute Settlement Body (DSB) constituted by the General Council.

Transparency

The Members of the WTO are required to periodically publish their regulations which allows for effective review and administration. The Trade Policy Review Mechanism (TPRM) ensures that periodic reviews of the trade policies are done in regular intervals to ensure that these policies are in sync with the current state of international trade.

Modern concepts under international trade

International trade changes with every passing day. As nations develop, they come up with different ways and strategies to trade in goods and services. There are various ways in which trade can be controlled and facilitated today. Some of them are as follows –

Trade Agreements – Countries often enter into trade agreements which can be bilateral or plurilateral. They contain elaborate details about the trade undertaken with details such as the tariff schedules, the description of the products and the legal angles in case there is a breach by one party.
The MFN and the National Treatment – The Most Favoured Nation (MFN) clause and the National treatment clause are the two basic principles under the principle of non-discrimination through which the WTO ensures that all members are treated equitably. The MFN clause states that any provision or benefit given to one member of the WTO has to be given to all the other members. The national treatment clause states that the treatment accorded to domestic products and the products that enter the country through authorised means must be given the same treatment.
Declarations and Ministerial Conferences – There are various rounds of declaration such as the Doha Declaration which bring about vital changes and developments in trade. In addition to this, the countries meet at regular intervals to discuss and negotiate various aspects of the trade.

Modern theory of international trade: features and essentials

The theories of international trade can be divided into two aspects – (a) Classical or country-based theories; and (b) Modern Theory or the Heckscher-Ohlin Theory.

Classical or country-based theories are based on the concept of growth economics. They were classical economists who were concerned with how the wealth of the nations increased. According to them, foreign trade was important in increasing the wealth of a nation since it enlarged the scope of the market and allowed for specialisation and the division of labour. In the classical approach, two main questions were considered – (a) What product should a country specialise in which it can export?; and (b) In case the countries produced different goods, what would be the ratio of exchange of these goods?

Before the advent of the Modern theory of international trade, there were certain classical theories of international trade which are as follows –

Mercantilism

It is the first classical theory of international trade which states that a country must give priority to its welfare first before considering other countries. Hence, a country must always look to increase exports and decrease the rates. This is based on the idea that the wealth of the country depends on the treasures that it is holding and hence through exports these would increase which thereby increases the wealth of a nation. It is also called the protectionist theory since the countries are in a defensive mode and trying to protect themselves.

Absolute Advantage Theory

Adam Smith in his book “Wealth of Nations” propounded the theory of absolute advantage. According to this theory, the economic growth and prosperity of a country depends on the specialisation and the division of labour that a country adopts. The governments must not interfere and try to regulate trade between the nations nor should they try to impose any restrictions on international trade. He was in favour of free trade and stated that government interference would be a barrier to trade and hence harmful to the free trade in a country.

Comparative Advantage Theory

This theory was propounded in the 19th Century by David Ricardo. As per this theory, a country must export that kind of goods in which there is a beneficial and relative cost advantage as compared to the absolute cost advantage. Even though a country has the resources to produce a certain product, it can still import the same from other countries if it feels that there is a relative advantage in bringing in such products.

The modern Theory is also referred to as the Heckscher-Ohlin theory or the factor endowment theory. It was developed by two Swedish economists, Eli Heckscher and his student Bertil Ohlin at the Stockholm School of Economics. This theory states that a country’s exports depend on its resource endowments. A country can either have a capital-abundant economy or a labour-intensive economy. In case it is a capital-abundant economy, it will produce and export capital goods with relative ease, whereas, in case of about intensive economy, it will produce and export labour-intensive goods.

Modern theory is based on the concept of resource or factor endowments. Simply put, factor endowment means the number of resources that a country has for manufacturing and trading. These resources could include land, labour, and money, among others. The number of factor endowments is directly proportional to the number of exports of a country.

Illustration: Consider the factor endowment as ‘iron ores’. Country A is abundant with these, while country B does not have any iron ores. Hence, country A will specialise in and export iron due to its endowment of iron ore land.

It further states that comparative advantage is the reason why a country chooses to produce and export goods. Comparative advantage essentially means taking advantage of the factors present in abundance in your country. Since these factors are present in abundance, they will be available at a lower cost due to less demand, while products with more demand but fewer factors in the country would lead to high prices. The latter is when the country chooses to import the goods.

Under this theory, the absolute amount of capital or labour is not important, but the amount available per person is what counts. For example, India might have a bigger capital factor than, say, a small country like Austria. But if counted in capital per person terms, Austria might be higher than India, and this is what is taken into consideration under this theory.

Features and essentials

The following are the features and essentials of the theory –

The trade depends on factor intensity

Different factors are used in different proportions to manufacture a product. Hence, when we say that a commodity ‘A’ is labour intensive it means that more labour is used in the production of the commodity than it is used in producing a commodity ‘B’. On the same lines, more capital would be used to produce commodity ‘B’ as compared to commodity ‘A’

Illustration: Let us say commodity ‘A’ needs 10 units of capital and 10 units of labour. Here, the capital-labour ratio is 10/10 = 1. In the same way, commodity ‘B’ needs 5 units of capital and 10 units of labour. Hence, the capital-labour ratio is 5/10 = 0.5. Thus, we can conclude that commodity ‘A’ is more capital-intensive than commodity ‘B’.

The theory is based on factor endowments (Heckscher-Ohlin Theorem)

Factor endowments mean the availability or abundance of the factors in a nation. Different countries are endowed with different kinds of factors or resources. Hence, a country with more capital resources will produce capital-intensive goods, while a country with abundant labour will produce labour-intensive goods.

Illustration: Country ‘X’ has abundant capital resources to manufacture cars, while country ‘Y’ does not have capital resources but is labour-intensive. Hence. Country A will produce and export cars, while country B will concentrate on labour-intensive goods such as toys.

The prices of both factors are inversely proportional to each other (Stolper-Samuelson Theorem)

This theorem states that if, say, the price of a capital-intensive good increases its price, then the factor used to produce such good i.e., will fall while the labour wage rates will fall. The inverse is also true, which states that if the price of a labour-intensive goods increases, then the wage rates will increase while the rental rates of the factory will rise.

The prices of the final goods will equalise the prices of the factors (Factor-Price Equalisation theorem)

This theorem states that when the price of the final goods that are traded is equalised, then the prices of the factors, i.e., capital and labour will also be equalised. However, it is based on the fundamental assumptions of this theory that the technology remains the same and there is perfect competition in the market.

However, this theorem would fail in its practical application since it is very rare that the technology between two different countries is the same or that there exists perfect competition in the market. A logical conclusion that can be drawn is that the prices would not be equalised, but the prices of the factors would move in the same direction as the final goods.

An increase in the production of one kind of good will result in a decrease in the production of another kind of good (Rybczynski theorem)

This theorem states the relationship between the production of the two different kinds of goods. It states that increasing the endowment of one factor would lead to an increase in the production of such goods. Consequently, it would lead to a decrease in the production of other kinds of goods (based on the other factor).

Illustration: Country ‘S’ has come up with a policy to invest heavily in capital equipment. Hence, the country will start producing more capital-intensive goods,this would result in a decrease in the production of labour-intensive goods.

Free trade in goods increases the aggregate efficiency

The theory states that when countries undertake free trade, then the aggregate efficiency will increase resulting in a shift in the production of goods in the country. This means that the country will concentrate on increasing its exports and decreasing its imports. This shift in production will increase the efficiency of production in the country. This in turn will result in better consumer prices, ultimately increasing aggregate efficiency and the welfare of the nation.

However, this theorem also suffers from certain limitations. While the income of the owners of a certain factor will increase, the income of certain factors will decrease. Overall, the aggregate sum of the increase will be more than the decrease. This leads us to the compensation principle.

The compensation principle states that as long as the benefits that are derived from the trade exceed the losses, the excess income that has been derived from such benefits can be redistributed to the losers, which would result in income equalisation.

Assumptions of the theory

The 2-2-2 model – According to this theory, there are two countries, two products and two factors of production – labour and capital.

The constant return to scale – There are constant returns to scale for both commodities. This means that in case the inputs of the products are doubled then the output also will be doubled.
Technology is identical in the markets – This theory assumes that the same technology is used for production in both countries. Thus, only the factor endowments will differ and all the other circumstances remain the same.
Perfect competition exists in all the markets – According to this theory, there are no monopolistic or oligopolistic structures. There is perfect competition and hence economic profits would not exist in the long run and each of the factors is paid according to their marginal product.
The factor density is used to rank the commodities – If a nation is producing two products then one of them will require less of a factor while the other will require more of a factor. This allows us to rank them according to the capital-labour ratio.
There are no transportation costs – The theory assumes that there are zero transportation costs. Though they might lead to a reduction in the trade volume, the trade pattern would not change due to the transportation costs.
It is based on free trade and complete specialisation is not possible – The final outputs can be freely traded in the markets as per this theory and complete specialisation is not possible in producing one commodity. Hence, both nations would be producing both commodities.

Criticism of the theory

The difference in preference

The Hecksher-Ohlin theorem presumes that trade in the country is dependent on the factor of endowments. However, sometimes there are differences in the preferences or differences in the pattern of the demand. There are certain demands that a country has domestically that might not match with the factor endowments.

Illustration: Country ‘A’ and country ‘B’ have the same factor endowments, and as per the theory, trade will not happen since there is no incentive to trade in goods. However, Country A might have certain preferences because they are producing a certain good that they are not producing in another country. Hence, trade is possible between both countries.

Leontief Paradox

The theory suggests that the relative prices of the factors or the resources are directly proportional to the availability of resources, i.e., in case there is an abundance of the factor in the country, the prices will be lower due to its availability.

Limiting factors are taken into consideration

This theory takes into account only two factors – capital and labour. It only studies the relationship between these two factors while ignoring other important factors in trade such as transportation, other external circumstances and economies of scale which have a significant effect on production costs.

The assumptions are idealistic and too simple

The theory is based on the assumption of perfect competition in the markets and identical technology. However, the real world does not work this way. Every country has different levels of technology and having a perfect competition situation is rare.

It does not take product differentiation into account

Product differentiation as the name suggests is a strategy used to highlight the unique or distinct characteristics of its product or service to attract customers into the market. The theory does not take this into account even though they may be identical products from the perspective of the functionality of the product.

Illustration: Country ‘B’ exports its paper-cutting machine to various countries due to its cutting-edge technology. Here, even though other countries can produce the goods in their country, they import the machine due to product differentiation.

The trade is not always dependent on the factor proportions

The theory states that countries which have higher capital will produce capital-intensive goods while those with excess labour will produce labour-intensive goods. This may not always hold since countries still export capital goods to another country that is capital intensive, and vice versa.

Illustration: Country ‘T’ and Country ‘V’ engage in the trade of capital goods, though both countries are capital intensive. Here, the presence of the factors is not the only factor that leads to trade between the countries. There are various other factors such as economies of scale, the cost of transportation etc.

The factors have mobility

The theory is based on the concept of specialisation and the factors are not mobile between the nations. However, we see today that the international flow of capital and labour is frequent. Labour is often imported from labour-intensive countries to undertake production within their countries.

Technology can not be identical

One of the assumptions of the theory is that technology is identical in countries. However, this is not true since the level of technology depends on the economy and the level of investment in science and technology by the country. Different countries adopt different technologies to advance their economy. This will not be identical due to the differences in the preferences of the countries and the current state of the economy.

Benefits of the theory

The H-O theory has certain benefits which are as follows –

Trade patterns can be observed in a better manner

Before the H-O theorem, it was based on the concept of comparative advantage which stated that trade is based on the opportunity costs based on the technological differences in both countries. However, this theory assumes technology to be identical which means that the trade of the country depends on the factors it is endowed with. This helps us to understand trade patterns in a better manner.

It provides a more realistic approach

Since it is based on the factor endowments of a country it is a more realistic and accurate way of comparing the imbalance of trade (if any) between the countries.

It provides insight into the impact of economic growth on the trade patterns in the country

The theory takes into account the growth of the economy and the efficiency of production due to the increase in factor endowments which helps provide insight on the impact of economic growth of the country.

It takes into account the effect of politics on trade

This theory takes into account the prevailing political situation in the country. This enables us to get a holistic view after taking into account the relevant political effects on trade.

Conclusion

The Hecksher-Ohlin theory takes into account both factors – capital and labour. In the long run, the outcome would be such that it would fully adjust to the change in prices. The theory is based on the factor of endowments and how countries use it to their advantage to increase trade. The Ricardian theory attributed foreign trade to resource immobility. However, this theory took into account the factor endowments of a country which acts as the biggest contributor to trade.

Frequently Asked Questions

Why was there a shift in the theories of international trade?

Due to changes in the conditions of society, it changed from mercantilism and absolute advantage to comparative advantage and the H-O model.

What is the importance of international trade theories?

International trade theories provide useful insights into the situations prevailing when these theories were in force. Different countries decide their trade policies based on different theories as per their requirements. Hence, an in-depth study of the theories is important to apply them in the right sense.

Why did Mercantilism phase out of international trade?

Mercantilism as a practice was both a means of wielding state power and a hindrance to free trade. As the trade scenario developed, trade liberalisation policies helped open up the market through which the barriers put forth by Mercantilism were aimed to be reduced.

References

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