International Trade Note 1

The theory of trade

Introduction
The theory of trade has a central place in economic analysis, and underpins the doctrine of free trade.
Free trade doctrines have a long and fascinating history in Europe. In 1846 ritain repealed the !orn
"a#s, an historic event #hich mar$ed the start of the era of free international trade, and lasted until the
great depression of the 18%&s. The !orn "a#s #ere the duties on imports of grain, #hich had 'een in
force in England since the middle of the (fteenth century. )ther European countries had similar ta*es+
France, ,#eden, avaria, elgium and -olland.
The reasoning 'ehind the !orn "a#s #as as follo#s. .rain, chie/y #heat, is a staple foodstuff,
especially important in the diets of la'ouring people. ut its price varies greatly from year to year,
depending on the si0e and 1uality of harvests. 2uties on imports #ere levied on a sliding scale in order
to sta'ilise the price of #heat. 3hen the domestic price #as high 'ecause of a poor harvest, duties
#ere lo#ered to permit imports. 3hen the domestic price #as lo# 'ecause of a 'umper harvest,
import duties #ere raised.
In the decades leading up to the repeal of the !orn "a#s in ritain, the system had fallen into
disrepute. In fact the sliding scale of duties #as tending to increase rather than reduce fluctuations in
the price of #heat. 3hen the domestic price #as high, traders tended to #ithhold supply to raise the
price even further. They anticipated that import duties #ould soon 'e lo#ered, #hich #as in fact #hat
tended to happen. Then, #hen duties fell, traders 'egan to import large 1uantities of grain. 4s supply
rapidly increased, and prices fell dramatically, import duties #ere 1uic$ly increased. The net effect #as
to amplify mar$et fluctuations through speculation, ma$ing a vulnera'le mar$et even more unsta'le,
much to the detriment of consumers.
The !orn "a#s had another important effect. They 'ene(ted agricultural interests at the e*pense of
the ne#ly emerging manufacturing sectors. -igh prices of grain, maintained through restricting foreign
supply, increased the value of land. "ando#ners, understanda'ly, came to constitute an important
pressure group for the maintenance of the !orn "a#s. 4gainst these landed interests #ere ranged the
'urgeoning manufacturing classes. In ritain, the opposition to the !orn "a#s centred on 5anchester,
the home of the te*tile industry. The 6free traders7 as they #ere called, 'elieved that lo#er grain prices
#ere needed so that the la'ouring classes in industrial areas #ould have access to cheap foodstuffs.
"ed 'y !o'den, formerly a manufacturer, the free traders argued for the opening8up of ritish mar$ets
to cheap grain imports from overseas. 5anufacturers #ere also an*ious that free trade principles
should 'e reciprocated in other countries, so that foreign mar$ets #ould 'e opened up to e*ports of
cheap manufactured goods from ritain.
In ritain free trade principles eventually triumphed. In the t#entieth century, #ith the important
e*ception of the period 1918 to 19:9, free trade principles also came to dominate the #orld economy.
In this chapter #e e*plore the economic principles #hich underpinned the doctrine of free trade, a
doctrine #hich is argua'ly one of the most ro'ust of any in present8day economics. !hapter ; starts
#ith the mercantilist thin$ing #hich pre8dates the free trade era, and passes on to the #ritings of 4dam
,mith and 2avid <icardo, #hich formed the 'asis of the case for free trade. These principles #ere
reinterpreted in terms of modern economics 'y the economist -a'erler in the 19:&s.
Finally, a #ord of #arning = the theory of comparative cost, on #hich everything in this chapter rests,
is deceptively simple> In 1996, the #orld8famous ?, economist @aul Arugman came to 5anchester,
?A, to give a paper to mar$ the 1B& years #hich had elapsed since the repeal of the !orn "a#s. -e
entitled his address 6<icardo7s 2if(cult Idea+ 3hy Intellectuals 2on7t ?nderstand !omparative
4dvantage7. In it he made clear that intelligent people #ho read, and even those #ho #rite a'out #orld
trade, often fail to grasp the idea of comparative advantage. The aim of this chapter is to ensure that
you fully understand the 'asis of the theory of trade.
Objectives
When you have completed this chapter, you should be able to:
C outline the $ey features #hich distinguish mercantilist economic thin$ingD
C sho# ho# 4dam ,mith7s theory of absolute advantage, in the 'oo$ Wealth of Nations, 'ro$e #ith the
mercantilist traditionD
C de(ne absolute and comparative advantage and sho# ho# they constitute a basis for tradeD
C understand the theory of comparative advantage #hen it is stated in terms of the modern concept of
opportunity costD
C descri'e ho# factor endowments may constitute an e*planation of the 'asis of tradeD
C $no# the results of formal testing of the Ricardian and HeckscherOhlin models of tradeD
C relate your $no#ledge of the theory of trade to real world trade patterns in the nineteenth and early
t#entieth centuries.
Mercantilism
The theory of trade is part of the classical li'eral tradition of economic thought. !lassical li'eralism is
often descri'ed as the dominant ideology of capitalism. It is associated #ith the industrialisation of
#estern Europe, a process #hich 'egan in the eighteenth century.
5ercantilist economic thin$ing is a philosophy of political economy #hich predates classical li'eralism.
It #as characteristic of economic thin$ing in Europe from the late 5iddle 4ges through to the si*teenth
and seventeenth centuries.
It is important to understand the $ey principles of mercantilist thin$ing 'ecause mercantilist ideas
lingered on in international trade even #hen they had 'een largely discredited in the domestic conte*t.
Indeed in the present day there are many #ho are still #edded to certain mercantilist philosophies in
the international economy, and advocate protectionist policies in foreign trade #hich might 'e
descri'ed as 6neo8mercantilist7.
5ercantilism emerged in the period 'et#een 1:&& and 1B&&, #hen Europe #as e*periencing an acute
shortage of gold and silver 'ullion for use as money in domestic and international transactions. Trade
#as gro#ing 'ut the money supply could not $eep pace. To ensure suf(cient 'ullion to meet the rising
needs of commerce, monarchs and their advisers discouraged imports of goods since an e*cess of
imports over e*ports re1uired the e*port of gold and silver in payment for imports. y the same to$en,
every effort #as made to e*pand e*ports of goods, since e*ports #ould dra# in gold and silver from
a'road and thus increase the domestic money supply. )f course, since one country7s e*ports are
another7s imports, this could never 'e a recipe for harmonious international relations. 4ll countries
could not enEoy the 'ene(ts of an e*port surplus>
The follo#ing features characterised the mercantilist system as it operated in Europe in the centuries
'efore the rise of free trade+
Extensive regulation of imports and exports. ,ome imports #ere prohi'ited altogether, others
#ere su'Eected to high rates of import duty. In England the Navigation 4cts of 16B1 and 166& aimed to
e*clude foreign ships from 'oth the import and e*port trade. Even the e*port of ra# materials F#ool,
for e*ampleG from England #as restricted in order to $eep input prices lo# and ma$e the (nished
product Fte*tilesG more pro(ta'le in foreign and domestic mar$ets.
Trade monopolies flourished. .overnments permitted one merchant For a group of merchants
acting togetherG to operate in domestic and foreign mar$ets. This meant that merchants could sell
goods a'road at high prices 'ecause there #as no price competition among sellers. 5erchant
capitalists #ith monopoly po#er dominated economic activity in England, France, ,pain, elgium and
-olland.
Smuggling ourished. "arge pro(ts could 'e made 'y traders #ho #ere #illing to import or e*port
prohi'ited goods. ,muggling of 'ullion #as especially pro(ta'le. 5ost of the gold from ,outh 4merica
flo#ed into ,pain. In ,pain there #ere severe penalties, including death, for merchants #ho smuggled
'ullion out of the country. Nevertheless, large 1uantities of ,panish 'ullion found its #ay into all parts
of Europe.
!here "ere si#ni$cant incentives for European #overnments to establish colonial empires.
England France, -olland, elgium and ,pain esta'lished colonies. !olonies ena'led the metropolitan
country to control trade #ith #ea$er countries. The colony #as re1uired to provide cheap ra#
materials for manufacturers in the metropolitan countries. !olonies also provided protected mar$ets
for a home country7s manufactured e*ports.
Even #hen 'ullion supplies to Europe increased in the mid8si*teenth century, mercantilist restrictions
on international commerce remained. This #as 'ecause it #as #idely 'elieved that tariffs #ere a good
#ay to increase domestic output and employment, and to 'oost the po#er of the monarch. Tariffs
#ere a source of revenue for the monarch out of #hich the army and navy and huge state
'ureaucracies could 'e paid. Import restrictions, it #as 'elieved, stimulated domestic manufacturing
'y $eeping out foreign competition. To this end there #ere in place #ide8ranging domestic regulations
covering manufacturing and commerce. These included patents and monopoly rights, statutes
governing apprenticeships, ma*imum #age rates, and ta* e*emptions and su'sidies.
From the seventeenth century on#ards, ho#ever, it 'ecame increasingly apparent that regulations
imposed on domestic output and employment, together #ith restrictions on international trade, #ere
hindering the gro#th of enterprise. 3riters such as 2udley North F1641= 91G argued that economies
#ould flourish only if restrictive la#s #hich 'esto#ed special privileges #ere removed. y the
'eginning of the eighteenth century there #as a gro#ing recognition, even in mercantilist #ritings, that
emerging capitalists needed greater freedom to pursue pro(ta'le investment opportunities. This #as
the 'ac$ground against #hich 4dam ,mith pu'lished the path8'rea$ing 'oo$ Wealth of Nations in
1%%6, #hich is universally regarded as the foundation of modern mar$et economics, and is the starting
point for the theory of trade.
%dam &mith and absolute advanta#e
4dam ,mith #as a ,cotsman, 'orn in 1%;:, the son of a ,cottish Hudge 4dvocate and !omptroller of
!ustoms. -e 'ecame @rofessor of "ogic and then of 5oral @hilosophy in the ?niversity of .lasgo#.
This #as follo#ed 'y travels in France as tutor to the young 2u$e of uccleuch, #ith a final
appointment as !ommissioner of !ustoms, #hich he held until his death in 1%9&. ,mith can Eusti(a'ly
'e descri'ed as the (rst professional economist> -e #as also thoroughly familiar #ith the practicalities
of trade and tariffs.
,mith7s Wealth of Nations has 'een descri'ed as the most profound intellectual achievement of
classical li'eralism. It #as conceived as an attac$ on #hat ,mith called the mercantile system. The
'asis of ,mith7s criticism of mercantilism #as that it ena'led certain merchants to enrich themselves
'y e*ploiting monopoly concessions and other 6e*traordinary privileges7. ,uch activities did not
enhance the material #elfare of society. <egulations governing foreign trade, such as 'ounties,
monopoly grants and restrictive trade treaties, though they secured a large stoc$ of 'ullion and a
favoura'le trade 'alance, and may have enriched individual merchants, nevertheless conferred no
general 'ene(t on society.
3hat ,mith favoured #as a free mar$et #here hard #or$, enterprise and thrift #ould 'e re#arded. In a
free mar$et, #ithout state regulation, monopoly and privilege, entrepreneurs #ould 'e encouraged to
'ehave in a competitive, ef(cient and dynamic manner. In pursuing pro(t they #ould contri'ute to the
#ider social interest. They #ould 'e re#arded for doing things #hich added to the #elfare of society,
not for actions that diminished the common good.
&pecialisation and exchan#e
4dam ,mith o'served that the division of la'our increases productivity and #ealth. 4s individuals
specialise in certain activities they 'ecome more s$ilful and productive. ut they also 'ecome more
dependent on others for their needs. ,pecialisation therefore implies e*change 6#here every man may
purchase #hatever part of the produce of other men7s talents he has occasion for7 F Wealth of Nations,
'oo$ IG.
,pecialisation and e*change ena'le everyone in a community to 'ene(t 'y purchasing goods and
services from lo#8cost sources of supply. 4ccording to ,mith, it is 6the ma*im of every prudent master
of a family, never to attempt to ma$e at home #hat it #ill cost him more to ma$e than to 'uy7. ,mith
then e*tended this principle into the sphere of foreign trade+ 63hat is prudence in the conduct of every
private family, can scarce 'e folly in that of a great $ingdom.7 If commodities could 'e purchased
a'road more cheaply than they could 'e made at home, then it #ould 'e foolish to put o'stacles in the
#ay of importing them. ,uch restrictions could only impede the #elfare of the #hole community.
The criti1ue of mercantilism, together #ith the case for free trade, is contained in 'oo$s III and II of
Wealth of Nations. There are three po#erful ideas to 'ear in mind in the remainder of this chapter+
A nations wealth depends on its productive capacity. .old and silver do not of themselves
constitute a nation7s #ealth. .old and silver can 'e 6#asted7 on lu*ury spending. ut if gold and silver
are used to purchase materials and tools, or to employ la'our, then productive capacity and future
#ealth is assured.
Laissez-faire is the best way to increase productive capacity. .overnments should remove
restrictions and privileges to permit the e*pansion of industry and trade. )nce freed from the 'urden of
the state, social harmony and economic progress #ill triumph.
nternational trade is mutually bene!cial for all trading countries. Every country 'enefits from
'eing a'le to e*port those commodities #hich it produces ef(ciently, and 'eing a'le to import those
commodities #hich it produces inef(ciently. There are no 6losers7 from free trade. 4ll are 6gainers7.
%bsolute advanta#e
,mith claimed that a country should specialise in, and e*port, commodities in #hich it had an a'solute
advantage. 4n a'solute advantage e*isted #hen the country could produce a commodity #ith less
la'our per unit produced than could its trading partner. y the same reasoning, it should import
commodities in #hich it had an a'solute disadvantage. 4n a'solute disadvantage e*isted #hen the
country could produce a commodity only #ith more la'our per unit produced than could its trading
partner.
Ta'le ;.1 is a simple arithmetical e*ample of the principle of a'solute advantage. The countries in the
ta'le Fthe ?A and the ?,G are not, of course, the ones familiar to ,mith, nor are the commodities
F#heat and clothG the ones #hich feature in Wealth of Nations, 'ut the principle is universal. To
simplify matters, #e #ill continue to use these t#o commodities and countries #henever #e are
dealing #ith the t#o8country, t#o8commodity case.
Ta'le ;.1 indicates that the ?A has an a'solute advantage in cloth production and an a'solute
disadvantage in #heat production. The ?, has an a'solute advantage in #heat production and an
a'solute disadvantage in cloth production. oth countries #ill gain if the ?A specialises in cloth and
e*ports it to the ?,, and the ?, specialises in #heat and e*ports it to the ?A. In modern terminology,
trade is a positive sum game. Everyone gains from specialisation and e*change, though #e may note
from the outset that there is no reason to e*pect everyone to gain e1ually.
'abour theory of value
The classical economists, of #hom ,mith #as the (rst, regarded la'our as the sole source of value.
The 1uantity of la'our em'odied in a commodity measured the value of that commodity.
The arithmetical e*ample of Ta'le ;.1 is consistent #ith a la'our theory of value, since the e*change
value of each commodity is determined 'y the amount of la'our time Foutput per unit of la'ourG
necessary for its production. The classical #riters operated #ith a la'our theory of value. 4lthough
,mith had not developed a pricerelated demand schedule in the modern sense he did recognise that
demand for acommodity needed to 'e ta$en into consideration. @roducers in search of pro(t #ould not
continue to produce commodities for #hich there #as no mar$et. 5ar$et demand #as needed if
producers #ere to cover their costs of production. 5ar$et demand #ould determine #hat commodities
#ere to 'e e*changed and the relative amounts to 'e produced.
!able (.) %bsolute advanta#e *arithmetical example+
"utput per unit of labour #$ #S
,roduction of "heat B ;&
,roduction of cloth 1& 6
,mith also recognised that #or$ers differed in aptitudes and a'ilities. The la0y and uns$illed #or$er
#ould 'e less productive than the industrious and s$illed #or$er. It is la'our, as opposed to the
la'ourer, #hich is the measuring rod in the la'our theory of value. "a'our, ,mith claimed, #as alone
6the ultimate and real standard 'y #hich the value of all commodities can at all times and places 'e
estimated and compared7 FWealth of Nations, 'oo$ IG.
,olitical economy
4dam ,mith7s demonstration of the gains from specialisation and e*change, 'ased on the principle of
a'solute advantage, constituted an immensely po#erful argument for free trade. 4t the time of
pu'lication of Wealth of Nations, ritain #as already the most advanced capitalist country in the #orld
economy. 3e can imagine even today ho# appealing ,mith7s 'oo$ #as to the ne#ly emerging
manufacturing interests in ritain #ho #ished to 'e freed from state regulation, to import ra# materials
and to sell goods a'road. Its sentiments also appealed to the la'ouring poor, #ho stood to gain from
the opening8up of ritish mar$ets to imports of cheap grain from overseas.
,mith, and other classical economists, regarded themselves as operating in the sphere of political
economy. They #ere in the 'usiness of persuading governments #hat they ought to do. They #ere
concerned #ith normative, as opposed to positive, economics. The normative implication of ,mith7s
Fand later of <icardo7sG economics #as free trade.
The philosophy of economic li'eralism, of #hich the free trade doctrine is a $ey element, too$ strong
root in ritain in the early nineteenth century. The repeal of the !orn "a#s, #hich came at the end of
decades of pressure from industrialists, consolidated ritain7s lead in the #orld economy. Economic
li'eralism #as much slo#er to gain acceptance else#here in Europe. In continental Europe
protectionism had a (rmer grip. The ideas of Friedrich "ist, the .erman nationalist economist #ho died
in 1849, had a loyal follo#ing. "ist 'elieved that protectionism #as an important defence for .ermany
against the rapidly gro#ing political and economic po#er of ritain.
-avid .icardo and comparative advanta#e
orn in 1%%;, 2avid <icardo #as of 2utch parentage. -is family #as He#ish and settled in England
#here his father follo#ed the profession of stoc$'ro$er. The younger <icardo also made his fortune in
stoc$'ro$ing, and then retired from 'usiness to em'ar$ upon his intellectual Eourney. -is most
important #or$, The Principles of Political conomy and Ta!ation, #as (rst pu'lished in 181% and
contained, in addition to his theory of international trade, #or$ on the theory of value, #ages, pro(t and
rent, a theory of accumulation, and a theory of economic development. It is a complete account of the
#or$ings of an economic system, much more rigorous and less philosophic than Wealth of Nations.
The contri'ution of 2avid <icardo #as to demonstrate that even though a country may 'e a'solutely
more ef(cient than another in the production of all tradea'le goods, nevertheless trade #ill 'e mutually
advantageous.
4'solute advantage e*plains a certain proportion of trade ta$ing place in the #orld economy in the
eighteenth and early nineteenth centuries. ritain pro'a'ly had an a'solute advantage in
manufactured goods in the early stages of industrialisation and an a'solute disadvantage in the
production of commodities li$e sugar and to'acco, #hich re1uired speci(c climatic conditions. ,ugar,
to'acco, ra# cotton and tea #ere signi(cant commodities in ritain7s import 'ill.
ut suppose a country has an a'solute advantage over its trading partner in respect of all
commodities. Is there any 'asis for mutually advantageous tradeJ 4dam ,mith thought not. If the
trading partner had no a'solute advantage, then there #ould 'e no opportunity to trade.
!onsider Ta'le ;.;. The ?, has an a'solute advantage in the production of 'oth #heat and cloth. y
186&, this #as a distinct pro'a'ility. The ?, #as an agricultural economy capa'le of producing large
1uantities of lo#8cost #heat, as the margin of cultivation #as e*tended #est#ards. ut due to high
rates of investment, productivity levels #ere also rising in certain types of manufactured cotton goods.
@roductivity levels could #ell have outstripped those in the ?A.
ased on ,mith7s principle of a'solute advantage, Ta'le ;.; suggests that there is no 'asis for trade
'et#een the ?A and the ?,. The ?, is a'solutely more ef(cient in the production 'oth of #heat and
cloth. ut, loo$ing again at Ta'le ;.;, it is clear that the ?, is relatively more ef(cient in the production
of #heat Ffour times more ef(cient than the ?AG than it is in the production of cloth, #here it is three
times more ef(cient than the ?A. The ?, has a comparative advantage in #heat production. The ?A,
comparatively spea$ing, is more ef(cient in cloth production than #heat.
<icardo #as the first of the classical economists to recognise that it is relative rather than a'solute
values #hich are fundamental to the operation of a mar$et economy. This insight #as critical to the
further development of the theory of trade.
!onsider again Ta'le ;.;. The ?, has a (*ed 1uantity of la'our availa'le to produce #heat or cloth.
)ne unit of la'our can produce ;& units of #heat or 6 units of cloth. 4ssume that trade ta$es place
and the ?, sends ;& units of #heat to the ?A. To produce ;& units of #heat the ?, has sacri(ced 6
units of cloth. ut the ?, #ill 'e a'le to o'tain 8 units of cloth from the ?A in e*change for ;& units of
#heat, 'ecause #ithin the ?A ;& units of #heat trade for 8 units of cloth. In the ?A, 1 unit of la'our
can produce B units of #heat or ; of cloth. 4ssume no# that trade ta$es place and the ?A sends ;
units of cloth to the ?,. To produce ; units of cloth, the
!able (.( /omparative advanta#e *arithmetical example+
"utput per unit of labour #$ #S
,roduction of "heat B ;&
,roduction of cloth ; 6
0ox (.) .icardo1s analysis of comparative cost
Ricardos analysis of comparative cost constituted such a powerful case for free trade because it demonstrated that benets
accrue to trade even if one economy is more efcient than another in the production of a wide range of goods. As the world
economy expanded in the nineteenth century, leading economies emerged which were indeed more efcient than others over
a wide range of output. But this did not destroy the basis of trade. On the contrary, economists argued even more strongly for
free trade. conomists have extended and refined Ricardos analysis over the past two hundred years, but they have not
changed the essential argument for free trade based on the principle of comparative advantage.
?A has sacrificed B units of #heat. ut the ?A #ill 'e a'le to o'tain 6.6 units of #heat from the ?, in
e*change for cloth 'ecause #ithin the ?, ; units of cloth trade for 6.6 units of #heat.
<ecognition of the principle that it #ill 'e 'ene(cial for a country to specialise in the commodity in
#hich it has a comparative advantage, and e*port it to another country in e*change for a commodity in
#hich it has a comparative disadvantage, is fundamental to the doctrine of free trade. In dra#ing
attention to the principle of comparative cost, <icardo sho#ed enormous insight. 4lthough a'solute
advantage provides a 'asis for trade, it is li$ely, in practice, to apply to a fairly limited range of goods+
trade in foodstuffs and ra# materials 'et#een tropical and temperate 0ones, for e*ample. !omparative
advantage, on the other hand, can apply #henever there are productivity differences 'et#een
countries, in respect of t#o or more commodities.
Opportunity cost and the pure theory of trade
,o far in this chapter, the free trade doctrine has 'een discussed in terms of ala'our theory of value in
#hich the value of a commodity is determined 'y the amount of la'our time used in its production.
Follo#ing on from ,mith and <icardo, economists in the nineteenth century su'se1uently modified
and finally a'andoned the la'our theory of value. It #as replaced #ith the familiar economics 6tool8'o*7
of the present day, in #hich the value of a commodity is related to its mar$et price, #hich depends not
only on supply and cost conditions, 'ut also on demand.
2eo3classical trade theory
The economists #ho later overturned the la'our theory of value #ere from continental Europe as #ell
as from ritain. Hean aptiste ,ay F1%6%=18:;G #as French. Though a(rm disciple of ,mith, he #as
the (rst economist to 'rea$ a#ay entirely from the la'our theory of value. -e is generally credited as
developing the forerunner of formal e1uili'rium analysis. )f the three 6founders7 of the marginal utility
school in the late nineteenth century, Hevons #as from England, 5enger from 4ustria FIiennaG and
3alras from ,#it0erland F"ausanneG.
The 6neo8classical7 thin$ers, led 'y Hevons, 5enger and 3alras, developed theories of an economic
system 'ased on large num'ers of producers and consumers. .iven a competitive mar$et economy,
prices #ould guide consumers and 'ring a'out the most efficient allocation of resources in order to
ma*imise society7s income. Neo8classical economists also made great use of mathematical and
geometric e*position in order to sho# functional relationships 'et#een important varia'les such as
price and 1uantity demanded. The use of mathematics ensured greater rigour in the development of
their theories.
This is the conte*t in #hich economists have developed the pure theory of trade. The pure theory of
trade treats international trade #ithin the frame#or$ of neoclassical theory. It carries through to the
present day 4dam ,mith7s 'elief in the invisi'le hand of the mar$et, competition and the 'ene(ts of
laisse08faire policy in relation to international e*change. The pure theory a'andons the la'our theory
of value. Instead it is 'ased on rigorous analysis of consumer and producer 'ehaviour.
The pure theory of trade can 'e developed through a system of e1uations and this is the most e*act
#ay of presenting it. In this chapter, ho#ever, #e rely on a simple geometric e*position instead of on
e1uations.
Opportunity cost
The doctrine of free trade holds good even if #e discard the la'our theory of value. The 4ustrian
economist .ottfried -a'erler (rst demonstrated this in the 19:&s, utilising the concept of 6opportunity
cost7. If the concept of the 6indifference curve7 is also introduced into the analysis, it 'ecomes possi'le
for the (rst time to demonstrate the gains in real income from trade. 3hat follo#s here is a simpli(ed
form of the pure theory of trade 'ased on -a'erler7s Theory of "nternational Trade F19::G.
4ssume t#o countries, the ?, and ?A, and t#o commodities, #heat and cloth. The purpose of the
analysis is to demonstrate that the ?A gains from specialising in the production of cloth in #hich it has
a comparative advantage, and e*porting it to the ?, in e*change for #heat in #hich it has a
comparative disadvantage. The gains from trade come a'out 'ecause the domestic opportunity cost
of cloth in terms of #heat differs from the international opportunity cost of cloth and #heat.
Figure ;.1 sho#s the ?A Fcountry 4G. The a*is )y represents units of #heat. The a*is )! represents
units of cloth. If all resources availa'le in the ?A are devoted to producing cloth, )n# units of cloth #ill
'e produced. If all the resources availa'le in the ?A are devoted to producing #heat, )n units of
#heat #ill 'e produced. 4ny point on the curve nn# represents a com'ination of #heat and cloth
production. nn$ is the production possi'ility frontier for country 4. 4ssuming all resources are fully
employed, country 4 #ill 'e producing at some point on the production possi'ility curve #here 'oth
#heat and cloth are produced.
3here on the production possi'ility curve #ill country 4 'e locatedJ To ans#er this 1uestion #e need
information
C on the preferences of consumers in country 4 for #heat relative to cloth, and
C on the relative prices of #heat and cloth. <emem'er, at this stage #e have not introduced the
possi'ility of foreign trade.
Information on relative prices is therefore represented 'y the domestic price schedule. Information on
preferences is represented 'y the community#s indifference curve.
The indifference curve ii# in Figure ;.1 sho#s the t#o goods, #heat and cloth, and the com'inations of
#heat and cloth that are e1ually accepta'le to consumers in country 4. The price schedule pp# sho#s
the relative prices of #heat and cloth, the rate at #hich they can 'e traded one for another in country
4. In effect, the slope of pp# is the domestic opportunity cost.
The 6no foreign trade7 or 6autar$y7 e1uili'rium is at e. -ere the marginal rate of transformation in
production Fthe slope of nn#G is e1ual to the marginal rate of su'stitution in consumption Fthe slope of
ii#G and is e1ual to the domestic opportunity cost Fthe slope of pp#G. 4t e, country 4 produces )w of
#heat, and )c of cloth. This e1uili'rium represents the most ef(cient use of resources for 'oth
producers and consumers and yields the ma*imum level of real income in country 4.
4ains from trade
3e no# open up country 4 to foreign trade. To simplify matters, the analysis uses a partial e1uili'rium
approach, sho#ing the effects of trade on country 4 only. If #e #ere to introduce country , as in a
general e1uili'rium approach, more sophisticated geometric tools #ould 'e needed.
3e $no# that foreign trade is 'ene(cial if the domestic opportunity cost is different from the
international opportunity cost of #heat and cloth. 4 line TT# is constructed to represent the
international terms of trade, i.e. the rate at #hich #heat trades Fe*changesG for cloth in the
international economy. ecause it differs from the domestic opportunity cost it is constructed #ith a
different slope to pp#. TT# also indicates ho# much cloth country 4 #ill produce #hen it is opened up to
trade. It must 'e tangential to nn# 'ecause after trade, country 4 must still 'e some#here on its
production possi'ility curve, producing 'oth #heat and cloth. The location is indicated 'y the ne# post8
trade e1uili'rium eK. !ountry 4 has moved along the production possi'ility curve to eK, #here it is
producing more cloth and less #heat. It has specialised in cloth at the e*pense of #heat 'ecause it is
assumed to have a comparative advantage in cloth.
E*ports of cloth trade at the more favoura'le international opportunity cost represented 'y TT#. TT# is
determined 'y supply and demand conditions for #heat and cloth in country 4 and country . To arrive
at the post8trade e1uili'rium for country 4, move out along TT# until a point of tangency is reached #ith
a higher indifference curve ""#, at e#. 4t this point, country 47s marginal rate of su'stitution in
consumption Fslope of ""#G is e1ual to the marginal rate of transformation in production Fslope of nn#G,
and is e1ual to the relative prices of #heat and cloth in international mar$ets Fslope of TT#G. ""#
represents a higher level of real income for country 4. Foreign trade, #hich has led to specialisation
and e*change, results in a higher level of real income at the ne# post8trade e1uili'rium e#.
5actor endo"ments
3hat is the source or 'asis of comparative advantageJ Eli -ec$scher F1919G and ertil )hlin F19::G
#ere the t#o ,#edish economists #ho provided an ans#er to this 1uestion. The ans#er itself, and the
theoretical structure that underpins it, has turned out to 'e very in/uential in international economics.
3hy are there differences in comparative advantageJ 3hy do domestic opportunity costs differ from
international opportunity costsJ 4ccording to -ec$scher and )hlin it #as 'ecause of differences in
relative factor endo#ments 'et#een nations. !ountries li$e the ?nited ,tates and !anada #ere
relatively a'undant in fertile land. )ther countries, such as the ?A, #ere relatively a'undant in la'our.
The ?A could produce cotton te*tiles relatively cheaply 'ecause large amounts of cheap la'our #ere
used in the production process. 3heat #as cheap in the ?, relative to cloth 'ecause fertile land #as
a'undant in the ?, relative to la'our. !otton goods #ere cheap in the ?A relative to #heat 'ecause
la'our #as relatively a'undant in the ?A.
C !ountries have a comparative advantage in commodities #hich use more of their relatively abundant
factor of production. 4 la'our8a'undant country #ill e*port la'ourintensive goods. 4 capital8a'undant
country #ill e*port capital8intensive goods.
C !ountries have a comparative disadvantage in commodities #hich use more of their relatively scarce
factor of production. 4 la'our8scarce country #ill import la'our8intensive goods. 4 capital8scarce
country #ill import capital8intensive goods.
The -ec$scher=)hlin theory tells us that 1uestions a'out a country7s pattern of trade = #hich goods
and services it e*ports and #hich goods and services it imports = can 'e ans#ered in terms of factor
endo#ments. It #ill 'ecome clear later in this chapter that the appeal of the -ec$scher=)hlin
e*planation of comparative advantage does not lie in its po#er to e*plain real #orld trade patterns. 4s
an e*planatory model its present8day relevance is very limited. If it ever applied any#here, it #as
pro'a'ly only in the period 18B&=%B #hen reductions in transport costs opened up vast areas of
cheap, fertile land, and made availa'le e*ports of landintensive agricultural products from North and
,outh 4merica and 4ustralia.
If the -ec$scher=)hlin model has serious limitations in an empirical sense, #hy is it still important in
international economicsJ The ans#er is that it is a trade model #hich has important theoretical
1ualities. 5any of these 1ualities it shares #ith the <icardian approach to comparative cost. ut there
are $ey differences. 4n important difference is that the -ec$scher=)hlin model a'andons the classical
la'our theory of value, and ena'les several factors of production to 'e incorporated into the analysis.
/omparin# the .icardian and 6ec7scher8Ohlin trade models
The economist Hagdish hag#ati suggested in 1961 a useful schema for comparing the <icardian and
-ec$scher=)hlin models. This schema also plays a role in the 6testing7 of the <icardian and
-ec$scher=)hlin F-=)G models.
%chema for evaluating Ricardian and HeckscherOhlin trade models &following 'hagwati(
4ssumptions
@redictions
Empirical evidence
Normative implications
6Fruitfulness7 in terms of further #or$
!he assumptions and predictions of the t"o trade models
Ta'le ;.: sho#s that the <icardian and -=) models hold the maEority of their assumptions in
common.
oth the <icardian and -=) trade models assume perfect competition, so that the prices of goods
entering into international trade perfectly re/ect productivity differences F<icardoG or factor
endo#ments F-=)G. There are no monopolistic tendencies #hich
might undermine the relationship 'et#een la'our productivity and the price of goods F<icardoG, or
factor endo#mentsLfactor intensities and the price of goods F-=)G.
oth models also assume that costs of production are constant #ith respect to scale of output. 4gain,
this is necessary to maintain a clear relationship 'et#een price and productivity F<icardoG and price
and factor endo#ments F-=)G. There are no economies of scale to complicate the issue.
In 'oth models transport costs are 0ero. This assumption is highly unrealistic 'ut necessary, again to
ensure that international price ratios re/ect productivity differentials F<icardoG or relative factor
endo#ments F-=)G, rather than such things as location, distance and other costs of moving goods
across national 'oundaries.
Finally, if factors of production could move 'et#een countries, then factor mo'ility #ould rule out
differences in the prices of goods and factors of production #hich give rise to trade. It is only 'ecause
factors of production are immo'ile internationally that trade in goods and services 'ecomes possi'le.
None of the a'ove assumptions could 'e regarded as realistic, 'ut in this, as in other areas of
economics, they are necessary to the logical development of the model.
The (nal t#o categories of assumptions differ 'et#een the models, and highlight the difference in
approach 'et#een the classical model of <icardo, and the later -=) model #hich sits more easily in
the neo8classical tradition.
First, the <icardian model assumes only one factor of production, la'our. The costs of traded
commodities are determined 'y the amount of la'our utilised in production. The -=) model, on the
other hand, has several factors of production. The relative prices of traded commodities are
determined 'y the different factor intensities that they display.
,econd, in the <icardian model the relationship 'et#een la'our inputs and output for the same
commodity differs in the t#o trading countries. In other #ords, production functions for the same
commodity differ internationally in the <icardian model.
In the -=) model production functions are the same for 'oth countries #hen producing the same
commodity. In producing commodity !, country 4 and country 'oth face the same production
function. It is the factor intensities #hich differ 'et#een commodities ! and y, and factor endo#ments
#hich differ 'et#een countries 4 and .
Follo#ing hag#ati7s schema and comparing the <icardian and -=) trade theories, there are
important differences in assumptions #hich may lead to differences in predictions a'out li$ely trade
patterns.
If <icardian theory is selected, then a country7s e*ports and imports = the pattern of trade = are
determined 'y productivity differences. 4 country #ill e*port those commodities in #hich its la'our
productivity is comparatively high, and import those commodities in #hich its la'our productivity is
comparatively lo#.
If -=) theory is follo#ed, then a country7s pattern of trade is determined 'y relative factor
endo#ments. 4 country #ill e*port commodities #hich em'ody its relatively a'undant factor, and #ill
import commodities #hich em'ody its relatively scarce factor.
Empirical evidence has 'een $inder to the predictions of the <icardian model than to the -=) model.
The -=) model does not stand up very #ell to the test of real8#orld evidence. 3hyJ <eservations
a'out the real8#orld relevance of the -=) trade model have long 'een voiced 'y economists, and
they seem to centre on the fact that trading nations usually have very similar factor endo#ments. The
'ul$ of #orld trade is 'et#een countries #hich have similarly structured economies. 5ore than this,
the trade #hich ta$es place 'et#een these countries tends to 'e in commodities #hich have very
similar factor re1uirements.
2ormative implications and further "or7
There is no difference 'et#een the -=) and <icardian models so far as their normative, i.e. policy,
implications are concerned. oth approaches strongly support a policy of free trade. Trade is a
positive sum game. 4ll gain 'y participating in international e*change.
The -=) model is superior to the <icardian model, ho#ever, in that it can 'e used to tell us something
a'out ho# the gains from trade #ill 'e distri'uted. There are, potentially, four factors of production in
the -=) model and the prices of these factors Frents on land, #ages for la'our, interest payments on
capital and pro(ts for enterpriseG are the re#ards accruing to the factors, i.e. their real income. The -=
) model ena'les the economist to reach a general e1uili'rium solution #hich indicates ho# the
invisi'le hand of the mar$et determines #hat e*ports should 'e produced, ho# they are to 'e
produced and ho# the gains from trade are distri'uted among the different factors of production in the
trading countries.
It is the a'ility of the -=) model to provide a general e1uili'rium solution #hich e*plains #hy it
occupies a central place in the pure theory of trade, and #hy economists have found it so useful in
stimulating further theoretical #or$.
!estin# the .icardian and 6ec7scher8Ohlin models
!he .icardian model
The <icardian model, in #hich trade patterns depend on productivity differences, comes out #ell from
empirical investigation. The earliest tests #ere carried out 'y .. 2. 4. 5ac2ougall, and pu'lished in
the conomic )ournal of 2ecem'er 19B1 and ,eptem'er 19B;.
5ac2ougall inferred from the <icardian model that, in comparing ?, and ?A patterns of trade, the
ratio of ?, e*ports to ?A e*ports #ould 'e relatively high in commodities #here the ratio of
productivity of ?, #or$ers to ?A #or$ers #as also relatively high. ,o, in ta$ing a cross8section of
industries, 5ac2ougall found that in industries li$e te*tiles #here ?, productivity #as very close to ?A
productivity, the volume of ?, e*ports #as very close to the volume of ?A e*ports. In industries such
as car production, #here ?, productivity #as much greater than ?A productivity, ?, e*ports #ere
much greater in volume than ?A e*ports. This result 'roadly confirms the <icardian model in #hich
productivity differences Fcomparative costsG determine trade patterns.
Figure ;.; illustrates the results of 5ac2ougall7s empirical #or$. It uses the methodology of
correlation, a statistical indication of the relationship 'et#een t#o varia'les. @ositive correlation yields
an up#ard8sloping pattern as the t#o varia'les
! and y are plotted. Negative correlation is indicated 'y a do#n#ard8sloping pattern as the varia'les !
and y are plotted.
In 5ac2ougall7s test of <icardian theory, productivity ratios are measured on the y a*is and e*port
ratios on the ! a*is. @roductivity ratios and e*port ratios are correlated for a range of manufactured
goods. There is a clear positive relationship 'et#een productivity ratios and e*port ratios across the
commodities, ranging from te*tiles Flo# ?, productivity and lo# ?, e*portsG to motor vehicles Fhigh
?, productivity and high ?, e*portsG.
!he 6ec7scher8Ohlin model
The most famous test of the -ec$scher=)hlin model is that carried out 'y the ?, statistician 3assily
"eontief #hich #as pu'lished in 19B:. It used #hat #as then a pioneering methodology. The
methodology #as that of inputoutput analysis. It #as to #in "eontief the No'el @ri0e in 19%:.
Essentially input=output analysis involves representing the output of any product in terms of its input
re1uirements. 4 simpli(ed e*ample might relate to cotton te*tiles, #hich re1uire a certain 1uantity of
fuel FelectricityG, ra# materials Fra# cottonG, capital e1uipment Fmachinery for spinning and #eavingG
and la'our Fto produce the final outputG. E*tended to the economy as a #hole, it is possi'le to
represent all transactions in the economy in a 6snapshot7 form, at a particular point in time. The aim is
to highlight the interrelationships in the economy, as the output of one sector Fsay, te*tile machinery
from the capital goods sectorG is used as input in other sectors. In an economy such as the ,oviet
?nion 'efore li'eralisation, planners could use input=output analysis to avoid 'ottlenec$s, particularly
for critical inputs such as energy and ra# materials.
It is important to $no# something a'out the history of "eontief7s #or$, 'ecause here is an e*ample of a
methodology in search of something to test, rather than the other #ay around> For an economy the
num'er of calculations re1uired to produce a comprehensive input=output ta'le is vast. It is no
coincidence that "eontief7s #or$ coincided #ith the development of computers in the ?, in the late
194&s, 'ecause one of the first uses of the technology #as the construction of an input=output ta'le
for the ?, economy for the year 194%.
-aving constructed the input=output ta'le, "eontief considered its possi'le uses. Testing the
-ec$scher=)hlin model #as Eust one of these potential uses. It ena'led "eontief to compare the factor
intensity of ?, e*ports #ith the factor intensity of ?, import8competing goods. Ideally, "eontief #ould
have #ished to loo$ at the factor intensity of actual imports, rather than the factor intensity of ?,
goods #hich replaced imports. This #as not possi'le 'ecause data in the input=output ta'le relate
only to the ?,. -o#ever, "eontief #as 1uite Eusti(ed in using import replacements 'ecause of
assumption 6 in Ta'le ;.:, i.e. that the same commodity has the same production function in different
countries. This means that if, say, cotton te*tiles are relatively la'our8intensive in the ?,, they are also
relatively la'ourintensive in the ?A. If motor vehicles are relatively capital8intensive in the ?,, they are
relatively capital8intensive in the ?A.
!he 'eontief paradox
3hen "eontief had completed his calculations it emerged that the ?, e*ported relatively la'our8
intensive goods and imported relatively capital8intensive goods = as measured, in the latter case, 'y
the factor re1uirements of import8competing goods. The results #ere regarded as parado*ical
'ecause, 'y the end of 3orld 3ar II, the ?, economy #as generally regarded as the most capital8
a'undant country in the #orld economy, a position #hich it has maintained ever since.
"eontief himself re8did the calculations using an input=output ta'le for a later year, 'ut the results #ere
largely the same and it must 'e admitted that although more re(ned data and 'etter methods of
testing the -=) model have emerged over the past forty years, and even though other countries and
even trade 'locs have featured in o'servations and testing, the results for the -=) model have 'een,
at 'est, mi*ed.
Faced #ith the poor empirical performance of the -=) model, the economist has t#o choices+ either
C re*ect the HO e!planation of differences in comparative advantage, and pursue instead alternative
e*planations of trade patterns such as the ones discussed in the ne*t chapterD or
C accept that the -=) e*planation of differences in comparative advantage may still 'e valid and loo$
for reasons for the parado! #hich are consistent #ith an underlying -=) frame#or$.
ecause the -=) model is such a po#erful theoretical construct in neo8classical analysis, economists
seem reluctant to a'andon it altogether> The follo#ing reasons for the parado* have 'een advanced in
various research papers, 'y economists #ho 'elieve that the -=) e*planation of trade patterns is
fundamentally correct, despite its poor empirical sho#ing.
.easons for the 'eontief paradox
C Natural resources are neglected. This #as one of the earliest e*planations of the parado*, and one
#hich initially #as favoured 'y "eontief himself. y concentrating on la'our and capital, the test had
neglected to ta$e into account the relatively abundant natural resources of the ?,. )n closer
investigation, e*ports may have 'een natural8resource8intensive rather than capital8intensive.
C !ports are skill+intensive. "a'our is not a homogeneous commodity. The ?, has a relatively s$illed
la'our force. "a'our8intensive e*ports may have em'odied relatively large amounts of the abundant
skilled labour in the ?, economy.
C ,actor reversals occur. ?, import8competing goods may 'e produced in a capitalintensive #ay in the
?,, even though actual imports are la'our8intensive. 4lthough such factor reversals are ruled out 'y
assumption in the -=) model, they remain a distinct real8#orld possi'ility, depending on the relative
prices of factors of production.
C Trade policy is responsi'le for the parado*. The -=) model assumes perfect competition and free
trade, 'ut the ?, has very po#erful la'our unions #hich lo''y for protection against labour+intensive
imports- This means that entrepreneurs in profit8ma*imising import8competing industries are a'le to
use relatively capital8intensive techni1ues, even though actual imports may 'e relatively la'our8
intensive.
4lthough all four of these 6solutions7 to the parado* feature strongly in later empirical research, it
appears that economists are no nearer a satisfactory resolution of the parado*. <esults have 'een
inconclusive.
!he inuence of the free trade doctrine
From its early 'eginnings in the #ritings of ,mith and <icardo, the pure theory of trade emerged as
part of the marginalist revolution led 'y Hevons in England, 5enger in 4ustria and 3alras in
,#it0erland. It #as reinforced in the #ritings of the important 6second generation7 of neo8classical
thin$ers, those #hom -a'erler ac$no#ledged in his 19:: 'oo$+ 5arshall in England Fhis paper 6@ure
Theory of Foreign Trade7 F18%9GGD 3ieser and Mhm8a#er$ of the 4ustrian ,choolD and @areto from
"ausanne.
,mith and <icardo operated in the sphere of political economy, the art of persuading governments and
sectional interests of the mutual 'ene(ts of free trade. @olitical economy #as very much an English
phenomenon. Even 5arshall, trained as a mathematician and fully at home #ith formal analysis, #as
an*ious to root his en1uiries in economic reality. The continental European #riters, though no less
committed to competitive mar$ets, #ere more technical in their approach, more mathematical and
formalist.
It is also apparent that free trade doctrines #ere slo#er to gain a hold on governments in continental
Europe than they #ere in ritain. ritain #as the (rst country to adopt a policy of free trade, ushering
in an era of freer trade in the international economy #hich lasted from 18B& to 18%B. et#een 184&
and 188&, ritain reduced tariffs 'y ;& per cent.
It is not clear, ho#ever, ho# much of the free trade movement in ritain #as due to the persuasive
po#ers of economists. Economic historians have argued that the reductions in tariffs in ritain #ere
not due to free8trade doctrines, 'ut rather to the fact that government revenues #ere rising for other
reasons, and there #as no need to ta* imports in order to 'alance the 'udget. In particular, income
ta*es in ritain #ere coming to represent an increasing proportion of government revenue, helped 'y
rising national income.
France li'eralised trade policy after 186&, 'ut this #as largely through reciprocal 'ilateral trade treaties
#ith most favoured nations F5FNsG. )ften these treaties had a political rather than an economic
purpose. 3hen France concluded a trade treaty #ith @russia, the aim #as to e*clude 4ustria8-ungary
rather than to em'race #holeheartedly a free8trade doctrine. The south .erman states too #ere
protectionist, great supporters of their .ollverein, the free8trade area #hich maintained a high common
e!ternal tariff. The .ollverein #as not reformed until 1866.
The ?nited ,tates #as also slo# to convert to free8trade principles. Import duties #ere increased
every year until 186B. ,ectional interests continued to lo''y successfully for protectionism through to
the 188&s. 4s late as 188&, the import duty on steel in the ?,4 #as 1&& per cent. 3ool had a :B per
cent tariff.
The #orld depression in output and employment from 18%: on#ards resulted in rene#ed pressure for
protection. 3. !unningham, the contemporary historian, remar$ed of ritain that, 6the ,cience of
@olitical Economy spea$s #ith far less authority and receives far less respectful attention than it did
some years ago7 FThe Rise and /ecline of the ,ree Trade 0ovement, 19&4G. Nevertheless, ritain Eust
a'out held on to free8trade principles, and in 19&6 the !onservative @arty lost an election fought on
protectionist principles. ,igni(cant opposition had come from the s$illed artisan classes, fearing higher
food prices.
In .ermany, under the in/uence of the depression of the 18%&s, ismarc$ introduced a ne# .erman
tariff, #hich #as further increased in 189&. In France imports of ?, #heat #ere the cause of popular
agitation. <ates on a num'er of agricultural products #ere raised in the 189&s. y 189; French tariffs
on agricultural products averaged ;B per cent.
The ?,4 had al#ays 'een more protectionist than Europe and raised tariffs Fthe 5cAinley tariffG in
189&. 4t that point in time the average ?, tariff #as B% per cent. Interestingly the ?, tariff #as Eusti(ed
'y the need to protect ?, #or$ers from the cheap8la'our goods of Europe.
The 2epression of 19;9 signalled further decisive rounds of protectionist policies. oth nominal tariff
levels and trade restrictions, such as 1uotas, #ere raised in order to forestall massive price declines.
Italy imposed 1uotas on French e*ports of #ines and perfumes. France retaliated #ith 1uotas on
Italian fruit and vegeta'les. In the ?, tariffs #ere raised to help farmers and #ere later e*tended to
non8agricultural products. arter agreements on a 'ilateral 'asis 'egan to feature in international
trade. -ungary started to e*change foodstuffs for !0echoslova$ian coal. y 19:B #orld trade had
fallen to one8third of its 19;9 level. European nations such as ritain, #ith significant colonial lin$s,
tried to ride out the storm 'y entering into preferential trading agreements #ith colonies and
dominions. .ermany entered into 'ilateral clearing arrangements through the 'an$s #ith countries
such as Nugoslavia and <omania. y 19:8, more than half of .ermany7s foreign trade #as 'eing
carried out through 'an$8'ased 'ilateral clearing arrangements.
The e*perience of the 19:&s is a salutary lesson #hen economists contemplate the triumph of ideas
represented in the free trade doctrine. The ne# li'eral economic order #hich #as constructed 'y the
allies at retton 3oods in 1944 mar$ed the re8emergence and triumph of an intellectual tradition #hich
had faltered in the 189&s and had collapsed altogether 'y 19:9. In !hapter B #e learn a'out the
painsta$ing reconstruction of a free trade agenda, 'eginning #ith the ill8fated IT), later .4TT, and the
successive rounds of item8'y8item trade negotiations under .4TT #hich culminated in the ?ruguay
<ound of trade negotiations and the setting8up of the 3orld Trade )rganisation. The theory #hich has
underpinned the doctrine of free trade over the last t#o centuries can truly 'e descri'ed as robust in
surviving, among other things, the political and social dislocation of t#o #orld #ars and economic
slumps in t#o #orld depressions.
&ummary
C The theory of trade is the 'asis of the doctrine of free trade. Free trade principles emerged in ritain
as a protest against the effects of the !orn "a#s.
C 5ercantilist economic thin$ing #as characteristic of Europe up to the seventeenth century. It
featured #ide8ranging domestic regulations and restrictions on imports and e*ports.
C 4dam ,mith, the founder of modern economics, presented a criti1ue of mercantilism, together #ith
the case for free trade 'ased on the principles of a'solute advantage.
C 2avid <icardo recognised that it is relative or comparative advantages #hich lead to mutually
'ene(cial trade. !omparative advantage applies #henever there are productivity differences 'et#een
countries.
C 5odern economics replaces the classical la'our theory of value #ith the concept of opportunity cost.
This ena'les the economist to develop the pure theory of trade #ithin the frame#or$ of neo8classical
theory.
C -ec$scher and )hlin 'elieved that the source of comparative advantage is differences in relative
factor endo#ments 'et#een countries. !ountries e*port commodities #hich em'ody the relatively
a'undant factor, and import commodities #hich em'ody the relatively scarce factor.
C The <icardian and -=) models have most assumptions in common, 'ut have t#o important
categories of assumptions that differ. These relate to the num'er of factors of production, and the
properties of the production functions.
C The <icardian model performs 'etter in empirical investigation than the -=) model. Iarious
e*planations have 'een put for#ard for the "eontief parado*.
C The theory of trade #hich underpins the doctrine of free trade is very ro'ust. It has survived and
triumphed over many vicissitudes in the #orld economy.