An Overview of Trade Theory

We open this chapter with a discussion of mercantilism. Propagated in the sixteenth and seventeenth centuries, mercantilism advocated that countries should simultaneously encourage exports and discourage imports. Although mercantilism is an old and largely discredited doctrine, its echoes remain in modern political debate and in the trade policies of many countries. Next, we will look at Adam Smith’s theory of absolute advantage. Proposed in 1776, Smith’s theory was the first to explain why unrestricted free trade is beneficial to a country. Free trade refers to a situation in which a government does not attempt to influence through quotas or duties what its citizens can buy from another country, or what they can produce and sell to another country. Smith argued that the invisible hand of the market mechanism, rather than government policy, should determine what a country imports and what it exports. His arguments imply that such a laissez-faire stance toward trade was in the best interests of a country. Building on Smith’s work are two additional theories that we shall review. One is the theory of comparative advantage, advanced by the nineteenth-century English economist David Ricardo. This theory is the intellectual basis of the modern argument for unrestricted free trade. In the twentieth century, Ricardo’s work was refined by two Swedish economists, Eli Heckscher and Bertil Ohlin, whose theory is known as the Heckscher-Ohlin theory.

Free Trade

The absence of barriers to the free flow of goods and services between countries.

THE BENEFITS OF TRADE

LEARNING OBJECTIVE 1

Understand why nations trade with each other.

The great strength of the theories of Smith, Ricardo, and Heckscher-Ohlin is that they identify with precision the specific benefits of international trade. Common sense suggests that some international trade is beneficial. For example, nobody would suggest that Iceland should grow its own oranges. Iceland can benefit from trade by exchanging some of the products that it can produce at a low cost (fish) for some products that it cannot produce at all (oranges). Thus, by engaging in international trade, Icelanders are able to add oranges to their diet of fish.

The theories of Smith, Ricardo, and Heckscher-Ohlin go beyond this commonsense notion, however, to show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself. This is a difficult concept for people to grasp. For example, many people in the United States believe that American consumers should buy products made in the United States by American companies whenever possible to help save American jobs from foreign competition. The same kind of nationalistic sentiments can be observed in many other countries.

ANOTHER PERSPECTIVE Outsourcing: Putting Jobs into Growing Markets

Another way of looking at the hollowing out of the American knowledge-based economy through outsourcing is to see the process from the perspective of developing nations. To them, outsourcing brings with it the benefits of trade. It is one of the positive outcomes of globalization. Multinational corporations doing some business in their markets can locate their production in the very markets into which they are selling. As India, the Philippines, and China develop a knowledge-based labor supply, companies such as Intel and EMC that are selling into these markets may want to locate some of their research and development and other knowledge-based activities in these markets as a commitment to a local presence, as a way to learn more about the customer, and as a way to establish sustained and sustaining relationships. Yes, there are cost savings, especially on labor, but long term, such cost savings may be secondary.

However, the theories of Smith, Ricardo, and Heckscher-Ohlin tell us that a country’s economy may gain if its citizens buy certain products from other nations that could be produced at home. The gains arise because international trade allows a country to specialize in the manufacture and export of products that can be produced most efficiently in that country, while importing products that can be produced more efficiently in other countries. Thus, it may make sense for the United States to specialize in the production and export of commercial jet aircraft, because the efficient production of commercial jet aircraft requires resources that are abundant in the United States, such as a highly skilled labor force and cutting-edge technological know-how. On the other hand, it may make sense for the United States to import textiles from Bangladesh because the efficient production of textiles requires a relatively cheap labor force—and cheap labor is not abundant in the United States.

Of course, this economic argument is often difficult for segments of a country’s population to accept. With their future threatened by imports, U.S. textile companies and their employees have tried hard to persuade the government to limit the importation of textiles by demanding quotas and tariffs. Although such import controls may benefit particular groups, such as textile businesses and their employees, the theories of Smith, Ricardo, and Heckscher-Ohlin suggest that the economy as a whole is hurt by such action. One of the key insights of international trade theory is that limits on imports are often in the interests of domestic producers, but not domestic consumers.