Theories of International Trade since 1900

The theory of international trade in the post-1900 period was heavily influenced by the marginalist and neoclassical revolutions in economic thought that occurred in the last third of the nineteenth century. New bases were discovered for the valuation of goods and services, relying on the subjective attitudes of consumers toward them at the margin of consumption rather than on their cost of production, as the classical economists believed. In England, Alfred Marshall combined the insights of the classical and the marginalist economists by asserting that both subjective elements (the utility that consumers derive from goods and services) and objective ones (their cost of production comprising not only labor but also capital and other factors) concur to determine their prices, just as both blades of a pair of scissors are needed to cut a piece of paper. Marshall's Principles of Economics of 1890 synthesized the neoclassical theory of value and gave the field of economics its new name, replacing the older political economy.

NEOCLASSICAL TRADE THEORY

The new insights of the neoclassical economists soon spilled over to the theory of international values. Inspired by Marshall and by a founder of the marginalist school, Léon Walras, they sought to generalize David Ricardo's theory of comparative advantage by moving beyond the labor theory of value and exploring the bases of why countries have a comparative advantage in particular goods and services. The Italian economist Vilfredo Pareto greatly admired Walras's general equilibrium model that determined the prices and the quantities of commodities and of the services of factors of production transacted in a country via a system of simultaneous equations. He extended this model to two trading economies, yielding the amounts produced, consumed, and hence traded by them, subject to the balance of trade condition that the aggregate values of imports and exports should be equal. Another Italian economist, Enrico Barone, published in 1908 a book of economic principles in which he illustrated with a diagram how a country gains from international trade, in terms of the higher welfare level its citizens can attain by being able to import cheaper commodities than those available domestically.

A more substantial step forward was taken by the Austrian economist Gottfried Haberler, who independently of Barone discovered the production possibility curve. This concave curve illustrates how a country's given stock of factors of production can produce two commodities, such that additional output of commodity A implies an opportunity-cost expressed by a reduction in the output of commodity B. If the domestic opportunity-cost of A exceeds the international terms of trade (expressed in terms of commodity B), its importation in exchange for the export of B leads consumers to higher welfare. Haberler succeeded in generalizing Ricardo's comparative cost theory by showing that it remains valid in terms of countries' relative opportunity costs, even if the classical labor theory of value is rejected.

ELI HECKSCHER AND BERTIL OHLIN

Neither the Ricardian theory nor its generalization by Haberler in terms of opportunity costs provided any indication of why particular countries have a comparative advantage in certain commodities. The elaboration of this theory was a major contribution of two Swedish economists, Eli Heckscher and Bertil Ohlin, who reasoned that international trade was primarily due to countries' differential factor endowments. A land-abundant country would tend to produce and export commodities that are land-intensive, a labor-abundant country would do the same with commodities that are labor-intensive, and so on. Their combined efforts gave rise to what became known as the Heckscher-Ohlin (or factor endowments) theory of trade, which remains to this day the mainstream explanation of trade flows. In 1919 Heckscher published an article in Swedish that appeared in English translation thirty years later as "The Effect of Foreign Trade on the Distribution of Income" (1949). It had the twofold aim of investigating the reasons for the differences in comparative costs among countries, something that Ricardo had never addressed, and tracing the influence of trade on the distribution of income among factors of production. Heckscher linked a "difference in the relative scarcity of the factors of production between one country and another" to the condition "that the proportions in which the factors of production are combined shall not be the same for one commodity as for another." A third important assumption was that "the same technique is used to produce a given commodity in different countries" (Heckscher 1949, pp. 278–280). This is now usually denoted as the assumption of internationally identical production functions, where a production function expresses the output of a commodity as a mathematical function of the minimal quantities of inputs it requires. Heckscher concluded that international trade alters drastically the distribution of national income, resulting, under certain conditions, in the equalization of the prices of the factors of production in the trading countries, despite the assumption that factors do not move between them.

Heckscher's insights into the causes and effects of international trade, together with the general equilibrium approach to neoclassical economics of Gustav Cassel (another Swedish economist), were combined by their student Ohlin (1933) in a book-length account of the Heck-scher-Ohlin theory. Unlike Haberler and Heckscher, who only aimed to generalize and extend the Ricardian theory of comparative costs, Ohlin was a revolutionary thinker who argued that the theory should be discarded and replaced with a new one.

The new theory's centerpiece is the Heckscher-Ohlin theorem relating to trade between two regions (or countries): "Exports are in each region composed of articles into the production of which enter large quantities of cheap factors. In brief, commodities containing a large proportion of dear factors are imported, and those containing a large proportion of cheap factors are exported" (1933, p. 29). The cheapness or dearness of factors results from their abundance or scarcity compared to other countries. Chapter 3 of Ohlin's book presents "Another Condition of Interregional Trade," which is economies of large-scale production. Since the indivisibility of some factors of production may require certain economic activities to be concentrated geographically, foreign trade is needed to create an additional market for their output. Economies of scale reappeared as a significant cause of trade in the "new trade theory" described below.

THE HECKSCHER-OHLIN-SAMUELSON THEORY OF TRADE

The neoclassical contributions to trade theory of Haberler, Heckscher, and Ohlin were further developed by Wolfgang Stolper and Paul Samuelson (1941) and Samuelson (1948, 1949) into what became known as the Heckscher-Ohlin-Samuelson (or H-O-S) theory of trade. Samuelson made some strategic simplifications to the Heckscher-Ohlin theory by specializing it to two countries, two commodities, and two factors of production, yielding the so-called 2 x 2 x 2 model. To derive unambiguous results, some restrictive assumptions were made. Production functions are identical in all countries and show constant returns to scale. If the two factors are land and labor, commodities are distinguished by their factor intensities, such that one of them is more labor-intensive than the other at all factor prices. Relative factor endowments differ between countries. In both countries the demands for commodities are identical, and at the same relative price they are consumed in the same ratio. Perfect competition prevails in all product and factor markets. Free trade and zero transport costs are also assumed.

Samuelson then derived the Heckscher-Ohlin theorem, which asserts that the country abundant in a given factor exports the commodity that intensively uses that factor in exchange for the other commodity. The Stolper-Samuelson theorem shows that an increase in the relative price of a good increases the real wage of the factor used intensively in producing that good and lowers the real wage of the other factor. Given the additional assumption that neither country specializes in its export commodity, the factor price equalization theorem states that trade equalizes real factor prices in the two countries.

These results admirably synthesized, and rigorously proved, some of the main insights of Heckscher and Ohlin and laid the foundations for the postwar international trade theory. These theorems carry some important policy implications. The Stolper-Samuelson theorem shows that free trade, by raising the price of a country's export commodity, makes the factor that is intensively used in the export sector better off, but harms the welfare of the other factor. Tariff protection of the import-competing sector has the opposite distributional effects. One cannot therefore proclaim free trade to be superior to protectionism in the sense of making everyone better off, unless compensation is paid to the factor that it harms.

THE NEW TRADE THEORY

When the United States was considered the world's most capital-abundant country, after World War II, the Heck-scher-Ohlin theorem was tested empirically by Wassily Leontief (1953). To his surprise, Leontief discovered that the United States exported labor-intensive and imported capital-intensive commodities. This became known as the Leontief Paradox and gave rise to numerous articles that attempted to rationalize it or to reformulate the underlying H-O-S theory. The latter was extended to more factors than the two (capital and labor) considered by Leontief. Later empirical tests sometimes reversed and sometimes reaffirmed the Leontief Paradox. Economists also noted that, contrary to what the Heckscher-Ohlin theory suggests, most trade flows occur between industrialized countries whose factor endowments are fairly similar, and that much of this trade is intra-industry in nature, so that the same types of commodity (such as automobiles) are both exported and imported.

Dissatisfaction with the H-O-S theory led in the late 1970s and 1980s to the formulation of a new trade theory, some of whose models dispense altogether with the notion of comparative advantage and allow for increasing returns to scale, external economies, differentiated products, and the associated imperfectly competitive market structures. Trade is shown to arise even between economies identical with respect to factor endowments and technical knowledge. Ohlin had anticipated one of its main findings: "The character of this trade will be entirely a matter of chance, if factor equipment is everywhere the same; for it is of no consequence whether a certain region specializes in one commodity or another, just as uniformly endowed individuals can with equal advantage specialize in any kind of work" (1933, p. 55). Ohlin also remarked on the importance of history and accident in molding comparative advantage, a factor stressed by Paul Krugman (1990), one of the new trade theorists. A great achievement of the new trade theory is to provide a satisfactory explanation of intra-industry trade. In diametrical opposition to the prediction of the H-O-S theory, the volume of such trade is greater, the more similar are the trading countries' factor endowments.

Interested readers can supplement this brief survey of the theories of international trade after 1900 by consulting works such as Irwin (1996) and Maneschi (1998).

BIBLIOGRAPHY

Haberler, Gottfried. The Theory of International Trade. Edinburgh: William Hodge, 1936.

Heckscher, Eli F. "The Effect of Foreign Trade on the Distribution of Income." In Readings in the Theory of International Trade, ed. H. S. Ellis and L. A. Metzler. Homewood, IL: Irwin, 1949. First published in Swedish in 1919.

Irwin, Douglas A. Against the Tide: An Intellectual History of Free Trade. Princeton: Princeton University Press, 1996.

Krugman, Paul R. Rethinking International Trade. Cambridge, MA: MIT Press, 1990.

Leontief, Wassily W. "Domestic Production and Foreign Trade: The American Capital Position Re-examined." Proceedings of the American Philosophical Society 97 (1953): 331–349.

Maneschi, Andrea. Comparative Advantage in International Trade: A Historical Perspective. Cheltenham: Edward Elgar, 1998.

Ohlin, Bertil. Interregional and International Trade. Cambridge, MA: Harvard University Press, 1933.

Samuelson, Paul A. "International Trade and theEqualisation of Factor Prices." Economic Journal 58 (1948): 163–184.

Samuelson, Paul A. "International Factor Price Equalisation Once Again." Economic Journal 59 (1949): 181–197.

Stolper, Wolfgang F., and Samuelson, Paul A. "Protection and Real Wages." Review of Economic Studies 9 (1941): 58–73.

Andrea Maneschi