The theory of international trade

As already noted, British classical economists simply accepted the fact that productivity differences exist between countries; they made no concerted attempt to explain which commodities a country would export or import. During the 20th century, international economists offered a number of theories in an effort to explain why countries have differences in productivity, the factor that determines comparative advantage and the pattern of international trade.

First, countries can have an advantage because they are richly endowed with a particular natural resource. For example, countries with plentiful oil resources can generally produce oil inexpensively. Because Saudi Arabia produces oil very cheaply, it holds a comparative advantage in oil, and it exports oil in order to finance its purchases of imports. Similarly, countries with large forests generally are the major exporters of wood, paper, and paper products. The supply available for export also depends on domestic demand. Canada has large quantities of lumber available for export to the United States, not only because of its large areas of forest but also because its small population consumes little of the supply, leaving much of the lumber available for export. Climate is another natural resource that provides an export advantage. Thus, for example, bananas are exported by Central American countries—not Iceland or Finland.

Simply put, countries with plentiful natural resources will generally have a comparative advantage in products using those resources. A related, but much more subtle, assertion was put forward by two Swedish economists, Eli Heckscher and Bertil Ohlin. Ohlin’s work was built upon that of Heckscher. In recognition of his ideas as described in his path-breaking book, Interregional and International Trade (1933), Ohlin was a recipient of the Nobel Prize for Economics in 1977.

The Heckscher-Ohlin theory focuses on the two most important factors of production, labour and capital. Some countries are relatively well-endowed with capital; the typical worker has plenty of machinery and equipment to assist with the work. In such countries, wage rates generally are high; as a result, the costs of producing labour-intensive goods—such as textiles, sporting goods, and simple consumer electronics—tend to be more expensive than in countries with plentiful labour and low wage rates. On the other hand, goods requiring much capital and only a little labour (automobiles and chemicals, for example) tend to be relatively inexpensive in countries with plentiful and cheap capital. Thus, countries with abundant capital should generally be able to produce capital-intensive goods relatively inexpensively, exporting them in order to pay for imports of labour-intensive goods.

In the Heckscher-Ohlin theory it is not the absolute amount of capital that is important; rather, it is the amount of capital per worker. A small country like Luxembourg has much less capital in total than India, but Luxembourg has more capital per worker. Accordingly, the Heckscher-Ohlin theory predicts that Luxembourg will export capital-intensive products to India and import labour-intensive products in return.

Despite its plausibility the Heckscher-Ohlin theory is frequently at variance with the actual patterns of international trade. As an explanation of what countries actually export and import, it is much less accurate than the more obvious and straightforward natural resource theory.

One early study of the Heckscher-Ohlin theory was carried out by Wassily Leontief, a Russian-born U.S. economist. Leontief observed that the United States was relatively well-endowed with capital. According to the theory, therefore, the United States should export capital-intensive goods and import labour-intensive ones. He found that the opposite was in fact the case: U.S. exports are generally more labour intensive than the type of products that the United States imports. Because his findings were the opposite of those predicted by the theory, they are known as the Leontief Paradox.

Even if countries have quite similar climates and factor endowments, they may still find it advantageous to trade. Indeed, economically similar countries often carry on a large and thriving trade. The prosperous industrialized countries have become one another’s best customers. A main reason for this situation lies in what is called the economies of large-scale production (see economy of scale).

For many products, there are advantages in producing on a large scale; costs become lower as more is produced. Thus, for example, automobiles can be made more cheaply in a factory producing 100,000 units than in a small factory producing only 1,000 units. This means that countries have an incentive to specialize in order to reduce costs. To sell a large volume of output, they may have to look to export markets.

The smaller the country, and the more limited its domestic market, the more incentive it has to look to international trade as a way of gaining the advantages of large-scale production. Thus, Luxembourg or Belgium has much more to gain, relatively, than the United States. Indeed, the advantages of large-scale production were one of the major sources of gain from the establishment of the European Economic Community (EEC; ultimately replaced by the European Union), which was formed for the purpose of providing free trade between most western European countries.

Even a large country such as the United States, however, can gain in some cases by exporting in order to exploit the economies of production lines. For example, the Boeing Company has been able to produce airplanes more efficiently and cheaply because it is able to sell large numbers of aircraft to other countries. The importing countries also gain because they can buy aircraft abroad at prices far lower than they would pay for domestically produced equivalents.

Technological development can also provide a distinctive trade advantage. The relatively advanced countries—particularly the United States, Japan, and those of western Europe—have been the principal exporters of high-technology products such as computers and precision machinery.

One important aspect of technology is that it can change rapidly. This is perhaps most obvious in the computer field, where productivity has increased and costs have fallen sharply since the early 1960s (see Moore’s law). Such rapid changes present several challenges. For countries that are not in the front rank, it raises the question of whether they should import high-technology products or attempt to enter the circle of the most advanced nations. For the countries that have held the technological lead in the past, there is always the possibility that they will be overtaken by newcomers. This occurred in the second half of the 20th century when Japan advanced technologically in its automobile production to the point where it could challenge the automobile leadership of North America and Europe. Japan quickly became the world’s foremost producer of automobiles, and, by the early 21st century, Korean automakers were following the Japanese example with the aggressive export of automobiles.

Technological advances also strengthen global trade in a general sense: e-commerce (electronic commerce), for example, reduced the impact of geographic distance by facilitating fast, efficient, real-time ties between businesses and individuals around the world. Indeed, at the end of the 20th century, information technology, an industry that scarcely existed 20 years earlier, exceeded the combined world trade in agriculture, automobiles, and textiles.

The spread of technology across national boundaries means that comparative advantage can change. The most technologically advanced countries generally have the advantage in making new products, but as time passes other countries may gain the advantage. For example, many television sets were produced in the United States during the 1950s. As time passed, however, and technological change in the television industry became less rapid, there was less advantage in producing sets in the United States. Producers of television sets had an incentive to look to other locations, with lower wage rates. In time, the manufacturers established overseas operations in Taiwan, Hong Kong, and elsewhere. Concurrently, the United States turned to new activities, such as the manufacture of supercomputers, the development of computer software, and new applications of satellite technology.