New Trade Theory International Trade Operations
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Published: Tue, 25 Apr 2017
Mercantilism was the model use during the early stages of international trade. According to Brendan McGuigan Mercantilism is a mostly historical economic theory that holds the wealth of a nation can be measured by its ready supply capital, generally held in a concrete from gold or silver,(Mc Breanda, 2003). This model was practice throughout Europe in the 17th-18th centuries. It was a system that required nations to meet certain objectives, which were to export goods to other countries, rather than, importing from other countries. They believe that a nation wealth depended on treasure, gold or silver were the currency trade.
Adam smith and David Hume challenged the mercantilist model. In 1752, David Hume stated two problems, which were:
The quantity of gold/silver was less important than the quantity of goods and services the gold/silver could buy
The species-flow mechanism it was claimed would invalidate the long-run viability of mercantilism policies.
Adam smith published a book in 1776 called “Wealth of Nation”; which talks about the operation of the market in a modern economy. He mentions free international trade and that a country should produce only goods where it is more efficient, and trade it for those goods where it is not efficient, so this will make trade between countries more beneficial. A country has an absolute advantage, when it came produce a good with less resource than their competitors. An example from Adam smith book ” if one unit of labour in India can produce 80 units of wool or 20 units of wine; while in Spain one unit of labour makes 50 units of wool or 75 units of wine, then India has an absolute advantage in producing wool and Spain has an absolute advantage in producing wine. India can get more wine with its labour by specializing in wool and trading the wool for Spanish wine, while Spain can benefit by trading wine for wool”(Smith, 1904).
Ricardo came up with the model called “Comparative Advantage”, which basically means, a country will not have an absolute advantage. It also mentions that even if one country has an absolute advantage in all good, both countries will still gain by trading with each other. Ricardo also said that, countries that want to gain from trade, should not necessary access absolute advantage.
New Trade Theory Development (Ali Swehli)
New trade theory was developed in the 1970’s and 1980’s; however free trade can be said to have been in the making for almost two centuries. The trade theory which has set the path of modern trade theories such as the NTT and the NNTT was mercantilism which was widely used across Western Europe from the 1500’s up until the end of the 1700’s. Mercantilism is a theory which is said to have been the reason of many War’s in Europe at the time due to its theory that governmental supervision of foreign trade is of great importance for empowering the army to secure the country. A fixed set of mercantilist theories have never been defined as the theory alters from one theorist to another. The theory evolved over time, however in its most basic form the theory was considered bullionism, which calculates wealth based on the metals owned. Other common factors include creating networks, monopolizing markets, minimizing wage, and export subsidies.
The mercantilism theory was gradually in decline by the 17th century and by 1776 came the theory of absolute advantage (first described by Adam Smith) which was the second step of evolution of modern international trade. AA (absolute advantage) calculates the ability of a country, or a party to produce more of a good or service than their competitors using the same (or even less) amounts of resource. When Adam Smith first described the theory he used labour as the only input. The theory explains that an absolute advantage is based by comparing labour productivies, which creates the possibly of countries with no absolute advantage whatsoever, in that case AA indicates that no trade will occur with other countries. The theory of absolute advantage contrasts the theory of comparative advantage.
Comparative Advantage is the ability of a country to produce a specific good at a lower marginal and opportunity cost over other nations. The theory, which is an updated version I believe of the Absolute Advantage theory, explains that even if a country is more efficient in production in all its goods (absolute advantage) than other nations, both countries will still gain from trading with one another as long as the level of relative efficiencies differ from each other. The theory was first described in the early 19th century and later evolved in to two directions, the Ricardian theory and the Heckscher-Ohlin theory. In both theories the comparative advantage is created under the umbrella of two countries, with two commodity cases. It may however be extended (ex: 2 countries many commodities etc.).
The Hecksher-Ohlin Model is a General equilibrium mathematical model of global trade theory, a subsidiary of theoretical economics. It was first described by Eli Hecksher and Bertil Ohlin in the 1930’s and came to be a major mathematical theory in international trade. The theory builds on the ideas and beliefs set by David Ricardo (comparative advantage) and is the next stage in the evolution of our global theoretical thinking behind trade. The theory effectively says that countries tend export goods and services that use the countries cheap and abundant factors of production and import products that use the countries scare and limited resources. A great example of this is the USA’s importation of oil; the largest oil consumption nation in the world, the largest oil importer, while it has one of the largest reserves in the world.
International trade, the exchange of goods, services and capital across international borders has been evolving in an unprecedented manner for the past half a millennium. Trade theory’s which are used around the world are used for a specific purpose to fulfil the needs of specific groups of people. For example in the 15th hundreds the world’s major economic nations used the mercantilist theory of trade, which revolved around war and be a dominate nation. Although some of the mercantilist policies still exist today, the policies which deemed to be useless was scraped over its existence, and by the late 18th century the theory was not used altogether. However thanks to the some of the policies it established it created the path of upcoming trade theory’s that would benefit the world. As everything else, international trade has evolved and will continue on evolving to continuously meet the demands of not just the major economies but all the economies of the world. The New Trade Theory and the New New Trade theory is by no means a perfect set of economic policies and theories, however it is better than the theory’s used prior to it, and the theory’s that will come after it will undoubtedly be better.
New Trade Theory (Jamie Love)
New trade theory is a collection of economic models in international trade but addresses the shortcomings of traditional trade theory (old trade theory: Ricardo & Heckscher-Ohlin) by understanding some of the realities and complexities of trade and incorporating the factors it brings. Traditional trade theory mainly limits itself to perfect competition, Inter-industry trade and restricts to only labor intensity (Ricardo’s theory) and differences in factor endowments (Heckscher-Ohlin theory) between countries as a major source of comparative advantage.
Perfect competition- is a market structure in which there are many buyers and sellers in the market selling identical products or services that have no influence on the level of price.
Inter-industry trade- is trade between countries of goods from different industries.
Factor endowments are-, “a country’s amount of land, labor, capital, and entrepreneurship that a country possesses and can exploit for manufacturing (BusinessDictionary.com).”
New trade theory takes into account factors of comparative advantage within the model rather than outside, as opposed to traditional theory, and brings in factors such as Intra-industry trade, imperfect competition, mobility of factor endowments, transportation costs, and economical and political differences between nations.
Intra-industry trade- is trade between countries of goods from the same or similar industries. Types of intra-industry trade are homogeneous goods, horizontally differentiated goods and vertically differentiated goods.
Imperfect competition- is a market structure in which elements of monopoly allow producers or consumers to exercise some control over market prices.
Intra-industry trade is trade within an industry that produces differentiated products in the same industry. This trade does not reflect comparative advantage, but reflects economies of scale. Increasing returns to scale (economies of scale) and product differentiation are drivers of intra-industry trade. New trade theory assumes that an industry has increasing returns to scale when all factors of production are doubled and as a result output production more than doubles; which will force industry’s to engage in international trade. The existence of increased economies of scale implies that the industry may consist of monopolistic competition (imperfect competition) which leads to an engagement of international trade. Engaging in international trade increases market size, increases an industry’s economies of scale, decreases the average cost in an industry and increases trade variety (differentiation) of goods and services that consumer’s can buy and benefit from due to lower prices.
New trade theory suggests that industries that can produce a specific product at a lower cost than their competitors may exploit this comparative advantage, dominate the market, and still benefit the consumer. This comparative advantage is due to factor endowments such as natural resources or labour and skills when producing a product. New trade theory also suggests that countries may import a similar good that they export to produce more variety in the market and as a result, more variety for the consumer. This process also decreases the variety of goods around the world due to brand awareness of certain goods becoming staples in the worldwide economy.
New trade theory takes into account the limitations that traditional trade theory does not address, such as transportation costs of goods and services and mobility of factor endowments that are constituents to include in international trade. New trade theory acknowledges that transportation costs also affect international differences in goods prices and that prices are not equalized internationally as opposed to traditional trade theory. Mobility of factor endowments such as labour and capital mobility was also limited in traditional trade theory, but as global trends in international trade changed, new trade theory acknowledged that mobility of labour and capital between industries and nations are possible and a real world reality in international trade. An example of mobility of capital and labour would be of the global trends of capital investments of developed countries into developing countries for cheaper labour; and labour mobility caused by global trends of nations seeking jobs elsewhere for the benefits of higher wages, skills and education.
Economical and political differences between nations in international trade is also another factor that new trade theory acknowledges in its model by understanding the differences in taxation, laws, government interventions and currency exchange rates of international trade differences between nations and how they affect the prices of products and services. Examples of economical and political differences would be of protectionism measures such as trade barriers between nations of trade.
In conclusion, new trade theory addresses the limitations and assumptions of traditional trade theory. New trade theory argues that economies trade and specialize to take advantage of increasing returns and lower costs, not subsequent differences in factor endowments that traditional trade theory addresses. International trade allows countries to specialize in a limited variety of production without reducing the variety of goods available for consumption.
Limitations & Assumptions of Traditional Trade Theory (Ricardo & Heckscher-Ohlin):
Transportation costs ignored
Factors of labour and capital are immobile between nations
Full employment and demand are identical in both countries
No trade restrictions (ex. tariffs)
Consumer demand ignored
Ignores factors of technology, different qualities of labour, various techniques of production
Restrictive to only two countries and two commodities (labour and capital intensive)
Complete specialization (ex. England specializing fully on cloth and Portugal on wine)
Countries differ in factor of supply and factor intensity
Constant returns to scale (input is equal to output)
New Trade Theory Addresses:
That there is trade between many countries with many commodities
Labour and capital are mobile between nations and within nations
Takes into account factors of transportation, technology, and political and economical differences (ex. Trade barriers)that affect international trade and prices.
Demand, Supply and Consumption are taken to account
Notes that complete specialization of commodity depends on demand
Acknowledges that trade is possible between nations of identical size, industry, resources and demand
Economies of scale (cost advantages of industries due to size which provide a decrease in costs)
Increased economies of scale (increase in inputs leads to a more than proportional increase in outputs)
Acknowledges that specialization in goods and resources are based on economies of scale, factor endowments, technology, transportation costs, etc.
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