Home > Uncategorized > Free trade

Free trade

from Lars Syll

In 1817 David Ricardo presented — in Principles — a theory that was meant to explain why countries trade and, based on the concept of opportunity cost, how the pattern of export and import is ruled by countries exporting goods in which they have a comparative advantage and importing goods in which they have a comparative disadvantage.

Heckscher-Ohlin-HO-Modern-Theory-of-International-TradeRicardo’s theory of comparative advantage, however, didn’t explain why the comparative advantage was the way it was. At the beginning of the 20th century, two Swedish economists — Eli Heckscher and Bertil Ohlin — presented a theory/model/theorem according to which the comparative advantages arose from differences in factor endowments between countries. Countries have comparative advantages in producing goods that use up production factors that are most abundant in the different countries. Countries would mostly export goods that used the abundant factors of production and import goods that mostly used factors of production that were scarce.

The Heckscher-Ohlin theorem — as do the elaborations on in it by e.g. Vanek, Stolper and Samuelson — builds on a series of restrictive and unrealistic assumptions. The most critically important — besides the standard market-clearing equilibrium assumptions — are

— Countries use identical production technologies.

— Production takes place with constant returns to scale technology.

— Within countries, the factor substitutability is more or less infinite.

— Factor prices are equalised (the Stolper-Samuelson extension of the theorem).

These assumptions are, as almost all empirical testing of the theorem has shown, totally unrealistic. That is, they are empirically false.

That said, one could indeed wonder why on earth anyone should be interested in applying this theorem to real-world situations. Like so many other mainstream mathematical models taught to economics students today, this theorem has very little to do with the real world.

Since Ricardo’s days, the assumption of internationally immobile factors of production has been made totally untenable in our globalised world. When our modern corporations maximize their profits they do it by moving capital and technologies to where it is cheapest to produce.

So we’re actually in a situation today where absolute — not comparative — advantages rule the roost when it comes to free trade.

And in that world, what is good for corporations is not necessarily good for nations.

  1. June 23, 2022 at 1:40 am

    Application of this theorem in the real world is how representative democracies convince controlled populations that their leaders are following clear free-market capitalist rules-based order.

  2. Edward Ross
    June 23, 2022 at 2:54 am

    FREE TRADE the question is who does it really benefit , is i the nation importing the goods from a third world slave labour production. balance this against the loss of jobs tn the importing country. The the problem is as Lars Syll describes it as”multinational corporations” with the immense power that they have. Ted

  3. yoshinorishiozawa
    June 23, 2022 at 7:33 am

    First of all, I must point out that very few people are really interested in trade theory and, therefore, there are so much of wrong information about international trade theory or theories, both on mainstream and heterodox economics.

    As for mainstream trade theory (or international microeconomics), it is widely spread and believed that mainstream economics on international trade is developing rapidly, pointing out four generations of trade theories:
    (1) (textbook) Ricardian trade theory (illustrated by the “four magic numbers”)
    (2) Heckscher-Ohlin-Samuelson trade theory (Heckscher and Ohlin’s ideas formulated in mathematical formula by Samuelson)
    (3) New trade theory (inaugurated by P. Krugman in 1980’s, believed to have given an explanation of emergence and importance of intra-industry trade in comparison to inter-industry trade)
    (4) New new trade theory (began by Melitz around 2003, claims to have “discovered” that international trade is done by firms with productivity superior than others)

    It is well known that Ohlin and Krugman were awarded the Nobel Prize for Economics (the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) in 1977 and 2008 respectively.

    Those who advocate that (mainstream) international micro is advancing, although it is arguable, are missing the other side of the coin. All four generations have the common defect as theories of modern day international trade. Three theories from (1) to (3) exclude by assumption trade of input goods (or intermediate goods). The new new trade theory (4) is merely a research of a “small” open economy, i.e. the USA. It is hard to say if the New new trade theory has any trade theory at all in a proper sense. It is only a new trend of research which became possible by the availability of big data. To repeat it again, four generations of mainstream trade theories have the common defect, i.e. the impossibility to treat input trade. This defect is serious, as you will see it in (A) below.

    Theoretical situation of heterodox trade theory is quite different. This is a rare field of economics where the heterodox economics has a clear superiority over mainstream economics. A new trade theory, based on the tradition of Ricardo and Sraffa, came to be developed rather recently (around 2007 to 2014) and is still steadily developing. See Shiozawa (2017) A new theory of international values: an overview and Section 5 of Shiozawa (2020) A new framework for analyzing technological change.

    The new theory has characteristics very different from those of mainstream trade theories. Let me point out only three (A typical comparison with mainstream theories are given in [ ]):

    (1) The new theory has an explicit theory of how international wage discrepancies emerges. [Vague theory in (1), foolish result in (2), and no theory in (3) and (4)]

    (2) International competition is formulated as choice of production techniques. [Technology is often neglected as (2) and (3) are typical.]

    (3) It is a general theory that can analyze world trade economy with many countries, many goods, and input trade. [(2) is normally restricted to the case of two countries and two products. An exception was Ronald Jones’ theory (1963). (3) is only a partial theory that assumes the same cost conditions for firms.]

    There are two points on which the superiority of the new theory over all mainstream trade theories is apparent:

    (A) Raw materials, parts and components, and tools and machines are all input goods. The fact that the new theory can formulate input trade in a general form is extremely important. This is evident, if we see that global value chains (GVCs) occupy major part of world trade. Four generations of mainstream trade theories cannot analyse GVCs, because they have no theory of input trade (except some ad hoc ones). To incorporate input trade among the trade theory was in fact a challenging objective for trade theorists since decades, because, as suggested by L. McKenzie, Lancashire could not have been the birth place of Industrial Revolution, if cotton was not imported from abroad, i.e. Caribbean countries, the USA, and others.

    (B) Another remarkable property of the new theory is that it can treat unemployment under international trade situation (This became possible in 2017). Trade conflicts occur mainly because workers in some industries lose their jobs. Tradition trade theory could not analyze unemployment, simply because they assumed full employment as a conditions of equilibrium. The new theory is constructed on process analyses and there is no need to assume full employment as an assumption.

  4. yoshinorishiozawa
    June 25, 2022 at 3:01 am

    Many people argue trade policies but know very little about (or are interested in) trade theories. Attacking free trade now by criticizing Heckscher-Ohlin (HO) theory is like attacking old totems. In the 21st century, there are few economists who eagerly support HO theory and its derivatives, although they have no alternative theories.

    Since the native days of economics, controversies over trade policies were one of main vehement subjects. Trade theories were developed mainly in order to give support pros and cons in these controversies. However, a trade theory is usually neutral, although believers in mainstream trade theories have a clear tendency to support free trade policy (One of reasons of this fact is given later). But there are exceptions. For example, Dani Rodrik, a political economist who believes (or believed?) in HO theory, argued against unconditional support for free trade. There was now a famous controversy between Rodrik and Greg Mankiw. See for the details Mark Thoma’s blog: Economist’s View at the post April 28, 2007: On the Other Hand … Rodrik versus Mankiw (Others Also Weigh In)

    I once posted a question in ResearchGate on July 21, 2016 under the title
    Who still supports Heckscher-Ohlin model? There are 41 answers to date, but there are a few who dare to support Heckscher-Ohlin.

    It is necessary to distinguish theory, theorems, and assumptions. Unfortunately, in Lars Syll’s post above on June 22, 2022, these three are not well differentiated.

    Factor prices equalization (FPE) is a theorem (not an assumption) that comes out logically mainly from assumption that countries have the identical production technology, when factor endowments lies in the so-called factor-price equalization cone. So, it is not an assumption. A common misunderstanding with FPE theorem is that it indicates that factor prices (wages and profit rates between countries) will approach to equality, but the theorem claims they are equal. So, we have clear counter-evidence for this theorem. (Consequently, at least, some parts of HO theory, including some assumptions, are wrong.)

    Another misleading explanation in Syll’s post is this: FPE theorem and Stolper-Samuelson theorem and what is usually called HO theorem are independent theorems within the same theory (and assumptions).

    There is a long history of empirical studies on HO or HOS (Heckshcer-Ohlin-Samuelson) theory. The most famous one was Leontief paradox (See en.Wikipedia). Leamer (1980) claimed that the paradox is in reality no paradox if we interpret the data correctly, but Brecher and Choudri(1982) pointed that, if we interpret them as Leamer did, we must assume that American workers’ expenditure must be lower than world average. Some other works followed.

    In 1980’s and 1990’s there were a series of new empirical studies on what is called HOV (Heckscher-Ohlin-Vanek) theory. It is based on Vanek’s idea (Vanek 1968) that international trade must be exchange of factors embodied in finished products. By this reason, HOV theory is often called factor-contents theory. Bowen, Leamer, and Sveiskaus (1987) showed that HOV theory has little power to predict the pattern of international trade (which country export which product). In Daniel Treffler’s work ” The Case of the Missing Trade and Other HOV Mysteries” (1995), HOV theory could only tell the pattern correctly only in 148 cases among 297 (49.8%). This level of prediction can be easily obtained by shuffling dice. Another Treffler’s results depicted in HOV theory two mysteries: (1) missing trade (the total volume of international trade that the theory predicts is too small) and (2) paradox of endowed resources. There were many other contributions, but this kind of efforts stopped by early 2000’s, mainly because no good results were expected.

    As I pointed it out in my post on June 23 in this page, mainstsream trade theories are based on equilibrium theory that assumes full employment as one of basic assumptions. This inevitably gives sure bias for free trade, because unemployment is one of major issues in pros and cons in trade policies, but this situation is excluded simply by assumption. However, there is also a trade theory (in heterodox orientation) that can analyze how unemployment emerges by transition to a freer trade regime.

  5. yoshinorishiozawa
    June 27, 2022 at 9:43 am

    A small comment on Lars Syll’s passage (second to last paragraph):

    It is rather custom to talk about (the differences of) comparative and absolute advantage, as Lars did in his second to last paragraph. It is certain that he did not much reflected about it, but the phrase like “we’re actually in a situation today where absolute — not comparative — advantages rule the roost when it comes to free trade.” does not have no clear meaning.

    It is not easy to differentiate comparative and absolute advantage even for classical trade theories where it is supposed that only final goods are traded when there are many countries and many goods (more than 3 countries and 3 goods). In the presence of input goods (goods that are used as inputs in productions, or intermediate goods), to define comparative advantage itself is extremely difficult (or, better to say, there is no good definition to compare which industry of a nation has a comparative advantage over others). See Alan V. Deardorff’s 2005 paper: Ricardian Comparative Advantage with Intermediate Inputs. North American Journal of Economics and Finance 16(1): 11-34. The draft version of the paper is available here.

    What kind of meaning can one give to absolute advantage, when comparative advantage has no meaning? My tentative conclusion is that the notions such as “absolute” and “comparative” advantage have no means. It is better abolish those ambiguous notions.

    This does not exclude to claim that a product of a country has the cost advantage when its cost is lower than that of other countries. In this cost calculation, we need wages of countries and prices of goods. The new theory of international value is a theory on how this couple of two vectors, i.e. the wage vector w = (w1, … , wM) and the price vector p = (p1, …, pN), is determined. Mathematics is useful, even necessary, to construct this theory.

  6. Jorge Morales Meoqui
    June 28, 2022 at 12:11 pm

    Unfortunately, Lars is parroting the same blatant misinterpretations of David Ricardo’s theory of international trade that can be found in current Econ textbooks.

    Ricardo did not explain in his Principles the pattern of trade based on the concept of opportunity cost. How could he? Austrian economist Friedrich von Wieser originally developed the opportunity-costs approach as part of his marginal theory of value almost one hundred years after Ricardo’s death. Moreover, Wieser explicitly conceived his value theory as an opposing view and main alternative to what he believed to be Ricardo’s theory of value.

    Another Austrian economist, Gottfried von Haberler, reformulated Ricardo’s quantities-of-labor requirements with opportunity costs in 1930 because he erroneously believed that Ricardo’s numerical example was based on the labor theory of value.

    Ricardo’s explanation in the Principles of why countries trade and the pattern of trade is straightforward. He stated:
    “The motive which determines us to import a commodity, is the discovery of its relative cheapness abroad: it is the comparison of its price abroad with its price at home.”

    That has not changed since 1817.

    Moreover, nowadays capital does not move as easily between countries as it moves within the borders of the same country. That is why there are still persistent differences in the rate of profits between countries, as Ricardo pointed out in the Principles.
    However, Ricardo would have agreed with you on the last point: what is good for corporations is not necessarily good for nations. That is why he supported free trade: it is beneficial for consumers and hurtful for some corporations that would benefit from protection.

    Morales Meoqui, Jorge. 2021. Overcoming Absolute and Comparative Advantage: A Reappraisal of the Relative Cheapness of Foreign Commodities as the Basis of International Trade. Journal of the History of Economic Thought, 43 (3): 433–449. doi:10.1017/S1053837220000401.
    Morales Meoqui, Jorge. 2017. Ricardo’s Numerical Example versus Ricardian Trade Model: A Comparison of Two Distinct Notions of Comparative Advantage. Economic Thought, 6 (1): 35-55.

  1. No trackbacks yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: