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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.

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