Overview of Trade Theories

21^st century is a complex world, where world economy has been facing new threats every day. With rise in the interdependence between the nation, world market is now highly complex in nature that makes it even harder for the researchers to develop new theories that aid to have sustainable growth (Sachs 2015). Natural resource being exploited by all the economies has become scare that makes it tough for the economies to have sustainable growth.  Thus, with most of the countries involved in trades, it is highly important to understand the framework of resource production, allocation and consumption. Among most of the trade theories that tried to explain the phenomenon under analysis in this essay, comparative advantage theory produced by David Ricardo is one of the suitable one (Weder 2017). This essay is meant to analyse how well the Ricardian theory of Comparative can explain the framework of scare resource production, allocation and consumption. While analysing the phenomenon under research, this essay will provide insight to the real world scenarios and trace the magnitude of efficiency of the comparative advantage theory compared to other models of trade theories.

Since last two centuries, there has been various researches to trace how trading can define how scare resources are produced, allocated and distributed in the global economy, however most of them has proved to be failure to provide any fruitful solution (Tietenberg and Lewis 2016). Absolute advantage produced by Adam Smith was the then latest theory of trade that explained the trade flow properly (Feenstra 2015). If two economies are performing trade with two commodities, then the country that has absolute advantage in one good will exports the same and import the other and vis-a-vis (Levchenko and Zhang 2016). An economy that can produce a commodity with higher efficiency compared to other nation is said to have absolute advantage in production of that good compared to its trading partner. If there is difference in efficiency in production of tradable, then trade can take place between two countries (Watson 2017). However, absolute advantage model failed to provide any solution in the case if a country has absolute advantage in production of both the goods, then how trade will take place and scare resource will be produced, allocated and consumed. During 1817, another trade theory developed by David Ricardo came in and it explained the resource production, allocation and consumption theory in different way (Laursen 2015). According to the theory of David Ricardo, though one trading partner may have absolute advantage in production of both the tradable, yet trade can take place due to mutually beneficial trading (Granot 2017). Ricardian model of trade theory considers opportunity cost as the deciding factor of trade flow. According to the Morales (2017), Ricardian model accepts the opportunity cost that accepts the value, which has to be forgone to producing something else. It may so happen a country has absolute advantage in producing both the good; however it may not have comparative advantage in production of both the commodities. Depending upon this theory, Ricardian model tried to explain the scare resource production, allocation and consumption framework and achieved success (Rossi-Hansberg 2017). 

Comparative Advantage Theory

Utilising an analytical framework of comparative advantage, production, allocation and consumption theory of scare resources can easily get explained. As showcased in table 1, it can be seen that UK has absolute advantage in production of both the commodities. While endowing all the resources, UK can produce either 5 clothes or 12 aeroplanes and US can produce either 4 clothes or 1 plane utilising all the available resources. According to the absolute advantage theory, UK has production efficiency in both the commodities and there may not be any trade between these two nations (Cstinot et al. 2015). However, when the same production matrix is contested through the Ricardian model, then the result will be different.

Table 1: Maximum production matrix

Source: (Created by Author)

According to the Ricardian model, it will try to find the opportunity of producing both the commodities and decide the trade flow (Hoekstra et al. 2018). From table 1, it can be seen that opportunity cost of producing clothes for UK is (12/5 = 2.4) and US producing clothes is (1/4 = .25). On the other hand opportunity cost of producing aeroplanes by UK is (5/12 = .41) and opportunity cost of producing aeroplanes for US is (4/1 = 4). From this analysis it can be seen that US has higher opportunity cost in the case aeroplane production and UK has higher opportunity cost of producing clothes. Thus, according to the Ricardian model it is better for UK to produce aeroplanes and let the US produce clothes.

From the above analytical  example it can be said that Ricardian model has  the ability to explain how scare resources are produced, allocated and consumed through trading, however, over the time various other theories came in that either tried to develop the Ricardian model or tried to bring in new model of trade analysis. One such, example is Heckscher – Ohlin model which came in to existence during 1919 (Nunn and Trefler 2014). It argued that factor endowment capability is another deciding factor that controls the trade flow. According to this model of trade, different goods and services need different proportion of input for production and different countries have different level of factor endowment capability (Bodislab et al. 2016). Considering this factor endowment model, it can be said that a trading country will import only that goods or service in which production need those factors that are scare in that nation and export that commodity in which it has abundance of factor inputs. Thus, according to this new proposed model, factor endowment is another essential factor that determines the trade flow (Baldwin 2017). Utilising this framework it can be said that a trading country will produce only capital intensive goods if it has abundance of capital and import the labour intensive good. On the other hand a trading country, which has abundance in labour, will produce labour intensive good, while importing capital intensive good. Thus, this extended version of comparative advantage explains the scare resource production, allocation and consumption framework from the perspective of factor endowment. 

Heckscher – Ohlin Model

During the 19^th century, trade theories that explain the scare resource production, allocation and consumption framework become well documented; however, most of them explain the scenario from the theoretical perspective (Balistreri and Tarr 2016). Leontief attempted to test the validity of the Heckscher – Ohlin model and found himself in precarious situation. According to the Heckscher – Ohlin model of comparative advantage, country that has labour abundance, will export the labour intensive good and country that has capital abundance, will export capital intensive good. However, while contesting this phenomenon with the US data of export since 1947, Leontief found that, though US is a capital intensive nation, it has exported those goods, which are labour intensive in nature and imported those goods, which are capital intensive in nature (Iannaccone 2016). This phenomenon is acknowledged as the Leontief paradox and it rejects the Heckscher – Ohlin model and return to basis of Ricardian model of comparative advantage to describe the phenomenon under assessment in this essay. Leontief, proposed that, rather than focusing on factor endowment, it will be better for the economies to consider the terms of technology as the deciding factor of scare resource production, allocation and consumption framework. 

Vernon model of intra industry trade is one of the most developed theories that explain the present trading scenario. According to the research of Vernon, every product goes through a life cycle, which is sub-divided into five stages. According to the figure 1, product development is the first stage, where profit is negative. During introduction stage product started to gain customer and profit rises. Moving forward, growth stage, producer starts to export the good to the foreign market and profit enhances leading the product to the maturity stage (Matsuyama 2017). At this stage production is at its peak as well as profit. However, post this stage, importing countries gain technological knowledge regarding this product and starts to produce it.

It has been found by Vernon that, most of the products are being produced by the developed nations and exported to the developing nations initially (Charter and Tischner 2017). However, post the maturity stage, importing countries gain maturity in technology and become producer of the same good at lower cost. In this scenario, developed nation become the importer of the good that they were exporting.

Figure 1: Vernon product life cycle model

Source: (Tolentino 2017)

Jogn and GIllies contradicted the Vernon’s model and argued that with the governmental restrictions, trade can flow can be altered during the product life cycle (Lall 2016). For instance, Minimum wage law in developed nation constrained them to produce goods at lower cost and enhance the scope of intra –industry trade between developed and developing nations. This contradicts the Vernon’s principal greatly and makes it limited under factor like governmental law.  

Leontief Paradox

Classical trade theories of comparative advantage with porter model:

Classical trade theories of comparative advantage argue that factors like firm’s strategy, structure and rivalry defines the production, allocation and consumption of scare resources. With higher rivalry and better strategy scope of developing new technology is high, which will lead to export of goods and services t foreign nation. On the other hand enhanced demand will force to go for further development in technology aiding to higher production, allocation and consumption (Wu, Ma and Zhuo 2017).

Figure 2: national advantage diamond

Source: (Konsolas 2017)

With the help of governmental aid, demand and factor endowment condition can get enhanced, leading to higher degree of innovation, resulting in further trading (Akbar 2017). Besides this, Krugman’s theory of economies of scale is still valid to trace the framework of resource production, allocation and consumption framework (Balistrei and Tarr 2016).

Comparative advantage is one of the best models that described the scare resource production, allocation and consumption framework (Duchin et al. 2016). However, considering the present situation of the trading economy it can be seen that the model is not up to date. Though, initially comparative advantage was beneficial to trace the scare resource production, allocation and consumption framework, however owing to lack of finding the deciding factor of trade, it has now become obsolete (Gilpin 2016). New theories has been developed over time that considers the intra-industry trade as the incentive of trade and utilising the models like Vernon’s life cycle framework, porter’s model it has become well established. In the complex scenario of 21^st century, it has become clear that opportunity cost of production does not matter anymore, rather factors like skilled labour, knowledge of production, advancement in technological field, governmental support and cultural values influence the trade largely (Terjesen, Hessels and Li 2016). For instance, from the scenario of Russia, it can be seen that, though the country has abundance in oil, it does not export the same to Europe due to government restriction. Rising tension in the middle-east has imposed various sanctions on Russian export that has constrained the trading (Richter and Holz 2015). Thus, in present scenario factor abundance or opportunity cost of producing goods is not able to describe the production, allocation and consumption of scare resources that makes the comparative advantage theory obsolete. 

Conclusion:

From the above analysis it has been clear that comparative advantage is one of the best trading theories that explain the production, allocation and consumption of scare resources. With the help of the opportunity cost as the determinant of trade, it described the trade flow framework during 19^th century. Successive modification in the model by various researches like Heckscher Ohlin, Leontief has made the Ricardian model of comparative advantage more efficient to describe the trade flow. However, over the time trading economy become complex and lack of clarity in the Ricardian model made it exhausted. New theories of intra-industry trade have explained the trade flow from the multi spectrum view that has deliberately explained the scare resource production, allocation and consumption theory. Thus, to conclude this, it can be said that, Ricardian model of comparative advantage was potent during the early days however, in present scenario it is not that much able to describe the production, allocation and consumption of scare resources that one might have thought during initial phase of this research work. 

Vernon Model of Intra Industry Trade

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