International Trade Theories and Globalization Waves

Posted on Feb 9, 2025 in Economy

International Trade Theories: From Mercantilism to Modern Globalization

The Mercantilists, 1500-1800:

  • Minimize imports and maximize exports, generating a net inflow of foreign exchange and maximizing the country’s gold stocks.
  • The world’s wealth was considered fixed.
  • Gains from trade were believed to be at the expense of trading partners.

Adam Smith and Absolute Advantage

  • Smith argued that the world’s wealth is not a fixed quantity.
  • All countries can benefit from international trade.

Principle of Absolute Advantage: In a two-country, two-product world, trade will be beneficial when one country has an absolute advantage in one good and the other country has an absolute advantage in the other good. A country will export the good in which it has an absolute advantage and import the good in which it has an absolute disadvantage.

One limitation of the theory of absolute advantage is that mutually beneficial trade requires each country to be the least-cost producer of at least one good.

Comparative Advantage

The less efficient country should specialize in and export the good in which it is relatively less inefficient.

  • Differences:
    • Absolute advantage emphasizes labor productivity.
    • Comparative advantage emphasizes opportunity cost.

Comparative Advantage & Global Supply Chains

  • The Ricardian theory assumes production cannot move to other nations.
  • Global supply chains use outsourcing:
    • Subcontracting work to another firm, or
    • Purchasing components rather than manufacturing them.

Limits of the Ricardian Model

  • Labor is the only input of production.
  • No trade costs exist, leading to complete specialization.
  • Cannot explain intra-industry trade (among industrial countries).
  • Contradicts the theory of comparative advantage.

Factor Endowment Theory

The ultimate determinants of comparative advantage are technology, resource endowments, and demand. Ricardo only focuses on differences in technology (labor productivity) across countries. Factor endowment theory focuses on the role of relative differences in resource endowments.

Properties of Capital

  • Some forms of capital require investment (learning knowledge, building machines), others do not (natural resources).
  • Capital is only used in the production process.

A country exports goods using abundant resources and imports goods using scarce resources.

By redirecting demand away from scarce resources and toward abundant resources, trade also leads to factor-price equalization in addition to product-price equalization.

Gains and Losses from Trade

  • Ricardo assumes that labor is the only factor of production, with no differences within countries, making it unsuitable for analyzing the distributional effects of trade.
  • Factor-endowment theory involves two factors of production, allowing for analysis of the differential effects of trade on workers and owners of capital.
  • The effects of trade on the distribution of income can be summarized in the Stolper-Samuelson Theorem.

Stolper-Samuelson Theorem

An increase in the price of a product increases the income earned by resources that are used intensively in its production. Increased demand will make this resource more expensive in the domestic market, hence increasing the income of the owner. Conversely, the income of the owner of the resource abundantly used in producing the imported good will decrease.

Key Features of Trade Theories

  • Theory of absolute and comparative advantage:
    • Differences in labor productivity.
    • Everyone is the same within countries.
    • Product price equalization.
  • Factor endowment theory:
    • Differences in factor endowments.
    • Different groups within countries.
    • Product price equalization and factor-price equalization.

Inter versus Intra-Industry Trade

Factor endowment theory and the theory of comparative advantage only explain inter-industry trade, which is based on inter-industry specialization. Each nation specializes in industries in which it enjoys a comparative advantage.

Intra-Industry Trade

Advanced industrial nations emphasize intra-industry trade, which is two-way trade in a similar commodity. Most such trade is conducted among industrial countries.

Economies of Scale and Trade

Economies of scale can affect trade patterns through the home market effect: countries will specialize in products that have a large domestic demand. Krugman constructs an international trade model that includes the Dixit – Stiglitz demand function. A key feature is that utility from consumption does not only depend on the quantity consumed, but also the variety of goods consumed.

Comparative advantage can also be affected by:

  • Industrial policy: strategy to develop certain industries.
  • Regulatory policy: regulations on business.

Tariffs

  • Specific tariff: Fixed amount of money. Consumer price = producer price + specific tariff.
  • Ad valorem tariff: Consumer price = producer price *(1+ ad valorem tariff rate).
  • Compound tariff: Mixture of specific and ad valorem tariff.

Valuation:

  • Free-on-board (FOB) valuation: Tariff is applied to a product’s value as it leaves the exporting country. Used in the United States.
  • Cost-insurance-freight (CIF) valuation: Tariff is applied as a percentage of the imported commodity at its final destination. Used in European countries.

Rules of Origin

Two basic concepts:

  • If only one country is involved, the “wholly obtained” concept will be applied.
  • If two or more countries are involved in the production of goods, the concept of “last, substantial transformation” determines the origin of the goods, which can be determined by:
    • Change of product category.
    • List of manufacturing or processing operations.
    • Value-added rule.

Product Standards

  • Trade barriers associated with product standards.
  • Differences:
    • Tariffs increase the marginal cost of products reaching consumers.
    • Product standards can affect both the marginal cost and fixed cost of production.
  • Two principles of GATT/WTO:
    • Reciprocity.
    • Non-discrimination.

Most Favored Nations (MFN)

If GATT members granted lower tariffs to another member, it had to do the same for all other members.

GATT/WTO Rounds

  • 1964-67, Kennedy Round:
    • Focus shifted from product-by-product format to across-the-board format.
    • Tariffs negotiated on broad categories of goods; rate reduction applied to the entire group.
    • Tariffs on manufactured goods cut by an average of 35% to an average ad valorem level of 10.3%.
  • 1973-79, Tokyo Round:
    • Tariff rates cut across the board from 7% to 4.7%.
    • Tariffs so low that they are no longer a barrier to trade in industrial countries.
  • 1986-1993 – Uruguay Round:
    • Tariffs eliminated entirely in several sectors.
    • Many nations agreed for the first time to bind or cap a significant portion of their tariffs.
    • Progress in reducing non-tariff barriers.
    • “Tariffication”: eliminate quotas and other forms of trade barriers and only use tariffs instead.
    • The last successful round of multilateral negotiation.

Doha Round: 2002 –

  • Goal: further reducing trade frictions.
  • The needs of developing countries are acknowledged.
  • Center of debate: large reductions in developing countries’ industrial tariffs in exchange for greater access to agricultural markets of rich nations.
  • Last straw: disagreement on the Special Safeguard Mechanism, a measure designed to protect poor farmers by allowing countries to impose a special tariff on certain agricultural goods in the event of an import surge or price fall.

National Treatment

Imported products must be treated the same as domestic products, at least after entering the customs territory. This is the other pillar of the non-discrimination principle, intended to ensure that tariff reductions would not be circumvented through the substitution of policy instruments. It is the most powerful weapon to deal with regulatory protection in the GATT era.

Waves of Globalization

First Wave of Globalization

  • Exports as a share of world income nearly doubled to 8%.
  • Per capita incomes increased 1.3% per year, compared to 0.5% per year in the previous 50 years.
  • Nations that actively participated in globalization became the richest countries in the world.
  • Brought to an end by World War I.

Second Wave of Globalization (1945–1980)

  • The horrors of retreat into nationalism renewed the incentive for globalization.
  • Falling transportation costs fostered increased trade.
  • Trade liberalization was not uniform, mainly involving developed countries and manufactured goods.
  • Continuing trade barriers in developed countries, unfavorable investment climates, anti-trade policies of developing country governments, and dependence on agricultural and natural-resource products hindered progress.
  • Developing countries as a group were left behind.

Third Wave of Globalization (1980 to present)

  • Many developing countries have participated, led by China, India, and Brazil, which entered world markets for manufactured goods.
  • Other developing countries are increasingly marginalized in the world economy, with decreasing incomes and rising poverty.
  • Significant international capital movements have occurred.
  • The world is more globalized, with increased international trade and capital flows.
  • Global supply chains have emerged, with production separated into stages or tasks that are undertaken in many countries, forming an international production network.