Exploring The Standard Trade Model And Heckscher-Ohlin Theory In International Trade Essay.

Theories of Trade

The Standard Trade Model extends the theories of Absolute and Comparative Advantage to incorporate the importance of increasing Opportunity Costs in international trade. The Heckscher-Ohlin Theory extends these models further by seeking to explain the underlying determinants of Comparative Advantage.

(1) Explain briefly the main features of each of the concepts or theories highlighted in bold and italics above and how they are related to each other.

(2) Evaluate whether these theories are sufficient to adequately account for why countries engage in international trade and the benefits that such trade can yield for them.

(3) With reference to your own home nation, or any other nation known well to you, examine the extent to which that nation actively engages in international trade or practices restrictions upon such trade.

International economics uses the same fundamental methods of analysis like other domains of economics. This is because; the motives and the behaviour of the participants are same in the international trade as they are in domestic exchange.  This paper will briefly explain some concepts of international economics, like, standard trade model; absolute advantage; comparative advantage and Heckscher-Ohlin Theory. It will also evaluate whether these theories are sufficient to understand why countries are engaged in international trade. Moreover, one nation will be selected to examine its engagement in international trade and its restrictions upon such practices.

Absolute Advantage and Comparative Advantage

Absolute advantage and comparative advantage are two fundamental ideas in international trade. Here, the discussion will be made based on two countries and two commodities. Absolute advantage implies the capability of the country to produce a certain good more efficiently than other country. The capability is measured by comparing the resource engagement to produce that good. This means that, the country is said to have absolute advantage in producing a product, when it can produce the particular good with less of a given resource than its competitor nation. In other words, the cost of production of one country is less than the other one. Therefore, the absolute advantage compares the productivity of different countries.  According to this theory, the country will produce that commodity, which they can produce by engaging less resource (Krugman, Obsfeld and Melitz 2015). However, the limitation of this concept is that, it might happen that a country is resourceful and has absolute advantage in all commodities. However, one country will not produce all the goods if it has option for trade. Therefore, it has to decide which good it should produce and import to another country. Hence, the concept of opportunity cost arises.

Opportunity cost is the cost that arises due to shifting its resources from one good to another. Suppose the country can allocate its resources in goods, clothes and food. To produce one extra unit of clothes the country has to sacrifice some units of food. The forgone amount of food is the opportunity cost of the one unit of extra clothes. The country has a comparative advantage in producing a good if the opportunity cost of producing that good is lesser than the other country. According to this theory, the country will produce and trade that commodity whose opportunity cost is less, i.e. in which it has comparative advantage. The difference between opportunity costs provides the chances of a mutually beneficial rearrangement of the world production (Feenstra 2015). This solves the problem of absolute advantage, because even if the country has absolute advantage in all goods, the different countries have different comparative advantages. When the countries produce the good in which they have comparative advantage, both of them benefit from trading. This is because each of them will get the commodity at a price that is lower than its own opportunity cost of producing that particular good. This drives the country to specialize in that good, which has the lowest opportunity cost.

Absolute Advantage and Comparative Advantage

The Standard Trade Model extends the absolute advantage and comparative advantage theory by incorporating the importance of opportunity cost. In presence of Autarkic situation, the equilibrium occurs when the community indifference curve is tangible to the Production Possibility Frontier. The slope of the tangent gives the equilibrium relative price. This slope also indicates opportunity cost of producing one good in terms of forgone amount of another good (Gandolfo 2014).  The standard model of trade is driven by the differences in the opportunity cost. The following diagram (Figure 1) represents the autarkic situation in two countries. The nation 2 has less opportunity cost in producing cloth, reflected by the flatter slope (Green Line). Hence, it will specialize in Cloth. Similarly, the nation 1 will specialize in Food production.  The Figure 1 represents an autarkic situation.

Figure 1: Autarkic Situation

Now the trade has taken place between these two countries. The movement of production due trade will change the point of production along the PPF curve. At the new point of production, the countries will be able to trade and produce more of the commodity in which it has less opportunity cost. The community indifference curves of the both countries will shift to the higher position. The following Figure 2 represents the trade of the two nations. At point “    ” , the export and import of both nations matches with each other.

Figure 2: International Trade

The resource of the country influences the trading pattern. The Heckscher-Ohlin model uses the concept of comparative advantage. It shows that the resources influence the comparative advantage. The abundant factors of production and the intensity of the factors used, determines in which the country has comparative advantage. This model assumes that, there are two countries and two commodities; the two factors of production are capital and labour (Van Marrewijk, Ottens and Schueller 2012).  Suppose the two goods are A and B respectively. The cost of production depends on the factor price. If the wage, the cost of labour, rises then price of the good whose production uses labour will also rise. However, how much the factor price influences the commodity price depends on how much of that factor is involved to produce that good.

The For example, if the production of commodity A uses few labours then a rise in wage will not have much effect on the price of the commodity. In contrast, if the production of commodity B requires more number of labours, then a rise in the price of factor will lead to significant rise in the price of the good B. Hence, there is one-to-one correspondence between wage-rental ratio and the ratio of price of good A to that of B (Krugman et al. 2015). The major components of Heckscher- Ohlin Model are: Rybczynski Theorem; Factor Price Equalization Theorem; Stolper- Samuelson Theorem (Guillo and Perez-Sebastian 2015).

Standard Trade Model

How both countries are benefitted from trade can be explained by utilizing the concepts of theories of trade discussed above. The countries are different from each other in terms of factor abundances. When the trade is taking place between two countries the relative price tends to converge.  The country produces and trades the goods in which it has comparative advantage. By this way, the country can send one commodity to foreign country and receives another commodity, at lower price than it would have charged given the goods were produced in the home country. However, it is important to verify whether the both countries are gaining from trade. When the relative price of a commodity is greater than the opportunity cost of producing that good, then the country specializes in that commodity and exports it to foreign market . The country can produce a particular good more efficiently and indirectly produce the other good in the foreign market. Similarly, the foreign country indirectly produces the good in which it is inefficient. Hence both are gaining from trade. Moreover, the benefits of both countries can be verified by country’s new possibility of consumption. This is represented in the following Figure 3.

Figure 3: Gains from Trade (comparative advantage)

Moreover, the countries are involved in trade due to resource scarcity. Since, the country produces commodity that requires resources in which the country is rich in, it can still avail the good that uses the scarce resources, without involving those resources. Therefore, each country’s consumption possibilities are expanded through trade. The economy as a whole consumes more of both good. This can be illustrated through the following diagram, Figure 4. In this diagram, two countries’ relative price and PPFs have been represented. It can be seen that due to nation’s participation in trade, both countries have shifted to higher indifference curve. This indicates that the two countries are consuming more of both commodities than the autarkic situation (Rosnick 2013).

Figure 4: Gains from Trade (H-O Model)

With the growing development in the poor countries and due to the effect of globalization, the developed countries like United Kingdom have lost market share in exporting goods. However, the country has maintained its exports of service sector.  United Kingdom is the sixth largest trader in the world and third largest exporters of service. The exports and imports of goods and services totaled 1256 billion USD. The share of UK’s service export peaked in 2004; however, it fell down in 2007 and continued till 2010 (Gov.uk, 2012). On the other hand, the goods exports of UK declined in 2010. This country accounts for 22.8 % financial services export but only exports 2.6% of construction service export . The pharmaceutical export is significantly large. UK constitutes 3.3% of Singapore’s export (Gov.uk 2012). The growth in trade performance of this country within 2002 to 2008 was faster than the trade growth in the 1990s. However, the growth of international trade was halted during the global crisis.  During this time the exchange rate depreciated by 25%. This made the export of this country more competitive and made import much costlier (De Propris 2013). Though it has helped the country expand its volume of export but could not reduce the demand for import. As a result of this the net trade balance is negative for this country. Moreover, the trade balance of this nation is still negative due to large gap in export and import (Inman 2016).

Heckscher-Ohlin Model

United Kingdom has comparative advantage in Creative Industry; Tidal industry and Robotics and Autonomous Systems. This country has become efficient in generating knowledge and information. They are more developing their culture through their creativity. A creative economy comprises of art, crafts, fashion; Design; film etc. Human capital is the ultimate source of this industry (Ganotakis 2012). It is also global leader in marine energy. The research and development of advanced machineries might lead this country to become a leader in robotics industry.

UK is a part of the harmonized trade system of European Union and it follows export and import regulations of EC Commission. The services can be imported and exported freely in UK. However, there is some exceptions, such that, restrictions on technology with significant military application. In this case, an export license is required.  Objects like cultural interest, such as, artwork, old manuscript etc. also requires license from Arts Council (Gov.uk, 2012). Since, the creative industry is contributing significantly in the nation’s GDP, the UK government aims to protect this industry and hence, has imposed import restrictions. In order to protect the originality of this industry, the country is strengthening the intellectual property rights (Flew 2014). A custom duty relief is given when this country re-import EU goods that has been previously exported to EU for processing. The profits made by UK enterprises through exports are taxed like any other profits made in domestic market (nibusinessinfo.co.uk, 2016). If a person is going abroad for export his services, then also the UK National Insurance Contribution needs to be paid by that person (Borchert, Gootiiz and Mattoo 2013). Various business culture; legal environments and languages create confusion when engaging in international trade. Therefore, the country tries to formulate rules and restrictions in such a way that cannot create any further confusion and considers the interest of both parties. UK is a member nation of WTO, hence it enjoys benefits from it.

In short it can be said that United Kingdom practices free trade internationally. The authority has made few restrictions on import. However, it has some restrictions on exports. However, the restrictions are imposed for the purpose of well-being of the people as a whole. The depreciated sterling has made the exports more attractive to the international market. Moreover, the export of Creative industry is growing and contributing significant benefits to the net trade balance. The export in services is growing unlike the export of goods by UK.

Conclusion

From the above discussion, it can be said that countries engaged in international trade gains from trade. The paper has theorized some important concepts of international trade. It has discussed whether countries are benefitted from trade and the theories are sufficient to explain these benefits. At the end, the paper has taken United Kingdom to analyze the performance of the international trade and regulation practice in the country. It has identified some industries that has comparative advantages, and the country is specializing in it to gain more benefits from trade.

References

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