To what extent have economists provided a satisfactory theoretical and empirical explanation of the global patterns of trade?

by santiago-vermehotmailcom (student)

University Degree Business and Administrative studies

Economists study the economical behaviour of humans so they can produce models, theories and equations that mimic patterns of conduct in order to predict how they will behave in the future. Trade has always been of interest to economists. The last decades have seen an increase in the number of economists trying to come up with explanations of global patterns of trade. This is related to the recent increase in global trade and international integration, the swelling popularity of the globalisation phenomena and the increase in the number of economists advocating free trade as the best policy to further economic development and increase living standards. These explanations of trade patterns are useful as they help countries decide who to trade with, what to trade and how to do it. Many reputed economists have attempted to capture the essence of international trade in theories but not all manage to develop a theoretical model that would hold in the real world.

Back in the times when mercantilism was the main concept people had of accumulation of wealth, there was this general misconception that trading was a zero-sum game. This means that, when countries traded, one country got rich at the expense of the other one. Nations resorted to waging war between each other in order to gain the other’s resource and exploit them for wealth.

It was not until Smith, 1766, that the idea of international trade being crucial in raising global living standards was introduced. The belief that countries may have an absolute advantage, meaning that a nation is more productive in the manufacture of a good than another country, marks the basis for international trade. Smith argues that specialisation leads to the maximisation of output and both countries engaged in trade may benefit from the consumption of goods outside their production possibility frontier, hence, maximising their utility. Ricardo furthered Smith’s concept in order to explain that countries could also gain from trade even if they had an absolute advantage in both goods. He introduced the idea of comparative advantage, relying in the fact that a country’s opportunity cost in the production of a particular will give both nations a basis to benefit from trade (Salvatore, 2010),

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Work done by Heckscher and Ohlin developed the idea that countries trade was based in their different factor endowments, leading to them having a comparative advantage in certain kinds of production. The model revolved around the concept that capital abundant nations would produce and export capital-intensive goods while importing labour-intensive goods from labour abundant countries and vice versa. This diagram shows gains from trade according to the Heckscher-Ohlin Model:

On the other hand, although the concept of comparative advantage has been generally recognised as valid to describe inter-industry trade, it has failed various empirical tests, the Leontief ...

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On the other hand, although the concept of comparative advantage has been generally recognised as valid to describe inter-industry trade, it has failed various empirical tests, the Leontief Paradox being the most notable. Leontief (1954) provided proof that, the USA, the most capital abundant country in the world, exported mostly labour-intensive products, rendering comparative advantage invalid to explain trade in this particular case. Many critics, such as Swerling (1953) have tried to defend comparative advantage, claiming 1947, the year that Leontief collected the data he tested, was not a normal year as the economy was disorganized after the war. Leontief carried a second test in 1956 and Baldwin (1971) did a third one with data from 1961. Neither disproved the paradox. Studies made by Bowen, Leamer and Sveiskaus (1987), rendered the HOV theory useless and determined the HO model as having a poor predictive power. Still, in the words of Leamer and Levinsohn (1995), the theory, although statistically rejected, is left “completely unharmed nonetheless” as empirical tests shouldn’t test the validity of theories but “determine if the theory is working adequately in its limited domain”. Once again, this shows the limited scope economists have to work on in order to provide models that they can predict how they are going to behave (Salvatore, 2010). Economic models are built under assumptions that don’t always hold their own in the real world. For example, some of the things the Hecksher-Ohlin model assumes (such as perfect internal competition, countries with identical production technology and factor immobility between both trading countries) are very rare to find in two trading countries.

Trade patterns change as the world changes and it is getting harder to keep up and predict the causes of trade. For example, following the trade models previously proposed, comparative advantage couldn’t explain the increasing intra-industry between countries. Krugman (1979) had to step up with a new theory, known as the New Trade Theory, where he argued trade is “a way of extending the market and allowing exploitation of scale economies” (p. 469). This leads to brand specialisation instead of product specialisation. Baldwin (1968, p.2) states that, in order to predict trade patterns one must first explain “how the underlying structures of trade behave over time”. Economists have failed to do so. Human behaviour and needs are hard to encapsulate in one single model.

In conclusion, there have been many developments throughout the years by economists explaining trade patterns around the globe, but this has been achieved to a certain extent. Economists try to approximate a representation of trade patterns found in the real world by creating economic models that work in theory but struggle to survive in practice. In theoretical scenarios where assumptions are applied, economists have thrived, providing numerous patterns world trade would follow in those particular cases. In real life, empirical tests have proved inconsistences in many models suggested. The world is an ever-changing environment. Global societies constantly develop and human necessities differ. Economists try to catch up with these transformations, adapting and creating models to represent current trade patterns and predict the future of trading. Trade theories and benefits have come a long way since mercantilist times but, for the time being, there is yet to be a flawless model that can predict trade pattern over time.

References:

Leamer, E; Levinsohn, J. (1995), "International Trade Theory: The Evidence”, Handbook of International Economics, Volume 3, Amsterdam: North-Holland.

Krugman, P. (1979), "Increasing Returns, Monopolistic Competition and International Trade”, Journal of International Economics, pp. 469 - 479

Vanek, J. (1968). "The Factor Proportions Theory: The n-Factor Case," Kyklos 4, October, pp. 749-756.

Swerling, B.C. (1953). “Capital Shortage and Labour Surplus in the United States?”, Review of Economics and Statistics, Vol: 36.

Bowen, H; Leamer, E. & Sveiskaus, L. (1987), "Multicountry, Multifactor Tests of the Factor Abundance Theory", American Economic Review 77 (5), pp. 791–809,

Screpanti, E; Zamagni, S. (2005), “An Outline of the History of Economic Thought”, Oxford university press

Salvatore, D. (2010), “Introduction to International Economics”, (2nd edition), John Wiley

Baldwin, R. (1968), “Structural Change and Patterns of International Trade”, Working Paper No. 2058, accessed 29/11/2011, http://www.nber.org/papers/w2058.pdf

Leontief, W. (1954), "Domestic Production and Foreign Trade: The American Capital Position Reexamined," Economia Internatiozionale 7, (February), pp. 3-32.

Accessed 9th December 2011,