12.

3 The Traditional Theory of International Trade

A transaction is an exchange of two things, something is given up in return for something else.
Barter transactions The trading of goods directly for other goods in economies not fully
monetised
12.3.1 Comparative Advantage
Why do people trade? Basically, because it is profitable to do so. People usually find it profitable
to trade the things they possess in large quantities relative to their tastes or needs in return for
things they want more urgently. Because it is virtually impossible for individuals or families to
provide themselves with all the consumption requirements of even the simplest life, they usually
find it profitable to engage in the activities for which they are best suited or have a comparative
advantage in terms of their natural abilities or resource endowment.
Comparative advantage Production of a commodity at a lower opportunity cost than any of the
alternative commodities that could be produced. They can then exchange any surplus of these
home produced commodities for products that others may be relatively more suited to produce.
The phenomenon of specialisation based on comparative advantage arises, therefore, to some
extent in even the most subsistence economies. The principle of comparative advantage, as it is
called, asserts that a country should, and under competitive conditions will, specialise in the
export of the products that it can produce at the lowest relative cost.
Absolute advantage Production of a commodity with the same amount of real resources as
another producer but at a lower absolute unit cost.
12.3.2 Relative Factor Endowments and International Specialisation: The Neoclassical Model

The classical theory of comparative advantage in free trade is based on the idea that
countries can benefit from trading with each other by specializing in the production of goods in
which they have a comparative advantage.

The neoclassical factor endowment theory builds on the classical theory but introduces
the concept of factor endowments, which include land, labor, and capital. It explains how
differences in these factor endowments can lead to trade between countries.

The neoclassical theory assumes that all countries have access to the same technologies
for producing all goods. The basis for trade is not differences in technology but differences in
factor endowments. The theory suggests that countries will allocate their resources to produce
goods that make the most efficient use of their abundant factors. For example, labor-abundant
countries will specialize in labor-intensive products.

International Wage and Capital Cost Equalization. Over time, the theory predicts that
international trade will tend to equalize real wage rates and capital costs among countries. This
means that wages may rise in labor-abundant countries due to increased labor-intensive
production.

Trade can promote more equality in domestic income distributions within countries, as
the return to abundant resources, such as labor, increases. Stimulation of Economic Growth,
trade is seen as a driver of economic growth. It can stimulate investment, knowledge transfer,
and industrial output by allowing countries to access capital goods and technologies they lack
domestically.

The classical theory of comparative advantage, associated with economists like David
Ricardo and John Stuart Mill, laid the foundation for understanding the benefits of free trade. It
suggested that countries should specialize in producing goods in which they have a comparative
advantage, and through trade, all nations can benefit.

The neoclassical factor endowment theory builds upon this classical model but
incorporates the idea that countries differ in their factor endowments, such as land, labor, and
capital. However, it assumes that all countries have access to the same production technologies.
Trade, in this model, arises not due to differences in technology but because countries allocate
their resources differently based on their factor endowments.

Labor-abundant countries, for instance, are expected to specialize in labor-intensive

products, while capital-abundant countries will focus on capital-intensive goods. Over time, the
theory predicts that international trade will equalize real wage rates and capital costs among
countries. This means wages may rise in labor-abundant nations due to increased labor-intensive
production. Additionally, trade is believed to promote more equality in domestic income
distributions by favoring the returns to abundant resources like labor. Trade can also stimulate
economic growth by allowing countries to access capital goods, technologies, and knowledge
from other nations, ultimately leading to increased investment and industrial output.

In summary, the neoclassical factor endowment theory provides insights into how
differences in resource endowments drive international trade and how trade can lead to various
economic outcomes, including greater equality and economic growth.

12.3.3 Trade Theory and Development: The Traditional Arguments

1. Trade is an important stimulator of economic growth. It enlarges a country’s consumption
capacities, increases world output, and provides access to scarce resources and worldwide
markets for products without which developing countries would be unable to grow.
2. Trade tends to promote greater international and domestic equality by equalising factor
prices, raising real incomes of trading countries, and making efficient use of each nation’s
and the world’s resource endowments (e.g., raising relative wages in labour-abundant
countries and lowering them in labour-scarce countries).
3. Trade helps countries achieve development by promoting and rewarding the sectors of
the economy where individual countries possess a comparative advantage, whether in
terms of labour efficiency or factor endowments. It also lets them take advantage of
economies of scale.
4. In a world of free trade, international prices and costs of production determine how much
a country should trade in order to maximise its national welfare. Countries should follow
the principle of comparative advantage and not try to interfere with the free workings of
the market through government policies that either promote exports or restrict imports.
5. Finally, to promote growth and development, an outward-looking international policy is
required. In all cases, self-reliance based on partial or complete isolation is asserted to be
economically inferior to participation in a world of unlimited free trade.

12.4 The Critique of Traditional Free-Trade Theory in the Context of Developing-Country

Experience
 Trade and Resource Growth: North–South Models of Unequal Trade
Six basic assumptions of the traditional neoclassical trade model must be scrutinised:
 1. All productive resources are fixed in quantity and constant in quality across nations, and
are fully employed.
2. The technology of production is fixed (classical model) or similar and freely available to
all nations (factor endowment model). Moreover, the spread of such technology works to
the benefit of all. Consumer tastes are also fixed and independent of the influence of
producers (international consumer sovereignty prevails).
3. Within nations, factors of production are perfectly mobile between different production
activities, and the economy as a whole is characterised by the existence of perfect
competition. There are no risks or uncertainties.
4. The national government plays no role in international economic relations; trade is
carried out among many atomistic and anonymous producers seeking to minimise costs
and maximise profits. International prices are therefore set by the forces of supply and
demand.
5. Trade is balanced for each country at any point in time, and all economies are readily able
to adjust to changes in the international prices with a minimum of dislocation.
6. The gains from trade that accrue to any country benefit the nationals of that country.

12.4.1 Fixed Resources, Full Employment, and the International Immobility of Capital and
Skilled Labour

 Trade and Resource Growth: North–South Models of Unequal Trade

The traditional theory of international trade assumes that resources are fixed, fully
utilized, and immobile, which does not reflect the dynamic nature of the real world
economy. Resources, including capital, entrepreneurial abilities, and skilled labor, are
constantly changing in both quantity and quality. This dynamic situation challenges the
assumption of comparative advantage and can perpetuate inequality between rich and
poor nations.
In reality, resources that are crucial for growth and development, such as capital,
entrepreneurial abilities, scientific capacities, and technical skills, are not fixed but
continuously changing. These changes influence a nation's comparative advantage and its
ability to respond to international trade dynamics.
 Rich nations, with abundant capital, entrepreneurial ability, and skilled labor,
often specialize in activities that use these resources intensively, leading to further
growth. In contrast, developing countries, with abundant unskilled labor, may specialize
in low-skilled, unproductive activities with unfavorable demand prospects. This can lock
them into stagnant situations, hindering domestic growth in crucial areas.
The traditional model assumes identical production functions for different
products in various countries, ignoring the dynamic nature of resource development. This
static efficiency can lead to dynamic inefficiency, where trade exacerbates inequality and
perpetuates resource underdevelopment in low-income nations.
Some economists have developed dynamic models of trade and growth that consider
factors like factor accumulation and uneven development. These models focus on trade
relations between rich and poor countries, acknowledging the unique challenges faced by
developing nations.
Michael Porter's Competitive Advantage of Nations introduces the concept of
qualitative differences between basic and advanced factors of production. While standard
trade theory applies to basic factors like natural resources and unskilled labor, advanced
factors include highly trained workers and knowledge resources. Developing countries
should prioritize the development of advanced factors to escape from the limitations of
factor-driven national advantage. This perspective emphasizes the need for a more
nuanced approach to international trade.
 Unemployment, Resource Underutilisation, and the Vent-for-Surplus Theory of
International Trade
Traditional trade models assume full employment, which does not align with the
reality of widespread unemployment and underemployment in developing countries.
The recognition of underutilized human resources in developing nations gives rise
to the vent-for-surplus theory of international trade. This theory suggests that these
countries can expand their productive capacity and GNI by producing goods for export
markets that are not in demand domestically.
According to the vent-for-surplus theory, previously underemployed land and
labor resources can be used to produce more output for export to foreign markets. This
theory is illustrated by a shift in production from point V to point B in a production
possibility analysis.

Historically, the opening of developing nations to foreign markets, often through

colonization, provided the economic opportunity to utilize idle resources and expand
primary-product export production. However, in the short run, the benefits of this process
were often reaped by colonial and expatriate entrepreneurs.
While this approach may have provided short-term economic benefits, it
sometimes led to the structural orientation of developing-country economies towards
primary-product exports. This specialization inhibited the needed structural
transformation toward more diversified economies in the long run.
Masukin grafiiknya

Consider a developing country with substantial underemployed labor and land

resources. Before trade, this country produces primary products (X) and manufactures
(Y) at point V, well below its production possibility frontier.
With the opening of foreign markets, due to colonial influence or other factors,
the country can now utilize its underemployed resources and expand primary-product
production to point B on the production frontier. This shift results in an increase in
primary product exports (X' - X), which can be exchanged for more imported
manufactures (Y' - Y).
 While this process initially boosts economic activity, the benefits may primarily
flow to external entrepreneurs. Additionally, the country may become overly reliant on
primary-product exports, hindering diversification in the long term.

12.4.2 Fixed, Freely Available Technology and Consumer Sovereignty

Rapid technological change and the development of synthetic substitutes for traditional
products have transformed global trade. Additionally, the availability of Western-developed
technologies has allowed certain middle-income countries, like the Asian NICs, to move from
low-tech to high-tech production, changing their roles in international trade.

Since World War II, technological advancements have led to the creation of synthetic
alternatives for traditional primary products like rubber, wool, and cotton. This shift in
production has decreased the market share of developing countries in these sectors, affecting
their export earnings.

New technologies developed in the West have provided opportunities for some middle-
income countries, such as the Asian NICs, to benefit from Western research and development.
These countries, with their lower labor costs, can imitate products initially developed abroad but
not at the forefront of technological innovation. This strategy enables them to transition from
low-tech to high-tech production, filling manufacturing gaps left by more industrialized nations.
Some aim to catch up with developed countries, as exemplified by Japan, Singapore, South
Korea, and China's progress through this approach.

The assumption that consumer tastes dictate production patterns is unrealistic.

Multinational corporations, often supported by their home governments, disseminate capital,
production technologies, and influence consumer preferences through dominant advertising
campaigns. This influence is particularly notable in developing countries, where limited
information and imperfect markets lead to a situation of incomplete markets. For instance, in
many developing nations, over 90% of advertising is funded by foreign firms selling products in
the local market. This demonstrates how both local and international factors shape consumer
preferences and market dynamics, rather than solely relying on consumer choices.

12.4.3 Internal Factor Mobility, Perfect Competition, and Uncertainty: Increasing Returns,
Imperfect Competition, and Issues in Specialisation

The traditional theory of international trade assumes that countries can easily adjust their
economic structures in response to changing global prices and market demands. However, this is
often challenging, especially for developing nations, due to various structural and institutional
constraints.

In traditional trade theory, it's assumed that countries can quickly adapt to changes in
international prices and markets by reallocating resources between industries. While this concept
may seem feasible on paper, structuralist arguments suggest that such reallocations are
exceptionally hard to achieve in practice.

This difficulty is particularly evident in developing countries where production structures

are inflexible, and factors of production (like capital and labor) cannot easily move between
industries. For example, in economies heavily reliant on a few primary-product exports, the
entire economic and social infrastructure may be geared towards supporting this export-oriented
system. Roads, railways, communications, and more are built to facilitate the movement of
goods for export.

Over time, significant investments have been made in these facilities, making it
challenging to shift these resources into other sectors like manufacturing. This inflexibility can
make developing nations vulnerable to fluctuations in international markets. Structural rigidities,
such as inelastic supply of products, limited access to intermediate goods, and poor
infrastructure, can hinder a developing country's ability to respond smoothly to changing
international prices. Unlike rich countries, they often lack the resources and capacity to adjust
quickly.

Moreover, when developing countries try to diversify their economies by producing low-
cost, labor-intensive manufactured goods for export, they often encounter barriers like tariffs and
nontariff measures imposed by developed countries to protect their domestic industries. These
barriers can hinder the growth of developing economies.

Additionally, the traditional trade theory overlooks increasing returns to scale and their
impact on international trade. Economies of scale, where production costs decrease as output
increases, can lead to monopolistic control by large corporations in global markets. These
corporations can manipulate prices and supplies, disadvantaging smaller competitors and
developing nations. Furthermore, the theory doesn't account for risk and uncertainty in
international trade. Depending heavily on unpredictable primary-product exports can be
detrimental to low-income countries due to the instability of global commodity markets.

In essence, the traditional trade theory's assumptions about easy resource reallocation,
diminishing returns to scale, and the absence of risk in international trade often don't align with
the complex realities faced by developing nations.

12.4.4 The Absence of National Governments in Trading Relations

In countries, the government can help balance things out when it comes to rich and poor
areas, fast and slow-growing industries, and how the benefits of economic growth are distributed.
They do this through various means like government through legislation, taxes, transfer
payments, subsidies, social services, regional development programmes, and so forth.

However, at the international level, there isn't a powerful government that can do the
same job. So, when countries trade with each other, sometimes one country gets much more out
of the deal than the other. And because there's no international "referee" to make things fair, this
unequal situation can keep going. Powerful countries also tend to protect their own interests,
even if it means helping out certain industries.

On the flip side, when governments in developing countries actively support certain
industries or coordinate investments to boost their exports, it can lead to impressive economic
growth, like we've seen in South Korea. But not all developing countries have been able to pull
this off. Governments can also use things like taxes on imports and exports to control trade and
influence their position in the global economy. But when richer countries make economic
decisions, it often affects poorer nations, while the reverse isn't true.
 In the global economic arena, the bigger, more powerful countries usually have more say.
There isn't a super organization or world government to protect the interests of the weaker
nations, especially the least developed ones. So, when thinking about trade and industrial
strategies, we must consider the impact of these powerful governments from developed nations.

12.4.5 Balanced Trade and International Price Adjustments

The theory of international trade, like other perfectly competitive general-equilibrium

models in economics, is not only a full-employment model but also one in which flexible
domestic and international product and resource prices always adjust instantaneously to
conditions of supply and demand. In particular, the terms of trade (international commodity price
ratios) adjust to equate supply and demand for a country’s exportable and importable products so
that trade is always balanced; that is, the value of exports (quantity times price) is always equal
to the value of imports. With balanced trade and no international capital movements, balance-of-
payments problems never arise in the pure theory of trade.

12.4.6 Trade Gains Accruing to Nationals

In traditional trade theory, there's an assumption that the benefits of trade go to the people
in the trading countries. However, this assumption doesn't always hold true, especially in
developing countries.

In some of these countries, foreign companies might operate in ways that don't benefit the
local population much. They might pay low rents for land, use their own foreign capital and
skilled workers, hire local workers at very low wages, and not contribute much to the overall
economy. This depends on the bargaining power of these foreign corporations and the
governments of the developing countries.

The difference between two important economic measures becomes crucial here: GDP
(the value of everything produced within a country's borders) and GNI (the income actually
earned by the country's nationals). If much of a country's economy, like the export sector, is
owned and run by foreign entities, the GDP might be high, but the GNI, which reflects what the
country's people actually earn, could be much lower.

So, even though it might look like a developing country is benefitting from exports, in
reality, a big chunk of those benefits might be going to foreigners who own or control the
production factors involved. This is particularly true with multinational corporations operating in
these countries.

In essence, when analyzing a developing country's export performance, we need to dig

deeper and find out who really owns or controls the factors of production that gain from exports.

12.4.7 Some Conclusions on Trade Theory and Economic Development Strategy

We can now attempt to provide some preliminary general answers to the five questions
posed early in the chapter. We must stress that our conclusions are general and set in the context
of the diversity of developing countries. First, with regard to the rate, structure, and character of
economic growth, our conclusion is that trade can be an important stimulus to rapid economic
growth

Access to the markets of developed nations (an important factor for developing nations
bent on export promotion) can provide an important stimulus for the greater utilisation of idle
human and capital resources. Expanded foreign-exchange earnings through improved export
performance also provide the wherewithal by which a developing country can augment its scarce
physical and financial resources. In short, where opportunities for profitable exchange arise,
foreign trade can provide an important stimulus to aggregate economic growth.

But, as noted in earlier chapters, growth of national output may have little impact on
developmen. An export-oriented strategy of growth, particularly in commodities with few
linkages and when a large proportion of export earnings accrue to foreigners, may not only bias
the structure of the economy in the wrong directions (by not catering to the real needs of local
people) but also reinforce the internal and external dualistic and inegalitarian character of that
growth. It all depends on the nature of the export sector, the distribution of its benefits, and its
linkages with the rest of the economy and how these evolve over time.
 The answer to the third question the conditions under which trade can help a developing
country achieve development aspirations is to be found largely in the ability of developing
nations. Also, the extent to which exports can efficiently utilise scarce capital resources while
making maximum use of abundant but presently underutilised labour supplies will determine the
degree to which export earnings benefit the ordinary citizen in developing countries. Again, links
between export earnings and other sectors of the economy are crucial. Finally, much will depend
on how well a developing nation can influence and control the activities of private foreign
enterprises. The ability to deal effectively with multinational corporations in guaranteeing a fair
share of the benefits to local citizens is extremely important

The answer to the fourth question whether developing countries can determine how much
they trade can only be speculative. For small and poor countries, the option of not trading at all,
by closing their borders to the rest of the world, is obviously not realistic. Not only do they lack
the resources and market size to be self-sufficient, but also their very survival, especially in the
area of food production, often depends on their ability to secure foreign goods and resources.
Moreover, for most developing nations, the international economic system still offers the only
real source of scarce capital and needed technological knowledge. The conditions under which
such resources are obtained will greatly influence the character of the development process.

The fifth question whether on balance it is better for developing countries to look
outward toward the rest of the world or more inward toward their own capacities for
development turns out not to be an either/or question at all. While exploring profitable
opportunities for trade with the rest of the world, developing countries can effectively seek ways
to expand their share of world trade and extend their economic ties with one another.