Free trade

15 Jun, 2022 at 22:56 | Posted in Economics | 2 Comments

In 1817 David Ricardo presented — in Principles — a theory that was meant to explain why countries trade and, based on the concept of opportunity cost, how the pattern of export and import is ruled by countries exporting goods in which they have a comparative advantage and importing goods in which they have a comparative disadvantage.

Heckscher-Ohlin-HO-Modern-Theory-of-International-TradeRicardo’s theory of comparative advantage, however, didn’t explain why the comparative advantage was the way it was. At the beginning of the 20th century, two Swedish economists — Eli Heckscher and Bertil Ohlin — presented a theory/model/theorem according to which the comparative advantages arose from differences in factor endowments between countries. Countries have comparative advantages in producing goods that use up production factors that are most abundant in the different countries. Countries would mostly export goods that used the abundant factors of production and import goods that mostly used factors of production that were scarce.

The Heckscher-Ohlin theorem — as do the elaborations on in it by e.g. Vanek, Stolper and Samuelson — builds on a series of restrictive and unrealistic assumptions. The most critically important — besides the standard market-clearing equilibrium assumptions — are

— Countries use identical production technologies.

— Production takes place with constant returns to scale technology.

— Within countries, the factor substitutability is more or less infinite.

— Factor prices are equalised (the Stolper-Samuelson extension of the theorem).

These assumptions are, as almost all empirical testing of the theorem has shown, totally unrealistic. That is, they are empirically false.

That said, one could indeed wonder why on earth anyone should be interested in applying this theorem to real-world situations. Like so many other mainstream mathematical models taught to economics students today, this theorem has very little to do with the real world.

Since Ricardo’s days, the assumption of internationally immobile factors of production has been made totally untenable in our globalised world. When our modern corporations maximize their profits they do it by moving capital and technologies to where it is cheapest to produce.

So we’re actually in a situation today where absolute — not comparative — advantages rule the roost when it comes to free trade.

And in that world, what is good for corporations is not necessarily good for nations.

2 Comments »

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  1. Dear Lars,

    Unfortunately, you are parroting the same blatant misinterpretations of David Ricardo’s theory of international trade that can be found in current Econ textbooks.

    Ricardo did not explain in his Principles the pattern of trade based on the concept of opportunity cost. How could he? Austrian economist Friedrich von Wieser originally developed the opportunity-costs approach as part of his marginal theory of value almost one hundred years after Ricardo’s death. Moreover, Wieser explicitly conceived his value theory as an opposing view and main alternative to what he believed to be Ricardo’s theory of value.

    Another Austrian economist, Gottfried von Haberler, reformulated Ricardo’s quantities-of-labour requirements with opportunity costs in 1930 because he erroneously believed that Ricardo’s numerical example was based on the labour theory of value.

    Ricardo’s explanation in the Principles of why countries trade and the pattern of trade is straightforward. He stated:

    “The motive which determines us to import a commodity, is the discovery of its relative cheapness abroad: it is the comparison of its price abroad with its price at home.”

    That has not changed since 1817.

    Moreover, nowadays capital does not move as easily between countries as it moves within the borders of the same country. That is why there are still persistent differences in the rate of profits between countries, as Ricardo pointed out in the Principles.

    However, Ricardo would have agreed with you on the last point: what is good for corporations is not necessarily good for nations. That is why he supported free trade: it is beneficial for consumers and hurtful for some corporations that would benefit from protection.

    Best,

    Jorge

    References:

    Morales Meoqui, Jorge. 2021. Overcoming Absolute and Comparative Advantage: A Reappraisal of the Relative Cheapness of Foreign Commodities as the Basis of International Trade. Journal of the History of Economic Thought, 43 (3): 433–449. doi:10.1017/S1053837220000401.

    Morales Meoqui, Jorge. 2017. Ricardo’s Numerical Example versus Ricardian Trade Model: A Comparison of Two Distinct Notions of Comparative Advantage. Economic Thought, 6 (1): 35-55.
    https://www.worldeconomicsassociation.org/files/journals/economicthought/WEA-ET-6-1-MoralesMeoqui.pdf.

    • Curious about your comment that free trade is beneficial for consumers and hurtful for some corporations.

      For consumers it is only true if they are only consumers; if they are also part of the labour market, free trade can mean that corporations can freely move production away from them.

      For corporations when would free trade be hurtful? The only answers I can think of is when other corporations are free to undercut them or (as you say) they have been protected through for example import restrictions. Or put another way free trade is always good for global corporations that can easily choose where to produce – which sounds like a very good reason not to have free trade!


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