Assessment of Existing Trade Theories

The provided assignment is an essay that critically assesses existing trade theories, including Heckscher-Ohlin, Ricardian, and Porter's Diamond Model. The essay evaluates the impact of globalization on international trade patterns, discussing how countries import goods by exchanging specialized products. It concludes that all these theories aim to allocate scarce resources efficiently, despite depicting different trade patterns.

Running Head: FUNDAMENTALS OF ECONOMICS
Fundamentals of Economics
Name of the Student
Name of the University
Author note

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Theory of comparative advantage; how scarce resource are allocates, produced and
consumed globally
The essay aims at discussing the allocation of scarce resources in the global economy.
In this context importance of international trade is discussed and analyzed in light of existing
and evolving trade theories.
International trade and resource allocation:International trade theories provide the basis for
commodity exchange among different nations. The theory suggests trade between two nations
initially guided by existing difference in cost of production arises due to difference in
technology, factor endowment or any other factor. In order to make maximum utilization of
resource eacg nation should speicialize in production in which is enjoys a cost advantage.
When countries specialize in one particular good then it can produce the good excess of the
domestic need (Baumol and Blinder 2014). This excess production should be exported. In
exchange of exported items, nations import goods for which it faces a higher cost. The line of
specialization explains trade patterns among nations across the globe. Different trade theories
have evolved gradually by examining differenr trade pattern among nations.
Abolute and comparative trade model: Adam Smith suggested that interantional trade
primaril occur following difference in cost of production in abosolute terms. The absolute
advantage of a country is identified in terms of country’s ability to produce one good at a
lower absolute cost than another country. Then this country should specialize and export this
good in exchange of some other good that has a higher abosolute cost (Begg and Ward 2013).
The following example can explain the abosolute cost differece and basis of trade between
nation.

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Suppose there are two nations China and Brazil. Each produces rice and Wheat using labor
input. The table below summarizes unit of output for rice and Wheat produced using one unit
of labor.
Output using 1 unit of labor Rice
(Units)
Wheat
(Units)
China 100 50
Brazil 50 100
In China, 1 unit of labor can produce 100 units of rice and 50 units of Wheat. In Brazil,
however 50 units of rice and 100 units of Wheat can be produced with 1 unit labor. The
example shows China is able to produce more rice than Brazil using same labor input. China
thus enjoys an absolute advantage in rice while Brazil has an absolute advanatge in producing
Wheat.
The theory of absolute advantage is simple and easy to interprete. Nevertheless, the theory
has a very limited use as in real world one nation might has a absolute cost advantage in all
commodities. In thius situation the dimension of trade is determined by difference in
opportunity cost. David Ricardo pionnered the trade theory explaining trade pattern by
relative cost difference (Cohen 2016). The theory of realtive cost differenve is known as the
theory of comparative advantage.
The example below expalins the theory of comparative advantage and trade relation between
nations. The following table provides an hypothetocal situation where one nation has absolute
advantage in both the goods and realtive cost ratios are considered to explain trade between
the nation.
Output using 1 unit of labor Rice Wheat

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(Units) (Units)
China 20 8
Brazil 4 8
As shown from the above table, China has an abosolute advantage in production of both Rice
and Wheat. China by using only 1 units of labor can produce more Rice and Wheat than
Brazil can. Follwed from absolute cost theory, there is no frasible trade pattern. In such a
situation the ratio of relative costs shuld be conidered to determine soecualization and trade.
Relative cost
ratio
Rice
(Units)
Wheat
(Units)
China 8/20 =0.4 20/8= 2.5
Brazil 8/4 = 2 4/8=0.5
The table above showsthe opportunity cost that the two nations face in producing the
respective goods. The production of 1 unit of rice in China requires sacrfice of 0.4 units of
wheat. This is the opportunity cost of rice. The same for Brazil is 2. Therefore, it is beneficial
for China to specialize in rice. The similar argument holds for wheat suggesting that Brazil
must specialize in Wheat because of a lower opoortunity cost ( 0.5 < 2.5).
Ricardo showed that is is mutually beneficial for nations to specialize in goods in which it has
a lower relative cost. With specialization resources are shifted to a particular industry
enhancing efficiency of production. It is seen that world output increases after trade
providing a wide variety of goods for consumption (Grant 2013). The aggreagate welfare
increases after trade.

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The theory of absolute and comparative advantage are considered as two basic theories of
trade. The theories are however are based on number of assumption most of which are
unrealistic in modern world. The production cost is based on only labor cost in both the
theory. In addition to labor, there are a number of factors that influence cost of production.
Both the theory assumes labor is homgenous across nations. This is the most unrealistic
assumption of the these theories. The ignorance of trasportation cost is another drawback the
theory.
The Heckscher-Ohlin trade model begins from the ending note of Ricardo’s
comarative cost theory. The Ricardian theory states country trades depending on difference
on relative costs. However, this theory does not exaplain origin of these cost differences. The
H-O model suggests that the origing of comparative cost difference lies in difference in
relative factor prices (Ito, Rotunno and Vézina 2017). The relative factor price again depends
on avaibility of factor inputs.The factor that is abundant in a nation has a lower cost while the
scarce factor has a relaively high factor price. The commodities are then classfied accordinf
to relative intensity of factor and countries are categorized according to the abundance of
factor inputs. The specialization is then determined by factor intensity of the goods and
country’s relative abundant factor. For example, a labor-intensive nation should produce a
good that is produced with a higher labor-capital ratio. Goods that involve high capital-labor
ratio should be produced in a capital rich nation (Baldwin and Robert-Nicoud 2014)
Any theoreticial model is subject to empirical test to make the model more realistic. Some
contradictary trade pattern is found when HO model is tested using real world data. The
contradictary trade pattern first found for United State. In 1947, industrial data of US was
used to identify trade pattern. Among the 50 sectors taken for testing purpose 38 sectors were
involved in transaction in the international market (Simas, Wood and Hertwich 2015). The
following result was obtained from analysis

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Table 1: labor and capital requirement for producing export and import bundles
worthing one million dollar
(Source: Kohli 2016)
KX = aKx/ aLx = $14,300 (Exports)
Km = aKm/aLm = $18,200 (Imports)
The finding suggested that espite being one of the capital rich nation of world the imports od
US were more capital oriented than export did. The paradoxical trade pattern is known as
Leontief paradox follwing the name of professor Wassily Leontief. The trade pattern of
Canada also constitutes an inconsistency with H-O theory (Simas, Wood and Hertwich 2015).
Canada’s exports are mostly capital intensive in nature and exports are mainly delivered to
US market.
Another trade pattern popularizing in modern world is the intra industry trade among
countries. This is the trade commodities belonging to same industries from one nation to
another. The intta industry trade are again classified into three major groups – Trade of
homogenous good, trade of horizontally differentiated goods and trade of vertically
differentiated goods (Baldwin and Lopez‐Gonzalez 2015). The high income economies often
involve in intra-industry trade. US is one example of such economies. United State both
export and imports autos. The table below summarizes some of the largest categories of
import and export in US.

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(Source: bea.gov 2017)
As shown from the table in the all the above mentioned categories US is both a substancial
importers and exporters. As per Bureau of Economic analysis, in 2014 US imported autos
worth of $327 and exported the same valued $146. Intra-industry trade accounts
approximately 60% share in US total trade (Mankiw et al. 2016). There are two main reasons
exaplaining benefits of intra industry trade that is largely taking place in European Union,
United States and Japan. One is benefits of division of labor resulting in innovation, learning
and unique skills of existing labor force and other is benefits derived from economies of
scale.
Raymond Vernon developed a theory to explain the pattern of trade that HO model has failed
explain. The theory is widely known as Product Life Cycle Theory. Every product passes
through four different stages – introduction, growth, maturity and decline (Besanko et al.
2013). At the intriductary stage the product is just introduced in the market. This stage is
associated with a smaller profit and a small number of competitors. Gradually sales of the
product increases raising competitors in the market. This the second stage. At the maturity
stage the product has developed completely and has a large customer base. After reaching the
saturation point the product enters in the phase of decline. This is the phase where the product
has lost its economic feasibility (Tolentino 2017). According to product life cycle theory at
the initial production stage labor and other necessary inputs belong to the area where it was

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invented. After passsesof time the product become known to the world market and move
away from its origin. If might be the case that the orgin country itself becomes the importer
of the product at some later stage of production. The model is particularly applicable to
products that are labor saving and capital using in natute and associated with high income
groups.
Figure 1: Product life cycle
(Source: Jian, Cai and Chen 2017)
One example nation for product life cycle theory is United State. At the intial stage, US
produces capital intensive good like computer. However, in the later stages of production, the
production moves to the developing countries raising US import share of these items.

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Figure 2: Product life cycle theory for United State
(Source: Tolentino 2017)
The national comparative advantage is explained by Porter diamond model of trade. Michael
Porter, an American professor first developed this model. The factors determining the
comparative advantage of a nation is presented in the shape of a diamond and hence, the
model is known as Porter Diamond model of trade (Fainshmidt, Smith and Judge 2016). The
model assumes that the competitiveness of a business is associated with performance of the
related industries. Additionally, other important factors are considered together in the model
and tied to a value added chain important in regional or local context.

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Figure 3: Porter’s diamond trade model
(Source: Chung 2016)
The main essence of Porter Diamond model is that comparative asvantages enjoyed in the
home country is gradually transmitted to the international scale. The four basic factors of the
model include conditions of factor input, deamnd in the domestic market, growth of
supportive industries and finally structure, strategy and rivalry amonf firms. The factor
condition implies availability of natural resource and advanced infratructure. The domestic
demand condition helps to determine the level of success in the domestic market (Chung
2016). This is related to aspect like development of product and level of innovation. The
supported industries in the model refers to existing supply chain and related markets. The
action of government often plays an important role in expansion of the business in home and
abroad. There isa chance factor that implies opportunity of a concerned firm in undertaking
new operation.
In addition to above mentioned theories of trade Paul Krugamn has posited the New
Trade Theory. The new theory has emphasized on retirn to scale in determining feasibility of

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trade. Countries by producing one speific commondity reap the benefit of economies of scale
and thus becomes more competitve in the international market (Erdogan 2014). This however
does not limit consumption choice of people as countries import a variety of goods by
exchanging the good of specialization.
The essay has done a critical assessment of existing trade theories. All the theories
though depict a different trade pattern, the end objective is same that is to allocate scarce
resources in an efficient way.

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References list
Baldwin, R. and Lopez‐Gonzalez, J., 2015. Supply‐chain trade: a portrait of global patterns
and several testable hypotheses. The World Economy, 38(11), pp.1682-1721.
Baldwin, R. and Robert-Nicoud, F., 2014. Trade-in-goods and trade-in-tasks: An integrating
framework. Journal of International Economics, 92(1), pp.51-62.
Baumol W.and Blinder A., 2014 Economics: Principles and Policy, International Edition,
15th ed. Cengage
Bea.gov. (2017). BEA: News Release: U.S. International Trade in Goods and Services.
[online]Availableat:https://www.bea.gov/newsreleases/international/trade/
tradnewsrelease.htm [Accessed 14 Mar. 2018].
Begg, D. and Ward, D, 2013 Economics for Business, Berkshire, McGraw Hill
Besanko D., Dranove, D., Shanley, S. and Schaefer, M., 2013, Economics of Strategy. 6th ed.
US, John Wiley.
Chung, T.W., 2016. A Study on Logistics Cluster Competitiveness among Asia Main
Countries using the Porter's Diamond Model. The Asian Journal of Shipping and
Logistics, 32(4), pp.257-264.
Cohen,I.K, 2016 Economics for Business – A Guide to Decision Making in a Complex
Global Macroeconomy, London. Kogan Page.
Erdogan, A.M., 2014. Bilateral trade and the environment: A general equilibrium model
based on new trade theory. International Review of Economics & Finance, 34, pp.52-71.