The Reasons for Trade
The Ricardian Theory of Comparative Advantage Module
- Learn the five reasons why trade between countries may occur.
- Recognize that separate models of trade incorporate different motivations for trade.
The first theory section of this course develops models that provide different explanations or reasons why trade takes place between countries. The five basic reasons why trade may take place are summarized below. The purpose of each model is to establish a basis for trade and then to use that model to identify the expected effects of trade on prices, profits, incomes, and individual welfare.
Reason for Trade #1: Differences in Technology
Advantageous trade can occur between countries if the countries differ in their technological abilities to produce goods and services. Technology refers to the techniques used to turn resources (labor, capital, land) into outputs (goods and services). The basis for trade in the Ricardian model of comparative advantage in Chapter 2 "The Ricardian Theory of Comparative Advantage" is differences in technology.
Reason for Trade #2: Differences in Resource Endowments
Advantageous trade can occur between countries if the countries differ in their endowments of resources. Resource endowments refer to the skills and abilities of a country’s workforce, the natural resources available within its borders (minerals, farmland, etc.), and the sophistication of its capital stock (machinery, infrastructure, communications systems). The basis for trade in both the pure exchange model in Chapter 3 "The Pure Exchange Model of Trade" and the Heckscher-Ohlin model in Chapter 5 "The Heckscher-Ohlin (Factor Proportions) Model" is differences in resource endowments.
Reason for Trade #3: Differences in Demand
Advantageous trade can occur between countries if demands or preferences differ between countries. Individuals in different countries may have different preferences or demands for various products. For example, the Chinese are likely to demand more rice than Americans, even if consumers face the same price. Canadians may demand more beer, the Dutch more wooden shoes, and the Japanese more fish than Americans would, even if they all faced the same prices. There is no formal trade model with demand differences, although the monopolistic competition model in Chapter 6 "Economies of Scale and International Trade" does include a demand for variety that can be based on differences in tastes between consumers.
Reason for Trade #4: Existence of Economies of Scale in Production
The existence of economies of scale in production is sufficient to generate advantageous trade between two countries. Economies of scale refer to a production process in which production costs fall as the scale of production rises. This feature of production is also known as “increasing returns to scale.” Two models of trade incorporating economies of scale are presented in Chapter 6 "Economies of Scale and International Trade".
Reason for Trade #5: Existence of Government Policies
Government tax and subsidy programs alter the prices charged for goods and services. These changes can be sufficient to generate advantages in production of certain products. In these circumstances, advantageous trade may arise solely due to differences in government policies across countries. Chapter 8 "Domestic Policies and International Trade", Section 8.3 "Production Subsidies as a Reason for Trade" and Chapter 8 "Domestic Policies and International Trade", Section 8.6 "Consumption Taxes as a Reason for Trade" provide several examples in which domestic tax or subsidy policies can induce international trade.
There are very few models of trade that include all five reasons for trade simultaneously. The reason is that such a model is too complicated to work with. Economists simplify the world by choosing a model that generally contains just one reason. This does not mean that economists believe that one reason, or one model, is sufficient to explain all outcomes. Instead, one must try to understand the world by looking at what a collection of different models tells us about the same phenomenon.
For example, the Ricardian model of trade, which incorporates differences in technologies between countries, concludes that everyone benefits from trade, whereas the Heckscher-Ohlin model, which incorporates endowment differences, concludes that there will be winners and losers from trade. Change the basis for trade and you may change the outcomes from trade.
In the real world, trade takes place because of a combination of all these different reasons. Each single model provides only a glimpse of some of the effects that might arise. Consequently, we should expect that a combination of the different outcomes that are presented in different models is the true characterization of the real world. Unfortunately, because of this, understanding the complexities of the real world is still more of an art than a science.
- The five main reasons international trade takes place are differences in technology, differences in resource endowments, differences in demand, the presence of economies of scale, and the presence of government policies.
- Each model of trade generally includes just one motivation for trade.
- List the five reasons why international trade takes place.
Identify which model incorporates
- differences in technology,
- presence of economies of scale,
- differences in demand,
- differences in endowments.
- The Reasons for Trade
- The Theory of Comparative Advantage: Overview
- Ricardian Model Assumptions
- The Ricardian Model Production Possibility Frontier
- Definitions: Absolute and Comparative Advantage
- A Ricardian Numerical Example
- Relationship between Prices and Wages
- Deriving the Autarky Terms of Trade
- The Motivation for International Trade and Specialization
- Welfare Effects of Free Trade: Real Wage Effects
- The Welfare Effects of Free Trade: Aggregate Effects
- Appendix: Robert Torrens on Comparative Advantage