The field of international economics covers both international financial transactions and international trade in commodities and services. The first article below provides an integrated theory of these two major aspects of the field. The remaining articles under this entry deal with the theory and patterns of international trade. For government regulation of international trade, seeInternational trade controls. For further discussion of international financial transactions, seeInternational monetary economics. Other important aspects of international trade are discussed inInternational integration, article oneconomic unions, and in the article onCommodity agreements,international. Also relevant isCommunism, economic organization of, article oninternational trade.
I. THEORYHarry G. Johnson,
II. MATHEMATICAL THEORYLionel W.McKenzie
III. TERMS OF TRADEM. C. Kemp
IV. PATTERNS OF TRADEMichael Michaely
The theory of international trade is that branch of economic theory concerned with trade between nations and, more broadly, with all aspects of the economic relations between nations. The concept of a nation in this context is somewhat ambiguous and a matter of degree rather than of kind, but not so much so as to cause serious difficulty. To the classical economists, the distinguishing characteristic of a nation was the combination of internal mobility and international immobility of factors of production, an approximation that is, if anything, more appropriate to the twentieth than to the nineteenth century and still dominates the theory of international trade. It has, of course, long been recognized that a theory constructed on these assumptions is equally applicable to trade between geographic regions, whether these are contained within a larger national unit or themselves contain several nations. The theory can also be extended to the analysis of economic relations of groups in the economy between which mobility is restricted or absent, such as skilled and unskilled workers or (a recent application) white and colored workers where color discrimination exists.[SeeDiscrimination, economic.]
A nation may alternatively be distinguished by its political sovereignty, which entails both a special concern for nationals, as distinct from foreigners, and the existence of policies of intervention in economic relations with other nations. Sovereignty also entails a distinctive national currency, whose quantity and value in terms of other national currencies are subject to national control. This definition of the nation as the object of analysis has become increasingly relevant with the growth of nationalism and of governmental economic management and planning in the twentieth century; and these trends have evoked major changes in the approach, as well as the content, of international trade theory. Nevertheless, the economic and political definitions of a nation correspond sufficiently closely to each other and to economic reality for the scope of international trade theory to be reasonably clearly defined.
The theory of international trade is the application of general value theory and monetary theory to a special case in which the microeconomic decision units (households and firms) are grouped into subunits (countries or regions) of the macro-economy differentiated from one another in the way just described. This special case emphasizes certain problems and approaches that are usually given much less prominence in general economic theory.
In the first place, the units of analysis are too large in relation to the whole for the methods of Marshallian partial-equilibrium analysis to be safely applied. While these methods have proved illuminating in particular contexts, at least transitionally, a general equilibrium approach to international trade theory is demanded by the nature of the problems. Second, the interest of the analysis frequently lies in the economic welfare of a particular national unit or the distribution of economic welfare among the owners of the different factors of production at the disposal of a particular national unit, rather than in the global welfare of the world economy. Third, the existence of separate national currencies necessitates a special concern with the problems of monetary equilibrium and particularly with the dynamics of monetary adjustment.
Broadly speaking, the theory of international trade has been historically developed largely in response to national concern with particular problems of international economic policy. One consequence has been that although in its early stages the theory contributed much to general economics, in modern times it has progressed mainly by refining and elaborating analytical techniques originating in general economic theory; an important exception, however, is the recently originated “theory of second best,” a generalization from customs union theory capable of wide application in other branches of economics. Another consequence is that much of the literature of the subject is ad hoc and unsystematized. For this reason, and also because the analytical techniques employed are among the most complex in economic theory, there exists an unusually wide gulf between the theory as understood by specialists and the principles commonly advanced in popular debate and public policy formation or even employed by general economists writing on international economic problems. The modern “classics” (Haberler 1933; Ohlin 1933) are seriously out of date in both orientation and technique, while the only postwar work of comparable analytical quality and range (Meade 1951–1955) is forbiddingly abstract and taxonomic in style. Fortunately, however, a number of excellent recent surveys of the field or major sections of it, including extensive bibliographies, are available to guide the interested reader (Caves I960; Mundell 1960a; Haberler 1954; Johnson 1962; Bhagwati 1964; Corden 1965).
The theory of international trade is customarily divided into two major branches: the “pure,” or “real,” theory of international trade equilibrium (”the theory of international values”) and the “monetary” theory of balance-of-payments adjustment (”the theory of the mechanism of adjustment”). The former is concerned with the determination of relative prices and real incomes in international trade, abstracting from the intervention of money. The implicit assumption that whatever adjustments of money wage and price levels or exchange rates required to preserve international monetary equilibrium do actually take place is a potent source of difficulty and confusion in applying the theory to actual problems. International monetary theory, in its classical formulation, was concerned with the automatic mechanism by which international monetary equilibrium was attained or preserved under the gold standard and, subsequently, with the automatic mechanisms of adjustment under fixed and floating exchange rate systems. Since World War II, however, the development of independent national economic policies aimed at full employment, price stability, and economic growth, with the consequent appearance of the maintenance of balance-of-payments equilibrium as a policy problem, has led to the reformulalation of the theory of adjustment as an explicit theory of balance-of-payments policy. The pure theory of international trade deals with problems very similar to those posed in location theory but differs from location theory in the level of abstraction practiced and in taking relatively little account of transport costs and economies of scale as determinants of the location of economic activities and the pattern of trade. The separation of the two is unfortunate, and their integration is a desirable objective of future development.[SeeSpatial economics.]
The pure theory of international trade
Comparative advantage and gains from trade
The central concern of the pure theory of international trade is to explain the causes of international trade and the determination of the equilibrium prices and quantities of traded goods and to analyze the effects of trade on economic welfare; that is, the theory is concerned with both positive and normative questions. The normative concern is particularly dominant in the theory of the effects of tariffs and other governmental interventions in international trade—a perennial problem that has acquired new interest in the modern world of planned economic development based on protected industrialization and deliberate import-substitution.
The classical theory. The classical economists developed the basic concepts of the theory in two steps: Ricardo contributed the theory of comparative costs, which explained both the cause and the mutual beneficiality of international trade by international differences in relative costs of production; and John Stuart Mill added the principle that the relative prices of the goods exchanged must be such that the quantities demanded in international trade are equal to the quantities supplied. The theory of comparative costs is most easily understood from Ricardo’s example: in England a gallon of wine costs 120 and a yard of cloth 100 units of work, while in Portugal the costs are 80 and 90 units of work, respectively. England has an absolute cost disadvantage in both goods but a comparative advantage in cloth, since the production of a yard of cloth involves sacrificing production of 1⅛ gallons of wine in Portugal but only ⅚of a gallon in England, these being the prices of cloth in terms of wine that would rule in the two countries if labor in each is perfectly mobile and prices accurately reflect labor costs. Ignoring transport costs, a price of cloth in terms of wine anywhere between ⅚ and 1⅛ would make it profitable for England to export cloth and import wine and for Portugal to export wine and import cloth. By so doing, each could obtain more of each of the goods with the same amount of work or consume the same amounts with less expenditure of labor. This example conveys the fundamental point that the beneficiality of international trade depends in no way on the absolute levels of economic efficiency or “stages of economic development” of the trading partners but only on differences in their relative costs of production in the absence of trade. It has been reformulated here so as to bring out the essential point that what matters is differences in the alter-native opportunity costs of commodities in the absence of trade. Ricardo’s own formulation, with its assumption of a single factor of production producing goods at constant costs and its concept of a fundamental unit of real cost (hours of work), unnecessarily tied trade theory to the labor theory of value. The result of his successors’ attempts to abandon the simple labor theory of value while retaining the real cost concept was an increasingly cumbersome theoretical structure, which was ultimately abandoned in favor of the opportunity cost approach. This, the modern approach, can incorporate theories of production of any desired degree of complexity and specifically allows alternative opportunity cost to vary with changes in the production pattern. However, as soon as more than one factor of production is introduced, the analysis of the effects of trade on economic welfare becomes more complex than in the classical system, and the demonstration of gain from trade requires considerably more conceptual sophistication.
The modern theory. The modern approach to the question of the gains from trade recognizes that the inauguration of trade or a change in the conditions of trade, such as that involved in the erection or removal of tariff barriers, will have differential effects on the welfare of individuals—either by changing the relative prices facing them as consumers (affecting differentially individuals with different tastes) or by changing the relative prices paid for the factors of production (affecting differentially the incomes of individuals who own the factors in different ratios). The evaluation of gain or loss therefore necessitates interpersonal welfare comparisons, which must be excluded as illegitimate. In their absence, welfare conclusions can only be derived either on the (unrealistic) assumption that a social judgment of the desirable distribution of real income exists and is implemented consistently or in terms of potential welfare, that is, in the sense that in one situation everyone could be made no worse off and some be made better off than they would be in the alternative situation, by means of appropriate compensations through transfers of income.
Ethical neutrality further requires that this result should be true for all possible distributions of economic welfare (real income) among individuals, not merely for the distribution that happens to prevail before or after a change of situation. This requirement is satisfied by any change that makes more of all commodities (including leisure) available to the economy or, in the limit, no less of any commodity, regardless of how the community allocates its consumption among commodities. In technical terms, such a change produces an outward shift of the transformation frontier—the relation embodying the alternative maximal combinations of commodities and leisure the economy can produce with its resources and available technology.
Provided that domestic economic organization is such that free competition would maximize welfare in the potential sense (which requires the absence of “external effects” of production or consumption by one firm or consumer on the efficiency or welfare of others, and the absence of taxes and other distortions preventing prices from corresponding to relative marginal costs), the inauguration of international trade by a closed economy is such a potential-welfare-increasing change. The availability of international relative prices different from the relative prices ruling in the closed economy enables the country to “produce” goods more cheaply by exporting other goods in exchange for them. The gains from trade so obtained derive conceptually from two sources: the gain from substituting lower-cost for higher-cost goods in consumption (the consumption effect of trade) and the gain from diverting resources from direct, higher-cost to indirect, lower-cost production of goods imported from the world market (the production effect, or specialization effect, of trade). It is to be noted that the gains from trade do not depend on specialization in production: the gain from the consumption effect would accrue even if resources were completely immobile between industries.
In the same potential welfare sense, it can be shown that free trade will maximize world income by equating the marginal values of commodities to all consumers and the marginal costs of production of goods by all producers. This does not, however, imply that in the absence of international compensations a free trade policy will always maximize a country’s economic welfare. While trade is always superior to self-sufficiency, restricted trade may be superior to free trade. This will be so if the country has any monopoly or monopsony power in world markets that it can exploit by appropriate tariffs or other restrictions. The exploitation of such power is, indeed, a necessary condition for maximizing the country’s welfare: the tariff rate or degree of restriction required is analyzed in the theory of the optimum tariff and of optimum tariff structures. Moreover, a country may attain a higher level of welfare by following an optimum tariff policy, even if other countries retaliate, than it would under universal free trade. Thus, the case for free trade, frequently asserted with considerable dogmatism in the past, appears in contemporary international trade theory as an extremely qualified proposition, dependent on the maintenance of international monetary stability, on efficient representation of alternative social opportunity costs by money costs and prices in the domestic currency, on the social acceptability of the resulting distribution of income or the adoption of a social policy with regard to income distribution, and on the possible need for international income transfers. [SeeInternational trade controls, article Ontariffs and protectionism.]
The gains from international trade are obviously dependent on the difference between the prices for exports in terms of imports established in international trade (“the commodity terms of trade”) and the prices that would rule in a closed economy. The classical economists attempted to relate the distribution of the gains from trade to the precise point between the closed-economy comparative cost ratios at which the equilibrium international price ratio fell. Clearly, however, this is inadequate, and the gains for an individual country can only be measured in theory by the application of one or another version of the compensation principle—that is, by calculating the amount of resources that could be extracted from a country while leaving it no worse off than it would have been in the absence of trade or by calculating the amount of resources that it would have to be given in the absence of trade to make it as well off as it would be if allowed to trade. In practice, while this approach has been applied in specialist studies of the welfare cost of protection, economists have generally been content to analyze changes in countries’ gains from trade by reference to changes in an index expressing one or another concept of the terms of trade[seeInternational trade, article onterms of trade]. Of the various terms-of-trade concepts that have been developed, the most defensible and reliable is the commodity terms of trade—the price of imports in terms of exports or its reciprocal. The loss or gain accruing to a country as a result of short-run changes originating externally can be measured to a first approximation by the change in the commodity terms of trade multiplied by the value of imports. But changes in the commodity terms of trade, especially in the longer run, may be the result of internal developments—changes in productivity or changes in taste. In this case, their implications for economic welfare cannot be readily interpreted except in the circular sense that real income would have been measurably different if the terms of trade had remained unchanged.
The Heckscher–Ohlin model
The classical theory of international trade explained trade by differences in the comparative productivity of labor. This approach has its modern followers, who have been surprisingly successful in explaining differences in the relative shares of different countries in world imports of different products by differences in their relative labor productivity in the relevant industries. The existence of the differences in comparative costs underlying international trade, however, was merely assumed and not explained by the theory. Contemporary international trade theory attempts the more fundamental task of explaining these differences by differences in the ratios in which countries are endowed with factors of production. The theory originated with Heckscher (American Economic Association 1949, chapter 13) but was significantly elaborated by Ohlin (1933); in its contemporary form it owes a great deal to analytical techniques and propositions contributed by Samuelson (1948 and elsewhere). As commonly expounded and applied, the theory employs a simple but elegant model of production and distribution in the national economy, usually referred to as the Heckscher–Ohlin model, although its mechanics are, as mentioned, largely the work of Samuelson. The Heckscher–Ohlin model assumes a perfectly competitive economy in which two commodities (call them X and Y) are produced by two factors of production (call themK and L), utilizing production functions characterized by constant returns to scale and diminishing marginal rate of substitution between the factors. The quantities of the factors available are assumed fixed, and the production functions are assumed to be such that at any given ratio of the price ofK to the price of L, the production of X is K-intensive and the production of Y is L-intensive, in the sense that X employs a higher ratio of K to L than does Y. For the analysis of international trade the world is assumed to be composed of two such national economies, the production functions and factors are assumed to be identical in the two countries, and the tastes of consumers in the two countries are assumed to be similar, in the sense that, at the same commodity price ratio, they will consume the two goods in roughly the same ratios.
The production side of this model has two fundamental properties, from which an extensive and elegant set of theorems can be derived. These result from the assumption of constant returns to scale, which makes the ratios in which factors are employed in the two industries depend only on their relative prices; the assumption of the invariance of relative factor intensity, which links relative factor prices uniquely to relative commodity prices; and the assumption of fixed factor endowments, which links the production pattern uniquely to commodity or factor prices. Consider a particular factor price ratio: this will fix the ratios in which factors are used in the two industries. The factor use ratios in combination with the factor price ratio will fix the relative costs of production and price ratio of the commodities. The factor use ratios in combination with the endowment ratio will fix the ratios in which the commodities are produced, since their aggregate factor requirements must just absorb all of the available factor supplies.
Stolper–Samuelson relationship. Now consider a rise in the relative price of factor K. This will raise the relative price of commodity X, which uses relatively more K than does commodity Y. It will induce a substitution of L for K in both industries, raising the marginal product ofK and lowering that of L in terms of both X and Y, so that owners of K will be unambiguously better off and of L worse off, regardless of their tastes for the two goods. The induced decrease in the ratio of K to L in both industries, in combination with the fixed factor endowments, will necessitate an increase in the production of X (the K-intensive commodity) and a reduction in the production of Y, if all factor supplies are to remain employed.
Thus, as long as the economy produces both goods, there is a unique relation between the commodity price ratio, the factor price ratio, the real incomes of factor owners, and the pattern of production. An increase in the relative price of a commodity increases the relative price of the factor used intensively in producing it, raises the real income of that factor and lowers the real income of the other factor, and increases output of that commodity at the expense of the other. This relationship is known as the Stolper–Samuelson relationship (American Economic Association 1949, chapter 15).
Rybczynski theorem. Alternatively, consider an increase in the quantity of one factor available to the economy, the commodity price ratio and therefore the factor price ratio and factor-intensities remaining constant. To absorb the increased quantity of the factor while paying it the same price, the economy must release a quantity of the other factor to work in combination with it. This can only be done by contracting the industry that uses the other factor intensively and expanding the industry that uses the augmented factor intensively, thereby freeing some of the other factor for re-employment with the additional supply of the augmented factor. Hence, at constant commodity prices, an increase in the quantity of a factor implies an increased output of the good that uses it intensively and a reduction in the output of the other good. This relationship is referred to as the Rybczynski theorem (1955).
Samuelson factor price equalization theorem. It follows from the Rybczynski theorem that the country with a relative abundance (high endowment ratio) of a particular factor would, at any given commodity price ratio, produce relatively more of the commodity that uses that factor intensively; and hence that, assuming similarity of tastes, the price of that good would be relatively lower than in the other country, in closed-economy equilibrium. In other words, relative factor abundance gives rise to comparative advantage. It follows from the Stolper–Samuelson relation and the assumed identity of factor prices and production functions that the equalization of commodity prices in the two countries that would result from free trade in the absence of transport costs would tend to equalize relative factor prices (and, therefore, absolute factor prices, given the identity of production functions), and would in fact exactly equalize factor prices if both countries produced both goods(i.e., were “incompletely specialized”) in the free trade equilibrium. In this case trade would serve as a complete substitute for factor movements, and immobility of factors would not prevent the maximization of world income. This is the Samuelson factor price equalization theorem (1948). It will generalize beyond the two-factor two-commodity model, factor prices being equalized as long as the number of goods produced in each country is equal to the number of factors, although the restrictions required on the factor-intensities of the commodities are necessarily more complex. The theorem has sometimes been cited as evidence of the irrelevance of international trade theory to the real world, on the grounds that the theorem is inconsistent with the existence of great inequality of income per head. This criticism is invalid, since the theorem relates to factor prices and not per capita income (which depends on factor endowment); and the theorem should be interpreted, not as a prediction about the real world, but as a statement of the necessary conditions for factor price equalization. The nonfulfillment of these conditions in the real world accounts for the observed inequalities of factor prices.
Effect of tariffs. The Stolper–Samuelson relation clarifies the theory of tariffs by permitting unambiguous conclusions about the effects of tariffs on the real incomes of factors. In the normal case, in which the two trading countries’ demands for each other’s exports are elastic, a tariff will improve a country’ terms of trade and raise the internal price of imports, thus shifting production toward import-substitutes and raising the real income of the factor used intensively in producing them. Whether the country as a whole loses or gains (in the potential-welfare sense) depends on whether the tariff is sufficiently higher than the optimum tariff for the gain on the terms of trade to be offset by the restriction of trade volume. There are two “exceptional” cases: if the country’s own demand for imports is inelastic and if those who spend the tariff proceeds have a stronger marginal preference for imports than the average consumer, the demand for imports may increase and the terms of trade turn against the country; if the foreign country’s demand for imports is inelastic and if domestic consumers have a stronger marginal preference for the export good than do foreigners, the terms of trade may improve so much that the internal price of imports falls and the income-distribution effects are opposite to those normally expected (Bhagwati & Johnson 1961).
Effect of economic growth. The Rybczynski theorem is the foundation of the theory of the effects of economic growth on trade: an increase in the available quantity of the factor used intensively in the export industry must increase production of export goods and reduce production of import-substitutes at the initial equilibrium terms of trade, thereby making the country more dependent on imports and tending to turn the terms of trade against it; and the converse. An extension of the logic of the theorem indicates the effect of technical change: technical change in an industry reduces its relative costs; to restore the cost ratio to equality with the initial terms of trade, the relative price of the factor used intensively in that industry must rise. This will reduce the use ratio of that factor in both industries, requiring an expansion of the technically improved industry and a contraction of the other to keep the factors fully employed. The exception is the case where the technical change is strongly saving of the factor used relatively unintensively in the improved industry (i.e., the change raises the intensity of use of the already intensively used factor sufficiently to offset the induced factor substitutions). Barring the exception and excluding the complications associated with the effects of the redistribution of income between the factors on the demands for the goods, it follows that technical change will make the country more dependent or less dependent on trade, and worsen or improve its terms of trade, according to whether the change occurs in the export or the import-competing industry (Johnson 1962, chapter 4; Meier 1963, chapters 2, 3).
Effect of transfer. A standard problem in international trade theory concerns the effects on the terms of trade of a continuing transfer from one country to another, such as reparations payments, foreign investment, or a balance-of-payments surplus; the point of the problem being that if the transfer worsens the terms of trade, it imposes a “secondary burden,” additional to the transfer itself, on the country making the transfer. Since the transfer shifts purchasing power from one country to the other, the question is simply whether its effect is to increase or decrease world demand for the exports of the country making the transfer. The criterion for this can be expressed in various ways. The one most commonly used is whether the sum of the proportions of the transfer by which the demand for imports is changed in the two countries exceeds or falls short of unity. Classical theory and the “common sense” of many economists indicate a presumption that the effect will be a worsening of the terms of trade. Such a presumption can be established theoretically, however, only on the assumption of unit income elasticities of demand for goods and of the presence of tariffs or of transport costs on imports incurred in the exported good, both of which will bias a country’s marginal expenditure toward its export good. This analysis is not altered by the introduction of nontraded goods, since there is no presumption that these are closer substitutes for exported than for imported goods (Johnson 1958, chapter 7).
Evaluation of the model. The Heckscher–Ohlin model appears to provide a sensible explanation of the causes of trade and, in the factor price equalization theorem, provides a powerful argument for the beneficiality of freedom of trade. Its simplicity, however, derives from two of its assumptions, whose crucial importance has been revealed by intensive exploration of the model. This critical examination was prompted, on the one hand, by incredulity concerning the factor price equalization theorem and, on the other, by Leontief’s empirical finding, derived from his input–output tables, that contrary to expectation United States exports are more labor-intensive and less capital-intensive than United States imports (1953). Leontief rationalized this result by hypothe-sizing that American labor is three times as productive as foreign labor.
Exploration of the model has demonstrated, first, that demand differences may counteract the influence of differing factor endowments on trade patterns; second, that unless the elasticities of substitution are the same in the two industries, the relative factor-intensities of industries will reverse themselves as relative factor prices change. (This possibility has been confirmed by empirical studies applying the constant-elasticity-of-substitution production function.) More generally, if elasticities of substitution are variable, relative factor-intensities may reverse more than once. Such reversibility means that a rising relative price of a factor will be associated alternatively with a rising and a falling price of the commodity that initially uses it intensively (the falling relative commodity price occurring after the factor-intensity reversal). It implies that even with similar tastes in the two countries, comparative advantage, as reflected in closed-economy equilibrium comparative-cost ratios, need not reflect relative factor abundance; and that, since more than one relative factor price may be associated with a given commodity price ratio, free trade with incomplete specialization in both countries does not necessarily imply factor price equalization and may indeed imply a greater divergence of relative factor prices than would exist in the absence of trade.
These two theoretical considerations—demand differences and factor-intensity reversal—have been advanced to reconcile Leontief’s findings with the theory. A more plausible argument is that in confining his calculations to labor and capital only, Leontief ignored the influence of third factors of production, such as natural resources, labor skill, or managerial ability, so that his results are not a fair test of the Heckscher–Ohlin theory. It has also been argued that these results may be attributable to the influence of the American tariff (Travis 1964).
The Heckscher–Ohlin theory is obviously a plausible approach to the explanation of trade in products for which localized natural resources are important; but it is equally obviously not very helpful in explaining the composition of trade in industrial products, both intermediate and finished, between advanced industrial nations, which accounts for a major share of total international trade. Various theoretical approaches to this problem have been suggested, none of which possess the logical rigor and elegance of the Heckscher–Ohlin model. Kravis (1956) has pointed to the influence of “availability” (existence and elasticity of marginal supplies) on trade between advanced nations. Burenstam Linder (1961) hypothesized that industry develops to supply the home market, adapts its products to the income level of that market, and exports primarily to countries with similar income levels. Travis (1964) and Johnson (1965a) have called attention to the influence of tariff structures on patterns of international trade. Others have emphasized such elements in industrial competitiveness as economies of scale, technological superiority based on research and development expenditure, and the availability of skilled labor (“human capital”). Vernon (1966) has attempted to integrate a number of these factors into a dynamic “product cycle” theory of international trade and investment. It is evident that further progress on this problem will require a deeper understanding of the economics of industry, including location theory, and that trade theorists will have to concern themselves with two aspects of international economic relations that have so far been relatively neglected: the influence of monopolistic competition on location and trade, and the content and influence of protectionist policies.
Protection and the theory of second best
Protection has been a perennial policy issue since long before the origins of international trade theory, and international trade theorists in the main tradition of the subject have consistently been concerned with advocating freedom of trade and exposing the innumerable fallacies of protectionist thinking. Two arguments for tariffs have, however, traditionally been acknowledged as valid—the terms of trade (“optimum tariff”) argument, and the infant industry argument, favoring temporary protection of industries capable eventually of establishing themselves in international competition. With respect to these arguments, international trade theorists have confined themselves to observing that protection is justified only if the empirical conditions posited are actually present and to arguing the superiority of a subsidy over a tariff in the infant industry case.
Contemporary interest in the economic development of the underdeveloped countries has revived both these arguments for protection—especially the infant industry argument, which has been broadened into an infant economy argument— and has added a new argument, the so-called Manoilesco argument (Corden 1965, pp. 60–61). This argument bases a case for industrial protection on the assertion that wages in the industrial sector of backward countries exceed the alternative opportunity cost of labor, either because labor in the industrial sector receives a wage differential over agricultural labor that is not justified by skill or cost-of-living differences or because in peasant agriculture labor receives a share of output equal to its average product and in excess of its marginal product, which may be zero.
Customs unions. Interest in the theory of tariffs has also been generated by the movement toward economic integration in Europe and by the associated problem of the economic effects of customs unions and free trade areas. (Both of these involve elimination of tariff barriers to trade between the members and the retention of tariffs against outsiders, but a customs union entails unification of the national tariffs in a common schedule, whereas in a free trade area the members retain tariff autonomy.) Such arrangements entail a simultaneous movement toward free trade (among the members) and protection (of members’ producers in each other’s markets). The problem is whether the net result is a gain or a loss of economic welfare for individual members, the union as a whole, outsiders, and the world as a whole.[SeeInternational integration, article On economic unions.]
The theoretical techniques required for dealing with these problems were provided by Viner (1950) in the concepts of trade creation and trade diversion: a customs union increases welfare to the extent that it creates trade by diverting demand from higher-cost domestic to lower-cost partner products and decreases welfare to the extent that it diverts trade from lower-cost, foreign to higher-cost, partner products. (A fuller analysis of the effects on the separate countries concerned must also take account of terms-of-trade effects.) Viner’s analysis employed a classical constant-cost model and considered only effects on the location of production, but it was readily generalized by others to take account of substitutions among goods in consumption and of varying production costs.
Following Viner, Meade (1951–1955, vol. 2) developed an elaborate analytical apparatus for analyzing the effects of tariff and other policy changes on welfare when these changes are introduced in an economy whose equilibrium is distorted by tariffs, taxes, and other factors preventing prices from corresponding to the social costs or values of goods. The essence of the technique is to attach welfare weights, reflecting the divergences of social from market costs or values, to the changes in economic quantities induced by the tariff change and to assess the total effect by the sum of the changes so weighted; the weights may include adjustments based on interpersonal comparisons of utility for different groups. The technique yields a number of propositions about the circumstances in which a customs union is likely or unlikely to increase economic welfare and also the proposition that preferential tariff reduction is more likely to be beneficial than complete free trade in such a union. Its main importance, however, is in providing a theory that is capable of quantitative application to practical problems.
The theory of second best. A customs union is, from the free trade point of view, a second-best arrangement; and the problems dealt with in Meade’s analysis all involve choices among alternatives when the first-best, or welfare-maximizing, solution is ruled out by assumption. This is the nature of most policy problems in economics, in other areas as well as international trade, so that Meade’s theoretical construction is of great general applicability. The findings of customs union theory and of other policy-oriented branches of economics have been synthesized by Lipsey and Lancaster in “The General Theory of Second Best” (1956). The central proposition of this theory is that when some constraint prevents the competitive system from achieving a welfare maximum, the achievement of the attainable second-best maximum will generally require a variety of other interventions in the competitive process. This is a principle of great importance, for it implies that “piecemeal” policies of seeking to establish perfect competition in particular sectors of the economy may decrease rather than increase welfare and that the welfare effects of particular governmental interventions can only be evaluated in the light of detailed knowledge of the other distortions from perfectly competitive conditions existing in the economy.
The theory of second best casts the traditional arguments for tariff protection in a new light. All such arguments except the optimum tariff argument are second-best arguments, in the sense that they recommend the introduction of a distortion in the competitive system to offset other distortions alleged or believed to exist (in the investment market, commodity markets, or factor markets). The implementation of such protectionist policies cannot, therefore, lead to a first-best welfare maximum; whether it leads toward or away from a second-best welfare maximum depends on the empirical circumstances and cannot be determined by a priori argument (Johnson 1965b), Despite the importance of the issue and the vast literature that has accumulated on tariffs and protectionism, there have been virtually no attempts to measure the effects of tariffs and test empirically the arguments advanced for protection.
Finally, it should be observed that the contemporary theory of tariffs, customs unions, and so forth, adopts as its standard of economic welfare the satisfactions enjoyed by individuals in their capacity as private consumers. It is this standard that sets the international trade theorist in perennial conflict with protectionists and national policy makers in general. If trade theorists were to consider seriously the values of the latter, which entail a less atomistic concept of social welfare, many of their policy conclusions would be radically altered; but they might be far more effective in persuading nations to follow more economically rational international economic policies[seeInternational trade controls, article ontariffs and protectionism].
The monetary theory of balance-of-payments adjustment
The classical adjustment mechanism
The pure theory of international trade assumes that money prices and costs will adjust passively to the real equilibrium of the international economy. The classical explanation of this adjustment was provided in Hume’s price–specie flow mechanism, originated to demonstrate the fallacy of the mercantilist view that national policy should aim at augmenting a country’s stock of gold by taking measures to ensure a permanent surplus on the balance of trade. According to the theory, the stock of international money (which was initially identified with gold and silver, whose total quantity was assumed fixed, although the theory was subsequently extended to incorporate deposit money and the intervention of central banks) would tend automatically to be so distributed among nations that each would have the quantity it demanded, consistent with international equilibrium. An increase in the quantity of money in a particular country would raise prices there, decreasing exports and increasing imports, bringing the exchange rate to the gold-export point and inducing an outflow of gold, which would cause domestic prices to fall and foreign prices to rise until equilibrium was restored with a generally higher level of world prices.
This account of the adjustment mechanism, which follows Hume and Viner (see Viner 1932, p. 265), is unsatisfactory in two respects. First, it fails to bring out clearly that it is the expenditure of unwanted cash balances that leads to the import surplus and the corresponding gold flow and that it is the adjustment of actual to desired cash balances, through the combination of international redistribution of money and reduction of its purchasing power by rising prices, that eventually restores equilibrium. Second, in deducing the movements of prices involved in the adjustment process from a mechanical application of the quantity theory of money to the separate national economies as if they were partially closed off from trade, it not only imposes an arbitrary causal sequence but greatly exaggerates the necessity of international money flows to the adjustment process. The strategic role in the adjustment mechanism assigned to international money flows as a result of naive quantity theorizing was inappropriately carried over from the analysis of adjustment to monetary disturbances to the analysis of adjustment to real disturbances in the predominant tradition of classical trade theory. In the work of Taussig and Viner it gave rise to spurious problems associated with the fact that observed flows of international reserves seemed much too small, relative to the magnitude of disturbances, to account for the preservation of international equilibrium.
The minority tradition, represented by Ricardo and Wheatley, argued that the adjustment to non-monetary disturbances would occur automatically through relative price changes, without an intervening sequence of money flows and inflationary–deflationary price movements. This view was strengthened by the recognition, in analyses of the transfer problem, of the equilibrating effects on the balance of payments of the changes in demands for goods associated with the transfer of purchasing power.
The difference in viewpoint over the importance of monetary adjustments in the correction of real disturbances is represented in the modern literature in the debate between Keynes and Ohlin over the problem of German reparations after World War I (American Economic Association 1949, chapters 6, 7). From the vantage point of modern monetary theory, it is clear that monetary adjustments will be called into play by real disturbances only to the extent that the latter entail monetary disturbances also, as, for example, when a decrease in demand for a country’s exports or a transfer reduces its real income and demand for cash balances and prompts a transitional excess of expenditure over income in the form of a balance-of-payments deficit. Thus—contrary to the authoritative judgment of Viner (1932, p. 206)—Bastable, Wick-sell, and Ohlin appear to have been justified in denying any significant role in the adjustment of real disturbances to price-level movements induced by gold movements.
Purchasing power parity. The classical theory of the adjustment mechanism and of international monetary equilibrium logically implies the theory of purchasing power parity, developed by Gustav Cassel for the analysis of exchange-rate changes in the period of monetary disturbance that followed World War i (the connection is denied in Viner 1932, p. 206, but well documented in Haberler  1961, pp. 45–51). The theory was discredited, largely as a result of Viner’s criticisms, in the interwar period but has been revived in connection with postwar exchange-rate problems—first concerning the European currencies in the “dollar-shortage period” and later the question of the overvaluation of the American dollar. The theory concerns the relationship between the equilibrium exchange rates among national currencies and their respective domestic purchasing powers (in a floating exchange-rate system) or between national equilibrium price levels and the exchange rates (in a fixed exchange-rate system).
The absolute version of the theory asserts that equilibrium exchange rates or price levels must be such that currencies exchange at purchasing power parity: if £1 will buy in England goods that would cost $2.80 in the United States, a free exchange market will establish a rate of $2.80 to £1; and if the British government fixes the rate at $2.80 to £1, the price level in England must be such that £1 will buy the same quantity of goods in England as $2.80 will buy in the United States. This version of the theory is either a truism—if attention is confined to internationally traded goods, and tariffs and transport costs are ignored—or demonstrably wrong, since the prices of nontraded goods relative to traded goods in the various countries will vary according to the relative efficiency of these countries in producing nontraded as compared with traded goods.
The relative version of the theory asserts that equilibrium exchange rates will change in proportion to changes in relative purchasing power, or equilibrium price levels in proportion to changes in official exchange rates. This version of the theory ignores the influence of changes in tariffs and transfers or in real demand and supply conditions, which will have differential effects on the trading positions of countries and on their relative price levels. Nevertheless, it is a reasonable approximation for the analysis of short-run monetary disturbances of the type with which Cassel was concerned and provides a rough guide for policy-makers obliged to decide the magnitude of exchange-rate changes. As a matter of fact, the exchange rates of the major countries do not de-part very far (typically less than 20 per cent) from purchasing power parity. Haberler ( 1961, p. 51) has argued that this reflects high elasticities of demand and supply in international trade.
The theory of balance-of-payments policy
The problems of international monetary disequilibrium that have beset the world economy since the end of World War I have prompted a rapid development and elaboration of the theory of international monetary adjustment and have transformed that theory from a theory of automatic mechanisms to a theory concerned with policy alternatives open to governments. The monetary disorganization that immediately followed World War I not only produced the purchasing-power-parity theory but led to recognition of the possible conflict between internal stability and external stability inherent in the choice of either a fixed or a floating exchange rate and to analysis of the comparative merits of the two systems. The circumstances of the restoration and collapse of the gold standard also stimulated theorizing on the role of capital movements, especially short-term capital movements, in the process of international equilibration and as a source of disequilibrium.
These issues again became lively with the postwar restoration of the convertibility of the European currencies and the reversal of the “dollar shortage.” With respect to these issues, international monetary economists divide into four positions, which can be identified closely with the influence of a dominating historical experience: advocacy of a return to the classical gold standard, associated with the post-World War I experience of inflationary monetary policies in Europe; advocacy of a floating exchange-rate system, associated with the 1930s experience of international deflation; support of the present dollar-based International Monetary Fund system, associated with practical experience in managing it; and advocacy of the establishment of a world central bank, associated with faith in the possibility of intelligent international monetary management combined with recognition of the defects of the present hybrid system.
The debate over the alternatives has for the most part covered familiar ground, but significant advances have been made in understanding of the theory of a floating rate system (Friedman 1953; Sohmen 1961) and of the problems raised in such a system by capital movements (Mundell 1963). Mundell (1961) and McKinnon (1963) have cast the issues in an illuminating new way by raising the analytical issue of the optimal size and properties of a currency area; and Kenen (1960) has contributed a theoretical analysis of the problems of an international monetary system in which the currency of one country is held as a reserve by the others, in substitution for international reserve money.[SeeInternational monetary economics.]
Elasticity and absorption approaches. The chief new analytical developments of the interwar period were the application of Keynesian multiplier theory to the mechanism of international adjustment by Metzler (American Economic Association 1949, chapter 8) and Machlup (1943) and the elaboration of the criterion for exchange stability by Robinson (American Economic Association 1949, chapter 4) and others. Multiplier analysis showed that in normal cases (a positive marginal propensity to save in both countries) part but not all of the adjustment to an international disturbance would be effected automatically by induced variations in income and employment. The exchange stability criterion is a mathematical expression in terms of the elasticities of demands for and supplies of imports and exports, such that exchange depreciation would tend to improve the trade balance if the expression is positive; a sufficient condition for stability is that the sum of the elasticities of demand for imports of the two countries be greater than unity. The exchange stability criterion was interpreted, insufficiently critically, as also being the condition for devaluation to improve the balance of payments; in terms of the model employed, this is only true if Keynesian unemployment exists and the marginal propensities to save are positive. The same analysis also yielded a criterion for whether or not depreciation would tend to worsen or improve the terms of trade. While Robinson and others argued a presumption that devaluation would worsen the terms of trade, on the grounds that a country’s exports are likely to be more specialized than its imports, this argument is not convincing.
The theory so constructed was limited to Keynesian conditions of general unemployment, involved a sharp separation between the theories of the effects of income variations and of price changes, and still adhered to the mechanisms of adjustment formulation of the theory. In the postwar situation of general inflation and full or overfull employment, concern with questions of overvaluation of currencies and the probable effectiveness of devaluation led to considerable skepticism about the relevance of the “elasticity approach” to devaluation and to doubts about the capacity of devaluation to improve the trade balance. This “elasticity pessimism” was reinforced by empirical studies that indicated low elasticities of international demand (the techniques used in these studies have since been shown to be biased toward underestimating the elasticities).
The elasticity approach was challenged by Alexander (1952), who produced an alternative in the “absorption approach,” In this approach the balance of trade is expressed, not as the difference between export and import values, but as the difference between total output and the total absorption of goods (i.e., the difference between national income and national expenditure). Devaluation will improve the trade balance only to the extent that it reduces absorption relative to output. If there are unemployed resources and an increase in output would raise absorption by a smaller amount than itself, devaluation can improve the trade balance by raising the demand for output. Otherwise, devaluation can improve the trade balance only through its indirect effects in reducing demand—for example, by reducing the real stock of money through increasing domestic prices, by redistributing income toward those with a higher propensity to save, or by increasing the real burden of a progressive tax structure—and these effects may be unfavorable rather than favorable. Subsequently, a number of international trade theorists have presented syntheses or reconciliations of the elasticity and absorption approaches. This is not a difficult problem, once it is recognized that the elasticity approach is primarily concerned with the effects of relative price changes in abstraction from limitations on total output and that the absorption approach is primarily concerned with the effects of money price-level changes in a situation of fixed aggregate supply.
Policy objectives approach. In essence, the elasticity-versus-absorption issue derived from the separation of the analyses of income variation and price variation in the new developments of the 1930s and reflected the need to integrate the two aspects of the adjustment mechanism. The required integration has been provided in the theory of economic policy elaborated in general terms by Tinbergen (1952) and with specific reference to international trade by Meade (1951 –1955, vol. 1), whose work was published about the same time as Alexander’s alternative approach to devaluation theory. This theory starts from the proposition that a government in a modern state has certain policy objectives, and its basic theorem is that to achieve these objectives the government must command as many independent policy instruments as it has objectives, independence meaning that the instruments have different effects on the economy. In Meade’s work the objectives are taken to be internal balance (full employment) and external balance (equilibrium in the balance of payments). The instruments are fiscal and monetary policy for controlling the aggregate level of demand by the economy; and the exchange rate, the internal price level, or tariffs or other trade restrictions, for controlling the division of the aggregate foreign and domestic demand between domestic and foreign goods. As Johnson (1958, chapter 6) has re-formulated the theory, a country with these two objectives needs to use both expenditure-reducing (or expenditure-increasing) policies, to make the level of the country’s aggregate demand match its full-employment level of output, and expenditure-switching policies, to assure that this aggregate demand falls on the country’s own domestic output by making the foreign demand for its exports exactly balance its demand for imports.
Meade’s work is flawed by a tendency to imply that a specific policy instrument can be associated with each objective; in general, policy instruments influence the attainment of both objectives and must be conceived as being used jointly to obtain the objectives jointly. Mundell (1960b) has subsequently shown, however, that when the dynamics of policy operations are considered, stability of equilibrium requires that each policy instrument be governed by changes in the variable on which it has the relatively largest effect.
Meade’s work and much of the literature of the postwar decade assumed that exchange rates could be changed or trade controls imposed if necessary, an assumption that has become decreasingly descriptive of the international monetary environment. In Meade’s framework a country that is committed to a fixed exchange rate, is averse to the use of controls, and is pursuing both internal and external stability appears to have one instrument too few. But this apparent dilemma is resolved, once a distinction is drawn between the current account (influenced by the level of income and employment) and the capital account (influenced by the level of interest rates) of the balance of payments and it is recognized that expansion by fiscal policy tends to raise, and expansion by monetary policy to lower, interest rates. A country suffering unemployment and a balance-of-payments deficit can therefore achieve its two objectives by appropriately combining fiscal expansion with monetary restriction (Mundell 1963). A third common policy objective, acceleration of economic growth, can be accommodated by designing fiscal stimuli to encourage saving and investment. These extensions of the Meade model, however, while valid for short-run analysis, abstract from the longer-run question of how national price levels are to be realigned so as to eliminate the need to rely on policy-induced international capital movements for the maintenance of international equilibrium. In actual fact this longer-run adjustment now depends on the inability of surplus countries to prevent inflation and of deficit countries to maintain full employment. Much work remains to be done on the dynamics of this system and also on criteria for optimizing the adjustment process.
Harry G. Johnson
ALEXANDER, SIDNEY S. 1952 Effects of a Devaluation on a Trade Balance. International Monetary Fund, Staff Papers2 :263 –278.
AMERICAN ECONOMIC ASSOCIATION 1949Readings in the Theory of International Trade. Edited by Howard S. Ellis and Lloyd A. Metzler. Philadelphia: Blakiston.
BHAGWATI, JAGDISH 1964 The Pure Theory of International Trade: A Survey.Economic Journal 74:1–84.
BHAGWATI, JAGDISH; and JOHNSON, HARRY G. 1961 A Generalized Theory of the Effects of Tariffs on the Terms of Trade.Oxford Economic Papers New Series 13:225–253. → A synthesis of the previous literature on this question.
[BURENSTAM] LINDER, STAFFAN 1961An Essay on Trade and Transformation. New York: Wiley. → A suggestive but nonrigorous attack on the Heckscher-Ohlin model.
CAVES, RICHARD E. 1960Trade and Economic Structure: Models and Methods. Harvard Economic Studies, Vol. 115. Cambridge, Mass.: Harvard Univ. Press. → A critical discussion of the Heckscher–Ohlin and other models of trade and their empirical testing.
CORDEN, W. M. 1965Recent Developments in the Theory of International Trade. Special Papers in International Economics, No. 7. Princeton Univ., International Finance Section.
FRIEDMAN, MILTON (1953) 1959Essays in Positive Economics. Univ. of Chicago Press. → See especially pages 157–203, “The Case for Flexible Exchange Rates.”
HABERLER, GOTTFRIED (1933) 1936The Theory of International Trade, With Its Applications to Commercial Policy. London: Hodge. → First published in German.
HABERLER, GOTTFRIED (1954) 1961 ASurvey of International Trade Theory. Rev. & enl. ed. Princeton Univ., International Finance Section. → First published as “Aussenhandel” inHandwörterbuch der Sozialwissenschaften.
JOHNSON, HARRY G. 1958International Trade and Economic Growth: Studies in Pure Theory. Cambridge, Mass.: Harvard Univ. Press.
JOHNSON, HARRY G. 1962Money, Trade and Economic Growth: Survey Lectures in Economic Theory. Cambridge, Mass.: Harvard Univ. Press; London: Allen & Unwin. → Presentations of comparative cost theory, balance-of-payments theory, customs union theory, and the theory of trade and growth.
JOHNSON, HARRY G. 1965a The Theory of Tariff Structure, With Special Reference to World Trade and Development. Pages 9–29 in Harry G. Johnson and Peter B. Kenen, Trade and Development. Geneva: Droz.
JOHNSON, HARRY G. 1965b Optimal Trade Integration in the Presence of Domestic Distortions. Pages 3–33 inTrade, Growth, and the Balance of Payments: Essays in Honor of Gottfried Haberler, by Robert E. Baldwin et al. Chicago: Rand McNally.
KENEN, PETER B. 1960 International Liquidity and the Balance of Payments of a Reserve-currency Country. Quarterly Journal of Economics 74:572–586.
KRAVIS, IRVING B. 1956 “Availability” and Other Influences on the Commodity Composition of Trade.Journal of Political Economy 64:143–155.
LIPSEY, R. G.; and LANCASTER, KELVIN 1956 The General Theory of Second Best.Review of Economic Studies24 , no. 1:11–32.
MACHLUP, FRITZ 1943International Trade and the National Income Multiplier. Philadelphia: Blakiston.
MCKINNON, RONALD I. 1963 Optimum Currency Areas.American Economic Review 53:717–725.
MEADE, JAMES E. 1951–1955The Theory of International Economic Policy. 2 vols. Oxford Univ. Press. ↖ Volume 1:Balance of Payments. Volume 2:Trade and Welfare.
MEIER, GERALD M. 1963International Trade and Development. New York: Harper. → Detailed exposition of the theory of trade and growth. Contains an excellent bibliographical essay.
MUNDELL, ROBERT A. 1960a The Pure Theory of International Trade.American Economic Review 50:67–110. → A geometrical and mathematical presentation.
MUNDELL, ROBERT A. 1960b The Monetary Dynamics of International Adjustment Under Fixed and Flexible Exchange Rates.Quarterly Journal of Economics74: 227–257.
MUNDELL, ROBERT A. 1961 A Theory of Optimum Currency Areas.American Economic Review 51:657–665.
MUNDELL, ROBERT A. 1963 Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates.Canadian Journal of Economics and Political Science 29:475–485.
OHLIN, BERTIL (1933) 1957Interregional and International Trade. Harvard Economic Studies, Vol. 39. Cambridge, Mass.: Harvard Univ. Press.
RYBCZYNSKI, T. M. 1955 Factor Endowment and Relative Commodity Prices.Economica New Series 22: 336–341.
SAMUELSON, PAUL A. 1948 International Trade and the Equalisation of Factor Prices.Economic Journal 58:163–184.
SOHMEN, EGON 1961Flexible Exchange Rates: Theory and Controversy. Univ. of Chicago Press.
TINBERGEN, JAN 1952On the Theory of Economic Policy. Amsterdam: North-Holland Publishing.
TRAVIS, WILLIAM P. 1964The Theory of Trade and Protection. Cambridge, Mass.: Harvard Univ. Press.
VERNON, RAYMOND 1966 International Investment and International Trade in the Product Cycle.Quarterly Journal of Economics 80:190–207.
VINER, JACOB 1932 International Trade: Theory. Volume 8, pages 200–208 inEncyclopaedia of the Social Sciences. New York: Macmillan.
VINER, JACOB 1937Studies in the Theory of International Trade. New York: Harper. → A monumental scholarly review of classical and neoclassical theory, containing much original analysis.
VINER, JACOB 1950The Customs Union Issue. Studies in the Administration of International Law and Organization, No. 10. New York: Carnegie Endowment for International Peace.
There are several reasons for applying mathematical techniques to the development of international trade theory. First, there are parts of the theory of international trade that are difficult to state without using mathematical notation. Second, many of the arguments are more efficiently conducted and more easily verified if mathematical derivations are used. Finally, mathematical formulas are needed even in the simpler parts of the theory to prepare for econometric studies of trade, since econometric studies involve estimation of parameters from mathematical relations appearing in the theory of international trade.
In this article certain parts of trade theory that depend most heavily on mathematics will be summarized. Usually these will be parts of the theory where the number of countries, the number of goods traded, and the number of factors of production are all allowed to exceed two. The fact is that much of the theory based on just two countries, two goods, and two factors of production is best developed with use of mathematical expressions and derivations (Kemp 1964), but the use of mathematics is not equally compelling in such cases.
The mathematical theory will be treated in five sections devoted to specialization in production, factor price equalization, comparative statics, Keynesian theory, and existence of equilibrium. The topics covered are the basic theoretical structures rather than applications or specialized developments. Except for price rigidities in the Keynesian theory, it will be assumed that the market structure in each country is perfectly competitive. Transportation costs are neglected, except in the case of factors of production, for which they are assumed to be prohibitively high.
Specialization in production
An early subject of the classical theory of trade concerns the determinants of what a country produces and thus may export. The Ricardian theory of comparative advantage (Viner 1937, chapter 8) deals with this question, as do the Haberler theory of opportunity costs ( 1936, chapter 10) and the Heckscher–Ohlin theory of comparative costs (Ohlin 1933, chapter 2). Ricardo assumed constant rates of transformation between the goods in a nation’s output. This is equivalent to supposing that there is but one factor of production, say, labor. Let aij be the amount of labor needed to produce one unit of the ith good in the jth country. Then if there are two countries and two goods, country 1 should produce good 1 if a11/a12 < a21/a22. This is the law of comparative advantage, which states that country 1 should produce good 1 even though the absolute cost of producing either good may be higher in country 1. It identifies the only direction of specialization in production that is consistent with efficiency in this case. It is also the only direction of specialization consistent with competitive equilibrium in the absence of impediments to trade, such as tariffs or excise taxes.
A generalized constant-cost model was extensively used by Graham (1948). However, when the number of countries and goods exceeds two, the criterion for efficient specialization is rather more complicated. Note that the criterion for two countries and two goods in the example cited could equally well be written a11a22, < a12a21. In this form the criterion can be generalized to the Graham model, which has constant rates of transformation in each country, with any number of goods and countries. Let a specialization be defined as a relation between countries and goods that relates each country with the goods that it produces. If a specialization relates each country with precisely one good, it is called an assignment. Let us say that a specialization is efficient if it is not possible to increase the output of one good without reducing that of another or increasing the use of labor in some country. Then a specialization is efficient if and only if every assignment is efficient that can be derived from it by confining each country to only one of the goods that it produces in the specialization.
Suppose there are n countries and m goods. There are mn distinct assignments, which may be grouped into classes Sk, where all assignments that allot the same number of countries to the ith good, for each i, belong to the same class. Let αk(j) = i represent the assignment of the jth country to the ith good in an assignment scheme αk Є S k. Then the assignment ¯αk is efficient if and only if the product ∏ia¯αk(i).i is less than or equal to ∏iaαk(i).i for any αk ЄS k (Jones 1961a; McKenzie 1954a). It is easily seen that this condition is not implied by the condition that the classical comparative advantage formula hold between each pair of countries in the assignment.
A specialization ¯αk is efficient if it is not possible to shift countries from their assignments in ¯αk toward their assignments in some other αk Є S k in a way that increases one output without sacrificing any other output. Let ΔY¯αk(i) be the decrease in output in the ith country of the good to which it is assigned in ¯αk, and let ΔYαk(i) be the increase in output of the good to which it is assigned inΔ αk when a unit of labor is shifted from one line of production to the other. Then ΔYαk(i)/ΔY¯αk(i) = a¯αk(i).i/aαk(i).i. Since the same number of countries are assigned to each good in Sk, for any i there must be a country shifting into the good with index ¯αk(i); that is, for some j, αk(j) = ¯αk(i). Then it is possible to shift appropriate amounts of labor so thΔYαk(j) = ΔY¯αk(i), and the output of this good is constant. Now it is clear that ∏i(ΔYαk(i)/ΔY¯αk(i) = ∏i(a¯αk(i).i/aαk(i).i), and by choice of the intermediate substitutions the first product may be reduced to ΔYαk(i)/ΔY¯αk(i for some i and j, where αk(j) = ¯αk(i). Thus, an improvement is possible if and only if this ratio exceeds 1, or no improvement is possible if ∏i(a¯αi(i), i/aαi(i), i) ≤ 1. This is the condition given above.
The application of these conditions for efficient specialization can be extended by replacing the labor input ratios in each country with rates of substitution between goods at a point on the production frontier. Then, in the absence of joint production or intermediate products, the foregoing criterion may be applied to determine the efficiency of a specialization for a given world output. The world output must be mentioned explicitly, since the absence of constant costs in each country means that a specialization that is efficient for one world output can be inefficient for another.
However, the generalized criterion of comparative advantage fails in the presence of intermediate products if they are traded or in the presence of joint products (McKenzie 1955a). It should be kept in mind that because of the nature of the problem of specialization, countries may be on the boundaries of their production frontiers. In the general case of competitive efficiency, where factor supplies may vary, intermediate products may be traded, joint products may appear, but where production functions are homogeneous of first degree and external economies of production are absent, there is no direct way to characterize an efficient specialization. There is, however, an indirect or dual characterization.
Let y ik be the vector of inputs and outputs of goods for the kih production process in the jth country when that process is operated at a unit level. Inputs are measured by negative numbers and outputs by positive numbers. Let x ik be the corresponding vector of inputs of the immobile factors. Let p be a price vector for goods and w j a price vector for factors in the jth country. Let tjk be the level of the kth production process in the jth country. Let the world net output of goods be y and the input of factors in the jth country be x j. LetIj be an index set for the production processes available in the jth country. An efficient world output (y,xl, • • •,x n) is achieved if it is not possible to increase the output of a desired good or reduce the input of a desired factor, without reducing the output of some other desired good or increasing the input of some other desired factor or exceeding the available supply of some factor. Then the input–output combination (y,x1, • • •,x n) is efficient if
for some tik ≤ 0, where pi > 0 if the ith good is desired and if the zth factor is desired in the jth country (Koopmans 1951, p. 82). On the other hand, if the sets Ij, are finite, these conditions are also necessary for efficiency. If some of the Ij are infinite, it may not be possible to achieve positive prices for all desired goods and factors.
The conditions (1) say that for goods and factors a set of prices exists that are positive for desired goods and factors and such that no production processes can earn positive profits and all processes actually used earn zero profits. Of course, this means that efficient specializations are precisely those that can appear in a competitive equilibrium, given appropriate demand conditions. The result is proved by observing that the convex set, Y, of possible world input–output combinations must be disjoint from the convex set of input–output combinations that contain more of desired goods or less of desired factors than (y, x1,•••,x n). Thus there is a separating hyperplane between these sets, p • ¯y + ∑w j . ¯x j = 0, with Y in the negative half space. The p and w j defining this hyper-plane are the p and w j of the relations (1).
The Heckscher–Ohlin theory of comparative costs determined by factor scarcities can be used to derive some results on partial specialization in production when technology is the same in all countries, i.e., when Ij = I for all j. If tastes are the same in all countries, these statements also apply to trade. (This is discussed in the section “Comparative statics,” below.
Factor price equalization
The theory of factor price equalization from trade is, in a sense, converse to the theory of specialization in production. It is the absence of specialization of countries to different goods in production that favors factor price equality. In order to produce circumstances in which factor price equality is likely, differences between production processes in different countries, which tend to lead them to specialize in different lines of production, are assumed to be absent. Also, specialization theory begins with the Ricardian model, in which there is one factor in each country, while the problem of factor price equalization does not arise until more than one factor is present in each country.
The proposition that when the same kinds of factors of production and the same production functions are present in each country free trade will lead to partial or even complete factor price equality was first defended by Heckscher. The model of trade to which the proposition was applied has come to be known as the Heckscher–Ohlin model. It was given precise mathematical form by Samuelson (1953), who is chiefly responsible for the modern development. This model ex-plains trade and specialization in terms of differences in the relative endowments of factors of production of the trading countries. It provides in the two-countries, two-goods, two-factors case the most frequently used model of trade in modern theory.
The theory of complete equalization of factor prices is equivalently a theory of uniqueness of factor prices given goods prices and certain ancillary conditions. Equations (1) may serve as the basic model if Ij, is set equal to I for all j. It is assumed that there exist free disposal processes for excess supplies of factors, so that p ≥ 0 and w j ≥ 0 for all j. Then given p and ω , the processes that are available in any country in an equilibrium are those for which p • yk + ω • x k> = 0. Suppose (p, ˜ω ) are another equilibrium price set, so that certain processes will be available at these prices. Also suppose that factor supplies in the jth country are constant and equal to x j. Let Kw be the convex polyhedral cone in the factor space spanned by the input vectors x k of processes available at (p, ω ), including disposal processes for zero-priced factors. Suppose that the number of factors is r and that Kw is r-dimensional. By the use of the profit conditions it can be shown that x Є interior Kw implies p • y + ω• x = 0 and p • y + ˜ • x < 0, so that ω• x < 0, whereas ¯x Є K¯w implies by the same argument that Δ •˜x ≥ 0. Thus, the interior of Kw is disjoint from K¯w and if x j lies in the interior of Kw it does not lie in K¯ω. This means that at (p, ˜ω ) factor supplies are not fully used or disposed of and therefore that the factor price vector ¯ω is not consistent with the goods price vector p and the factor supplies x j. In other words, p and x j uniquely imply ω in competitive equilibrium, and if x j lies in Kw for all j, factor prices are necessarily equal in all countries when the goods prices are given by p . Let us refer to Kw as the diversification cone of ω , given p . Then, given p , it is necessary for factor price equalization between countries jl and j2 thatx j1 and x j2 lie in the same diversification cone Kw, and it is sufficient for equalization that they lie in the interior of the same Kw (McKenzie 1955b).
A second result for equalization of factor prices refers not to factor supplies but rather to the set of processes that countries use in common. Let us suppose that the fcth process has an output of one unit of the kih good and that each process is integrated so that intermediate products do not appear explicitly. Suppose also that the minimum cost process, given any ω > 0, is unique. Let the index of the minimum cost process for the ith good be ki. Then competitive equilibrum requires pi = ω .x ki for each good that is produced, where x ki depends on the factor price vector ω . The matrix A = [x ki] is the Jacobian matrix of a transformation G : ω → p (G maps factor prices into goods prices).
Suppose the number of goods equals the number of factors, so that A is square. Then if the principal minors of A are positive for all ω > 0, the inverse mapping G-1: p→ω is defined over the set of all p such that p = ω A (ω ) for some ω > 0 (Gale & Nikaid ̂o 1965). Therefore, given that two countries produce r goods in common and that factor prices are positive in both countries, factor price equalization is implied when the condition of positive principal minors is met by the factor input matrix for these r goods. It should be noted that this theorem requires that the countries produce at least as many goods in common in the competitive equilibrium as there are factors. In addition, the choice of the order of columns in A implies an association of a particular factor with each good.
A third result relates factor price equalization to the direction in which factor prices change when goods prices change. The strong version of the Stolper–Samuelson theorem (Stolper & Samuelson 1941) holds if goods can be associated with factors in such a way that if a good rises in price while the prices of other goods are constant, its associated factor rises in price and all other factors fall in price. Thus, the associated factor has a real income that is unambiguously higher. This result is applied to show that the owners of a certain factor may benefit from appropriate tariffs.
Since p = ωA , and ω dA = 0 by cost minimization, it follows that dp = dωA and dω = dpA -1. Thus, the Stolper–Samuelson theorem implies that A -1 has the sign distribution over its elements of a Leontief matrix. Such a matrix has a positive inverse only if its principal minors are all positive. But this implies that A has positive principal minors as well, so the factor price equalization theorem holds. In other words, the strong Stolper–Samuelson theorem over an interval of factor prices implies the factor price equalization theorem over the same interval (Chipman 1964).
In this last result and also in the previous one an essential role is played by a one-to-one association of factors and goods. This suggests that a good, which is traded, is a proxy for a factor, which is not. Thus, the equating of goods prices through trade achieves an equality of factor prices because the factors are, as it were, traded indirectly. It is the positivity of the principal minors of A that establishes the necessary connection between the goods and the factors. In the two-factors, two-goods case, this is equivalent to the assumption that relative factor intensities differ and are not reversed, for ǀA ǀ ≠ 0 implies ǀA ǀ > 0 for an appropriate order of the columns. In the general case, it is implied if A has a dominant diagonal, that is, for each k (after units of measurement are redefined, if necessary).
A condition that is equivalent to the strong Stolper–Samuelson theorem is that for each k there exists a nonnegative linear combination of the inputs into the process other than the kth that has amounts equal to those of the kth process of all inputs other than the feth and a smaller amount of the kth input than the kih process. This may be deduced directly from AA -1 = I and the fact that A -1 is a Leontief-type matrix. Let A -1 = [αyi,] and . Then for i ≠ k. Dividing through by αkk gives the required linear combination for the kth process (Uekawa 1966).
It should be remarked that these results are concerned with complete equalization. It would be very desirable to have comparable results on partial equalization in the presence of impediments.
The preceding sections have been concerned with price and production patterns that are consistent with efficiency in production or with competitive equilibrium. Comparative statics deals with the shift in the equilibrium prices and quantities that may be associated with a change in some parameter of the trading system, for example, the level of a tariff or the supply of a factor [seestatics and dynamics in economics; see also Mundell I960]. This is the traditional realm of the two-by-two-by-two theory, but the generalization to n countries, n goods, andr factors can sometimes be made. In order to discuss the effects of parameter changes on the terms of trade, one special feature of the simpler model will be retained, namely, that each country has one of the n goods as its only export. This is at the opposite pole from the Graham model, which emphasizes the possibility that countries may have export goods in common.
Letpi be the price of the ith country’s good in terms of the first country’s good. Choose units so that initial prices equal one. Assume that monetary policy maintains a constant price for the export good in each country. Then the balance of payments of the ith country, bt, measured in terms of the first country’s good or currency, is a function of the prices p2, • • • , pn and whatever parameter α is subject to shifting. That is, the equations bi(p2, • • • , pnα) = 0, for i = 1, • • •, n, determine an equilibrium position. Let bij; = ∂bi/∂pj,∂α and B = [bij], i,j = 2, • • • , n. Then, assuming B is nonsingular, (2) or
where[biα] is a one-column matrix.
The method of comparative statics is to derive information from some prior relationships concerning the bα and then to place restrictions on B that allow conclusions to be drawn about the dpj/dα from (2). In the two-country case the assumption that the foreign exchange market is stable in terms of Walrasian dynamics implies b22 < 0. Then the sign of dp2/dα is seen to be the same as the sign of b2α; that is, if the change improves the balance of payments when prices are given, then in the new equilibrium the price of the currency will rise enough to return the balance to 0. However, Walrasian stability of the multiple market is too weak to give results in (2). A stronger assumption that will give results is that bij > 0 for i ≠j (the assumption that all exports are gross substitutes). This assumption implies that the equilibrium exists and is unique. It also implies that the equilibrium is globally stable. Note that –B is a Leontief-type matrix. On the other hand, since by Cournot’s law . Thus,B has a dominant diagonal, and all the elements of –B l are nonnegative or are positive if B is irreducible.
The assumption that all exports are gross substitutes gives results parallel to those resulting from the assumption of stability in the two-country case (for which the assumptions are equivalent). For example, if productivity rises in the first country and no goods are inferior, the rate at which the ith balance changes with constant prices is biα = mi1, where α is the level of output and income in country 1, and mi1 is the first country’s marginal propensity to import from the ith country. Then dpj/dα = –∑i≠1βjim1 >; 0, where B -1 = [βji],i,j ≠ 1. Since the choice of numéraire is arbitrary, we can conclude that all exchanges move against the country where the improvement has occurred.
Similarly it can be shown that the imposition of a uniform ad valorem tariff whose proceeds are distributed to consumers at home raises the relative price of the exports of the country imposing the tariff (Johnson 1960). However, unilateral transfer payments from the first to the jth country have an ambiguous effect. In this case dpjdα = ∑i≠1(mi1 – mij)βji, and the sign is not definite.
The balance of payments, bi, may be interpreted as the net gain of foreign exchange reserves and gold by the ith country per unit of time. Assume that the movement of other capital funds is not affected by a change in exchange rates. Assume also that surplus stocks are accumulated only where goods are exported. Then the change in bi will equal the change in the balance of trade or in the value of the excess demand by other countries for the ith good less the value of the excess demand by the ith country for other goods. Let be the excess demand for the kth good by the ith country—that is, the difference between demand for use and current production. Then where . Assume that hoarding or dishoarding of currency does not occur or is offset by changes in the money supply. Then from the definition of and the assumption concerning the flow of capital funds, Walras’ law will imply . Thus, bij also equals the rate of change in the total excess demand for the ith good. This means that the international economy is equivalent to a barter economy for the purpose of the comparative statics analysis.
In the case of two countries only one price is free and . The Marshall–Lerner stability condition is bi < 0 or 1 + η1 + η2 < 0, where and are the elasticities of import demand. (A searching examination of the stability problem for the exchanges and the distinction between this problem and that of devaluation may be found in Jones 1961b.)
A second type of result in comparative statics is implied by the strong Stolper–Samuelson theorem. Consider the factor input matrix A = [x jk] of a set of integrated processes, each having a single good as output. Assume that A is square. The x jk are functions of the factor prices ω. A set of relations dual to those of the Stolper–Samuelson theory is x j = Ay j, where y j is the output vector for these goods for the jth country and x j is the vector of factor inputs into this production.
Consider a nearby equilibrium in which all the goods continue to be produced. Let x’1 increase while all prices and other components of x j are constant. Then dy j – A -1δi, where all components of δi are zero except the ith, which is equal to δ > 0. The strong Stolper–Samuelson theorem means that the elements of A -1 have the signs proper to a Leontief matrix. Thus, the output of the ith good must increase, and the output of all other goods must decrease. Moreover, the conditions for factor price equalization are satisfied, so it is sufficient for the goods prices to remain constant for factor prices, and thus A , to remain constant also. This is a generalized Rybczynski theorem (1955). If units are chosen so that all the ωi = 1 and all the Pi = 1, pA-1 = ω implies that A -1 has a dominant diagonal. Then in each row of A the diagonal element is largest. Thus, an increase in y’1, accompanied by a decrease in yj1 of equal value, will lead to an increase in demand for the ith factor.
The generalized Rybczynski theorem is relevant also to patterns of specialization in production. Suppose technology is the same in each country. In a country where the ith factor is plentiful compared with the ;th, a large output of the ith good may be expected in comparison with the jth in the absence of trade. If factor price equality between countries holds, an exact statement can be made. The A matrix will be the same in all countries and, therefore, A -1 will also be the same. Suppose A -1 is a Leontief-type matrix, or, in other words, that the generalized Rybczynski theorem holds. Total world production of the goods involved will not be affected by the uneven distribution of factors (transport costs are neglected). But between any two countries the value of output of a set of goods in the first country, associated with relatively more plentiful factors, will bear a higher ratio to the value of the other goods than in the second country. This is a consequence of the fact that if Δx1>0, Δx2<0, where A -1 has been partitioned according to
The Δx is derived by comparison with an appropriate factor supply vector intermediate between those of the two countries.
This is a generalized Heckscher–Ohlin theorem. It is independent of the presence of other outputs, whether or not they are traded; if other outputs are present, factor supplies are measured net of the quantities employed in the production of the other outputs. The directions of trade, under the assumption of identical tastes between countries, are complementary to the directions of specialization in production.
In addition to the strong Stolper–Samuelson theorem there is a weak theorem that is closer to the intent of the original theorem for the two-factor, two-good case. The weak Samuelson–Stolper theorem says that n goods and n factors may be paired in such a way that an increase in the price of the ith good will lead to a proportionately larger increase in the price of the ith factor. An inter-mediate theorem of this type also concludes that the ith factor price rises proportionately more than does any other factor price. Uekawa (1966) has found interesting conditions that imply each of these results. The conditions for the latter theorem are easily interpreted in economic terms. If units are chosen so that all initial prices equal one, the matrix A is a share matrix—that is, is the share of the ith factor in the product of the jth industry. Let J and J be a partition of the numbers (1, • • •, n). Suppose that for any j1 and This means that the share of the factors in J in the product of industry j1 exceeds the share of the factors in ¯J in the product of industry j2. This is a generalized factor intensity condition that implies the intermediate Stolper–Samuelson result, when it holds for all partitions.
The Keynesian theory
After Keynes introduced his theory of short-run equilibrium with underemployment of labor in the 1930s, applications of Keynesian theory to trade between countries suffering from underemployment were not slow to follow. The n-country theory, developed by Metzler (1950), gives a multisector generalization of the Keynesian income multiplier. Prices are assumed to be rigid, and thus the only behavioral parameters of the system are marginal propensities to spend increments of income. In the pure multiplier model these are marginal propensities to spend on the outputs of the various countries. In addition, there is autonomous spending for subsistence and investment. Let ai be the level of autonomous spending on the output of the ith country, yi be the level of income and output in the ith country, and mij be the marginal propensity of country j to purchase the output of country i. Then equilibrium is given by
where M = [mij] is the matrix of marginal propensities to spend. If it is assumed that mij ≥ 0, I – M has the sign distribution of a Leontief-type matrix. If it is also assumed that ∑imij < 1, then each element of (I – M )-1 is greater than or equal to zero and all the multipliers are nonnegative.
Corresponding to (3), there is a dynamic Keynesian system that is written
Here y (t) is the income and output of period t, which in part determines the income of period t + 1. This system is stable provided the characteristic roots of I –M are less than 1 in absolute value. Therefore, stability is implied if ∑imij < 1 for each j, that is, if the total marginal propensity to spend in each country is less than 1. Indeed, if M ≥ 0, (I–M )-1 ≥ 0 is equivalent to stability (McKenzie 1960). Let (I – M )-1 = [μij]. Since μij > μij, for i ≠ j, when the system is stable, a shift of spending from home to foreign goods is always harmful to home employment (Johnson 1958, chapter 8). Thus, in the Keynesian system, the correspondence principle (Samuelson 1947, p. 284) does provide comparative static results. On the other hand, ∑imij > 1 for each j implies that the system is definitely unstable. Then a small fluctuation of autonomous spending may be magnified into a large and continuing fluctuation of incomes.
The pure multiplier model (4) may be expanded to allow for investment that depends on changes in the level of output. The result is an n-country multiplier–accelerator model (Brown & Jones 1962). Let Cij be the investment in the ith country’s output consequent on a unit increase in the jth country’s output. Then the multiplier–accelerator model is
In this system, mij is interpreted to exclude investment spending, so ∑imij < 1 is a natural assumption. The equilibrium solutions of (4) and (5) are the same, that is,y = (I – M)-1a However, the stability of (5) is not assured by the nonnegativity of (I – M )-1. Suppose that the domestic acceleration coefficients cij are larger than 1. Then F = – (I – M )-1 (I–C ) is a nonnegative matrix with a positive diagonal. Let λ be the maximal positive root of F . Then I/F -1, which is the coefficient matrix of y (t), has a root ρ = 1 + 1/λ, and the system is unstable. Thus, stability of the Keynesian model is unlikely in the absence of restraints arising from the scarcity of money balances relative to income and output (Tsiang 1961). These stabilizing restraints are neglected in the multiplier-accelerator models based on rigid prices and interest rates.
Another adaptation of (5) is to introduce an autonomous spending vector, ρt,a j, for the jth country, that is rising over time. Then the matrix replacing I–M in the equilibrium solution of (5) is ρj(l – C )+(C – M ). This matrix has the sign pattern of a Leontief-type matrix if ρj,(1 –Cij) + Cij – mij > 0 for each i. It has a positive inverse if it has a dominant diagonal—that is, if (ρj–1)∑imik for each k that is, if saving in each country from the expanded income is more than adequate to support the investment spending of that country induced by the autonomous spending on its output. There will be a solution, , corresponding to any country’s autonomous spending, and the sum of these is a solution for the case in which autonomous spending is present in each country.
The dominant diagonal of ρj(I – C ) + (C–M ) means that pj, < p, where p is the positive characteristic root of I + F -1. Thus, the repercussions of autonomous spending in the case where a meaningful equilibrium solution exists for the largest pj will eventually be swamped by any spending component associated with ρ; ρ is the warranted growth rate defined by Harrod (1948, p. 81). Moreover, expansion at these rates must encounter labor shortages unless population expansion and technical progress provide sufficiently high natural growth rates by Harrod’s definition.
A final possibility is to set autonomous spending equal to zero and examine a solution associated with ρ. Since F , on the assumption cij > 1, is a nonnegative matrix with a positive diagonal and λ is its maximal positive root, there is an associated positive characteristic vector ¯y;¯y is also a characteristic vector of I + F -1 forρ. Then ρt¯y will be a solution of (5) that is relatively stable, provided that p is the maximal root of I + F -1. However, this does not follow from the maximal property of λ. In any case, an indefinite continuation of the growth path would again depend on natural growth rates at least as large as ρ in each country. Thus, the developments based on the Keynesian model must be regarded as transitory. Unless there is deliberate government intervention, shortages will arise that require price adjustments or that lead to unbearable levels of unemployment. (See Johnson 1958, chapter 5, for some two-country examples of Harrod models.)
It is possible to combine the simple Keynesian model with price effects on demand like those that were described in the section “Comparative statics,” above. The resulting model may be used to study the effects of devaluation on the balances of payments in a world of partial employment. Suppose elasticities of supply are infinite—that is, because underemployed resources are present, marginal costs do not rise significantly with increasing output. Initial prices are set equal to one. Let ¯B =[bij], where i and j run from 1 to n, and where is the compensated demand function for the kth good in the ith country and . Then ¯B dp may be treated as a variation in autonomous spending (see Johnson 1958, chapter 7, for related analysis of the two-country case). The resulting variation of real income will be d¯y = (I –M )-1¯B dp in equilibrium, where d¯yi is defined as dyi – eidp. The change in the jth balance is dbj = (1–∑imij)d¯yj. This may be interpreted as the excess of the increase in real income over the increase in real spending in the jth country.
Let S be the diagonal matrix with diagonal elements si = (1 – ∑imij). Then dbS(I – M )-1¯B dp – D dp gives the consequences for balances of a set dp of currency devaluations. Suppose countries devalue when they are losing exchange reserves and revalue when they are gaining reserves. Suppose I –M has a dominant diagonal. Then (I–M )-1 is nonnegative, and the diagonal element is largest in each row. However, even if –¯B should be a Leontief-type matrix, convergence of the devaluation process is not assured in general. On the other hand, in the case of two countries the adjustment equations reduce to the familiar form db1 = (s1s2/Δ)¯b11dp1, where Δ = ǀI–M , and db1/dp1<0 (Jones 1960). If the effect of the change in terms of trade on spending is neglected, b11 replaces ¯b11 in this formula. Moreover, the devaluation process will converge in the general case if D has positive elements off the diagonal (Takayama 1961). Since by Cournot’s law the column sums of D equal 0, the principal minors of –D are then Leontief-type matrices.
Existence of equilibrium
Whether a meaningful equilibrium exists for a world economy with flexible prices characterized by relations like (1) and (2) is a difficult question, and only recently has much light been shed on it (McKenzie 1954b; Nikaidôo 1956). Consider relations (1), where the Ij, may be infinite sets and distinct from each other. This is the general production model for a competitive world economy with its associated profit conditions. It is sufficiently comprehensive to allow for transportation activities carrying goods between countries, as well as for the possibility that the resources of different countries have different qualities and the production processes may differ. The model must be completed by adding relations to determine demand for output. If the role of government is introduced and investment demand is included, these relations will be extremely complicated. Also, the supply of factors may be variable. However, if the structure of expectations is specified (and taken to be independent of the fluctuations of prices that occur as the market seeks its equilibrium), a model that is very broad in scope is obtained by adding to (1) the relations
The proof of existence depends critically on continuity properties of the demand functions. In order to isolate the aspects of world trade, the countries may be treated as single consumers on the demand side. Then continuity of each country’s demand function will be a reasonable assumption for all (p, ωj ) ≠ 0 that satisfy the profit conditions of (1), provided that each country can provide its own subsistence and can produce each good. Assume that demand cannot be satiated for all goods at once within the set of possible world outputs. Then there is a price vector (p*, ω*1, • • •,ω *n) and a world input–output vector(y*, x*1, ••,•,x *n) that satisfy (1) and (6) simultaneously. However, these are precisely the conditions for a competitive equilibrium, since the first two conditions of (1) say that (y*,x*1,...,x *n) is compatible with the technology available, the second two conditions say that no other choice of inputs and outputs that is compatible with the technology can increase profits for any production process when the price vector is (p*, ω*1,...,ω *n), and conditions (6) say that when the price vector is (p*,ω*1,...,ω *n) the quantities (y*,x*1,...,x*n ) are demanded. Thus, the technological constraints, the profit conditions, and the demand conditions are met, so a competitive equilibrium is realized.
Virtually all the conditions that lead to the existence of the competitive equilibrium can be relaxed to some degree—for example, the assumptions of free disposal and insatiability. The conclusion seems to be that under the usual assumptions of the competitive model—in particular, linear homogeneity of production functions and continuity of demand (derivable from convexity of preferences)—an equilibrium may be expected to exist. It should be noted that the model described includes the pure trading model, which starts from fixed initial stocks of goods, as a special case.
Of course, this does not establish the stability, optimality, or uniqueness of an equilibrium (Koopmans 1957). Stability of a full market process seems unlikely unless a price tâtonnement is stable. How-ever, a stabletâtonnement has been found only under special assumptions—for example, the assumption that all goods are gross substitutes or that the weak axiom of revealed preference holds for market demand functions (Arrow et al. 1959). Uniqueness of the full equilibrium is also special in much the same way as stability.
On the other hand, the optimality of the equilibrium, in Pareto’s sense, is easily proved on assumptions significantly weaker than those allowing a proof of existence. The profit conditions of (1) immediately imply that the value of the input-output combination is maximized over the set of all technically feasible combinations given the equilibrium prices. That is,p*.y*+∑ jω *j.x *j ≥p*.y+∑ jω *j.x j for any(y, x1,...,x n) that is compatible with relations (1). But if no one is satiated, the fact that no one is made worse off by a change means that the value of each person’s consumption has not fallen at equilibrium prices; if someone is better off, his consumption must be worth more at these prices. Thus, to make anyone better off and no one worse off requires that the value of the input-output combination should rise. That is, (y,x1,...,x n) better than (y*,x*1,...,x*n ) requires p*.y+∑j,ω *j.x j > p*.y *+∑jω *j.x *j. However, this is excluded by the profit conditions. Pareto optimality carries the implication that specialization in production is efficient, which confirms a claim made in the section “Specialization in production.” Of course, there is no reason why one country, by imposing tariffs or other restraints on trade, cannot improve its position at the expense of others. Also the assumptions that are needed for Pareto optimality do not allow for external economies or economies of scale. [SeeEconomic equilibrium.]
Lionel W. Mckenzie
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The terms of trade appears as an important variable in aggregative economic analyses of, for example, national or regional imports, exports, wage rates, and real product. It also serves as an indicator of changes in national welfare, in the extent to which a country benefits from foreign trade, and in the international division of trading gain. In view of the disparate roles that the concept has played, it is not surprising that several alternative definitions are current.
In most statistical calculations, however, and in nearly all public and professional discussion, it is the commodity, or net barter, terms of trade that is involved. The commodity terms of trade may be defined as an index or indicator of the average price of a country’s commodity exports in terms of its commodity imports. Thus, if Px(t) is an index of the prices of a country’s commodity exports during a specified period, t, or at a point in time, t, and if Px(t) is an index of the prices of the country’s commodity imports, the commodity terms of trade may be expressed as Tc(t) = 100[Px(t)/Pm(t)].
Similar definitions may be applied to the trade of a geographical region within a single country (e.g., the Mezzogiorno, the Paris Basin), to the trade of industrial sectors (e.g., the United States farm sector), and to the external trade of political or economic groupings of countries (e.g., the British Commonwealth, the European Economic Community). The definition is sometimes extended to embrace services (e.g., transportation services, the services of funds lent or borrowed), yielding the terms of trade oncurrent account. Note that the commodity terms of trade is not defined for a country that has no commodity imports or commodity exports; similarly, one can imagine conditions under which the terms of trade on current account is not defined. Needless to say, such conditions are likely to be observed only during the first months of new settlements.
Evidently there are as many measures of the commodity terms of trade as there are combinations of export and import price indices. Each combination has its own field of relevance. Most available indices, however, are of the Paasche type, with weights proportional to current quantities [seeIndex numbers].,
In recent years professional research and debate have focused on the existence and direction of long-term trends and cyclical swings in the terms on which broad and heterogeneous groups of commodities, especially primary products (including agricultural, mineral, forest, and fisheries products) and products of secondary manufacture, have traded against each other. The terms on which equally broad and heterogeneous groups of countries, notably the so-called underdeveloped and developed countries, have traded with each other, has been of comparable interest.
With only a few long time-series available, it cannot be pretended that any of the issues has been finally settled. The following conclusions, however, seem to be fairly firmly established. Thus, it seems clear that there has been no long-term trend in the terms of trade between primary and manufactured goods (Atallah 1958; Ellsworth 1956; Haberler  1961, pp. 280–289; Kindleberger 1956, pp. 258–275). Earlier views to the contrary (United Nations 1949, p.72) were based on an uncritical interpretation of a particular estimate of the commodity terms of trade of a single exporter of manufactured goods, the United Kingdom, for the particular period 1876 to 1938 (League of Nations 1945, p.18). It is now recognized that the behavior of the United Kingdom’s terms of trade during that period was not typical of the behavior of the terms of trade of industrial European countries; nor was it even in the pattern of its own earlier nineteenth-century behavior (Morgan 1959; Imlah 1958, pp. 94–98; Schlote  1952, pp. 76, 154–155). Moreover, the index used suffers from the common technical weakness of including freight charges in import prices while excluding them from export prices. Such an index would be reliable if the United Kingdom provided no shipping services whatever, either for exports or imports. In fact, of course, British ships carried a large proportion of the world’s cargo, including the United Kingdom’s own imports and exports. Further, freight rates were, on the whole, declining after 1875. Hence, considered as an estimator of the British commodity terms of trade (or, for that matter, of the British terms of trade on current account), the index suffered from an upward trend bias.
While the view that there has been a downward drift in the terms on which primary products exchange against secondary manufactures has been discredited, Kindleberger has produced evidence in support of the related hypothesis that in the long run the terms of trade has tended to move in favor of those countries that were developing most rapidly and against stagnant or slowly developing countries, regardless of the stage of development attained by the latter (1956, pp. 263–264). However, the evidence is admittedly unreliable, and the generalization allows for many exceptions.
One might, perhaps, expect greater success in detecting cyclical patterns in the terms of trade, for it is a well-known feature of business cycles that in general the money prices of primary goods (including coal and other minerals) fluctuate with greater relative amplitude than the prices of secondary manufactures. One therefore would expect that the terms of trade of primary exporting countries would move cyclically, rising during periods of business improvement and deteriorating during periods of recession, and that the terms of trade of industrial countries would move countercyclically. Even here, however, every generalization must be severely circumscribed. Thus, it has been found that only in the period between World War I and World War II was there a reliable and wide-spread association between the level of business activity and the commodity terms of trade of industrial countries. For the United Kingdom, before 1914 the association was more often reversed than not, for before 1914 coal, iron, and steel, the prices of which typically fall heavily in depression, bulked much more largely in the United Kingdom’s exports. Even for France and Germany, before 1914 the association is unreliable. The position has been well summarized by Kindleberger:
Taking prewar, interwar, and postwar periods together, it is clear that there is no simple, hard and fast generality about the relations between the business cycle and the merchandise terms of trade. The normal pattern for an industrial country exists: The terms of trade deteriorate in prosperity and improve in depression. However, this pattern is honored in the breach as well as in the observance, and may take on a substantial or a trivial amplitude. The rule has more validity in short, sharp inventory cycles, perhaps, than in more extended periods of depression and prosperity, though this cannot be adequately tested; certainly it has had more validity since 1930 than before, when in no country of Europe did the normal pattern long prevail. But it cannot be claimed that the normal pattern is currently valid. The year 1953 . . . was one of peak world prosperity in which the terms of trade turned consistently in favor of all the countries of Industrial Europe, except Belgium and Sweden, which behaved in the Korean crisis more like primary-producing countries. Unless information is available about the nature and intensity of the cycle, the structure of the economy concerned, and the long-run demand and supply positions of a country’s major exports and imports, it is difficult to predict with assurance the cyclical behaviour of its terms of trade. (1956, pp. 155–156)
The terms of trade and welfare
The commodity terms of trade often is accepted as an indicator of national welfare or of a single country’s gain from trade or share in the world gain from trade. It is, however, a very unreliable indicator.
That the commodity terms of trade cannot faithfully serve all three purposes is illustrated by a simple though artificial example. Imagine that a virtually self-sufficient country suffers some catastrophe (e.g., an earthquake or widespread fire or drought) that leaves it totally dependent on foreign sources of several indispensable materials. Clearly, the commodity terms of trade will turn against the country at a time when both the national gain from trade and the country’s share in the world gain from trade are increasing and national welfare is declining. In fact, the commodity terms of trade is an unreliable indicator of welfare, however defined. To see this, imagine that an export industry (possibly the transportation industry) benefits from a substantial cost-reducing improvement in technology. In those circumstances, it is quite possible for the commodity terms of trade to deteriorate but for national well-being and even the national gain from trade and the country’s share in the world gain to improve. Alternatively, suppose that the technological advance takes the form of a greatly improved product, produced, possibly, at only a slightly enhanced cost. In this case, from the point of view of the country’s trading partners, the deterioration of their commodity terms of trade will fail to indicate the increase in their welfare or the enhancement of their trading gain.
Recognition of the fallibility of the commodity terms of trade as an indicator of gain or welfare has resulted in the resurrection of the classical definition of the terms of trade and in the development of several new definitions.
The single factoralterms of trade is obtained from the commodity terms of trade by correcting the latter for changes in the productivity of the export industries. Thus, if πx(t) is an index of productivity in the export industries during period t or at time t, and if TSF(t) stands for the single factoral terms of trade, we may write TSF(t) =πx(t) Tc(t). The purpose of the adjustment is obvious: it allows for the possibility that a decline in the commodity terms of trade produced by greater efficiency in the export industries might yet be associated with an improvement in both total welfare and the gain from trade. But this is not the only type of disturbance imaginable; and even if attention is restricted to disturbances of this kind, the single factoral terms of trade is an imperfect welfare indicator. Without going into details, it is possible to conceive of a situation in which an improvement in productivity in the export industry gives rise to a more than proportionate decline in the commodity terms of trade but also to an increase in both total welfare and the gains from trade. A fortiori, the single factoral terms of trade cannot accurately reflect the degree in which welfare or gain has changed. Its chief weakness, perhaps, lies in its failure to make allowance for changes in the volume of trade. This weakness is quite independent of the theoretical and practical difficulties of choosing and calculating an appropriate index of productivity.
Three further definitions of the terms of trade, all designed to facilitate welfare comparisons of one kind or another, may be mentioned briefly.
The double factoral terms of trade is obtained from the commodity terms of trade by correcting the latter for productivity changes in both the domestic and the foreign-export industries. This is the classical definition, implicit in the writings of Torrens and Senior and given formal expression by Marshall (1923, pp. 157, 161–163, 330 ff.). If TDF(t) stands for the double factoral terms of trade during period t or at the point of time t, and if πrm(t) is an index of productivity in the foreign-export industries, we may write TDF(t)=[πx(t)/πM(t)]. In effect, the double factoral terms of trade measures the terms on which resources are bartered. Thus, its chief purpose is to serve as an indicator of the international division of the world gain from trade. Even allowing that the latter concept can be satisfactorily defined, the measure is, however, unsatisfactory, partly because, like the commodity and single factoral terms of trade, it fails to allow for variations in the international division of the volume of world trade.
The income terms of trade, TI(t), is defined as an index of the quantity of imports that could be purchased with the proceeds of a country’s commodity exports. It may be obtained from the commodity terms of trade by multiplying the latter by an index of the quantity of exports (see Dorrance 1948, p. 52; Viner 1937, p. 563; Imlah 1958, pp. 92–93, 112–113). Symbolically, T1(t) = 100[Px(t) E(t)/PM(t)] = Tc(t) E(t), where E(t) is an index of the quantity of exports. Thus, in the special case in which, on balance, capital movements, transfers, and trade in services cancel out, the income terms of trade coincides with the “capacity to import.” The definition is interesting in that allowance is made for the volume of trade; but as an indicator of changes in welfare or trade gains, it, also, is quite unreliable. For any change in export quantities and prices that leaves unchanged the value of exports will also leave undisturbed the income terms of trade. But it is not a matter of indifference, from the viewpoint of welfare or trade gain, whether export prices increase or decrease. Clearly it is possible, by changing the above illustration only slightly, to obtain a strong case in which the change in the income terms of trade is in the direction opposite that of the changes in welfare and trading gain.
The gross barter terms of trade, introduced by Taussig (1927, pp. 113–114), is denned as the ratio of an index of the quantity of commodity imports to an index of commodity exports. Like the income terms of trade, the gross barter terms of trade allows for changes in the volume of trade. Taussig argued that the gross barter terms of trade provided a better indicator of the gain from trade than did the simple commodity terms of trade, because it allowed for unilateral transfers, such as immigrants’ remittances and indemnity payments. But such payments rarely arise from trade. Further, a country’s gross barter terms of trade would show increased gain whenever the country engaged in foreign borrowing. (Further possible definitions are discussed in Viner 1937, pp. 559’561.)
None of the suggested modifications of the commodity terms of trade can be accepted as a reliable indicator of changes in total welfare, in the gain from trade, or in the international division of gain. The reason is that changes in the terms of trade, however defined, are almost always associated with changes in other variables (e.g., employment, volume of imports and exports, wage rates) having independent welfare significance. And how these other variables correlate with the terms of trade depends on the nature and initial impact of the disturbing factor. Generally speaking, any improvement in the commodity terms of trade that stems from a disturbance of foreign origin will be associated with enhanced well-being in all three senses. (One must, however, recognize the possibility that adjustment to the disturbance may be slow and accompanied by severe local unemployment, the existence of which outweighs all other considerations.) Similarly, any deterioration of the terms of trade of foreign origin usually will be associated with a deterioration of welfare. When the change is of local origin, however, the welfare outcome cannot be inferred from the movement of the terms of trade alone. It is necessary to know, in addition, the nature of the disturbance. As we have seen, a deterioration of the commodity terms of trade arising from cost-reducing technological changes in the export industries may or may not be associated with an improvement in welfare or in the gain from trade. Similarly, whether the terms of trade correctly signal the welfare implications of an import or export duty depends on the initial tariff level and the extent of the change in duty. There is an optimal tariff level, beyond which further increases are harmful to the tariff-imposing country.
As a welfare indicator, the terms of trade has never been more than a proxy, or substitute, for the individual commodity flows. The seriousness of its limitations in this role is now widely understood. As a result, the terms of trade is being replaced at the center of the policy stage by the commodity flows themselves.
The future course of the terms of trade. There have always been economists who claimed to have detected fundamental features of the world economy that would inexorably force the terms of trade between primary and manufactured commodities to follow a long-term trend in one direction or the other. There is, on the one hand, a long-standing tradition, originating in the classical writings of Torrens, Ricardo, and Malthus, that the law of diminishing returns in primary industry and the historical tendency of technological advances to favor secondary manufactures combine in the long-run to outweigh all other influences and force the terms of trade to move against manufactured goods (Torrens 1821, pp. 96, 98, 288–289). On the other hand, there is an influential modern view according to which Engel’s law (extended to cover all primary products) combines with the monopolistic practices of industrial enterprises to force the terms of trade to move against primary products (United Nations 1950, pp. 8–14; Haberler 1961, pp. 280–289).
History has so far withheld its favor from both groups of prophets. No doubt it will continue to do so.
M. C. Kemp
Allen, r. g. d.; and Ely, j. edward (editors) 1953 International Trade Statistics. London: Chapman; New York: Wiley.
Atallah, M. K. 1958 The Long-term Movement of the Terms of Trade Between Agricultural and Industrial Products. Rotterdam: Netherlands Economic Institute, Division of Balanced International Growth.
Dorrance, G. S. 1948 The Income Terms of Trade. Review of Economic Studies 16, no. 1:50–56.
Ellsworth, paul t. 1956 The Terms of Trade Between Primary Producing and Industrial Countries. Inter-American Economic Affairs 10:47–65.
Haberler, Gottfried (1954) 1961A Survey of International Trade Theory. Rev. & enl. ed. Princeton Univ., International Finance Section. → First published as “Aussenhandel” inHandwörterbuch der Sozialwissenschaften. See especially Chapter 4.
Haberler, Gottfried 1961 Terms of Trade and Economic Development. Pages 275–297 in International Economic Association, Economic Development for Latin America: Proceedings of a Conference. Edited by Howard S. Ellis and Henry C. Wallich. London: Macmillan.
Imlah, Albert H. 1958 Economic Elements in the Pax Britannica: Studies in British Foreign Trade in the Nineteenth Century. Cambridge, Mass.: Harvard Univ. Press.
Kindleberger, Charles P. 1956 The Terms of Trade: A European Case Study. Cambridge, Mass.: M.I.T. Press; New York: Wiley.
League OF Nations, Secretariat, Financial Section AND Economic Intelligence Service 1945 Industrialization and Foreign Trade. Geneva: The League.
Marshall, Alfred 1923 Money, Credit and Commerce. London: Macmillan.
Morgan, Theodore 1959 The Long-run Terms of Trade Between Agriculture and Manufacturing. Economic Development and Cultural Change 8:1–23.
Schlote, Werner (1938) 1952 British Overseas Trade From 1700 to the 1930’s. Oxford: Blackwell. →First published asEntwicklung und Strukturwandlungen des englischen Aussenhandels.
Taussig, Frank W. 1927 International Trade. NewYork: Macmillan.
Torrens, Robert 1821 An Essay on the Production of Wealth, With an Appendix in Which the Principles of Political Economy Are Applied to the Actual Circumstances of This Country. London: Longmans.
United Nations, Department OF Economic Affairs 1949 Relative Prices of Exports and Imports of Underdeveloped Countries: A Study of Post-war Terms of Trade Between Under-developed and Industrialized Countries. Lake Success, N.Y.: United Nations.
United Nations, Economic Commission For Latin America 1950 The Economic Development of Latin America and Its Principal Problems. Lake Success, N.Y.: United Nations, Dept. of Economic Affairs.
Viner, Jacob 1937 Studies in the Theory of International Trade. New York: Harper.
International transactions consist mostly of the exchanges of goods among nations. About four-fifths of all transactions are in goods; the other fifth includes mainly transactions in services— primarily transportation—whereas the rest are net transfers on capital account. A familiar and for many purposes most convenient classification of the goods that are exchanged in world trade distinguishes, in the broadest possible manner, two classes: primary goods (foodstuffs and raw materials) and manufactured goods. The first class includes those goods in which manufacturing activity contributes relatively little to the value of the good and in which a dominant role is played by natural resources—the availability of a suitable soil, a favorable climate, a plentiful supply of water, or mineral deposits. On the other hand, in the second class, which may include finished as well as semifinished goods, a substantial share of the value embodied in the good is provided by manufacturing processes, carried out with the aid of the services of labor and of capital.
The share of each class in world trade had been quite stable over a long period—from the last quarter of the nineteenth century until the early 1950s primary goods had usually formed somewhat less than two-thirds of all international trade in goods, fluctuations in the share being confined mostly to the range of 60 to 65 per cent of the total. Thus, for instance, primary goods were about 65 per cent of world trade in 1881, 63 per cent in 1913, 60 per cent in 1938, and 64 per cent in 1950. In more recent years this share has declined to about only one-half of total trade. It is hard to tell yet whether this represents a permanent move to a lower level or even a continuous trend still in force, particularly since this decline is to some extent due to a movement of relative prices, adverse to primary goods, which is not necessarily a long-term phenomenon. The majority of world trade, or at least half of it, is thus induced by variations among countries in the availability of natural resources; while variations among countries in the availability of capital, of labor force in general, and of particular human skills are the main source of the other part of world trade.
Each of the two classes of goods is dominated by a few important commodities. Among primary goods, petroleum has in modern times occupied a most conspicuous place. Other important raw materials in world trade are cotton, wool, coal, wood, pulp, and nonferrous ores, whereas coffee, wheat, sugar, and oilseeds are the most important foodstuffs. Among manufactures, machinery is by far the heaviest item in world trade; it is followed, among the finished goods, by transportation vehicles—chiefly road vehicles, but also ships and aircraft. Among semifinished goods, iron and steel, copper, paper, cotton fabrics, and textile yarn are the most important internationally traded goods.
Relation to development stages
By and large, the less developed the country—in terms of the level of its per capita income—the higher the share of primary goods in its exports. There are, of course, exceptions to this rule, such as Australia and New Zealand, on the one hand—countries with high per capita income levels which export mainly primary goods; or, on the other hand, Japan—a country with a relatively low per capita income, at least until a few years ago, which has traditionally concentrated its exports in manufactured goods. As a rule, too, although this rule is violated more often, the less developed the economy, the higher the share of manufactures in its imports. It does not follow, however, as is often implied, that most of world trade consists of transactions in which one country trades primary goods for another country’s manufactures or in which one of the parties to the transaction is an advanced country while the other is an underdeveloped country. Underdeveloped countries, it is true, rarely export manufactured goods, and although they often import primary goods in considerable amounts (mainly foodstuffs but also some raw materials) their trade may indeed be characterized as, by and large, the export of primary goods for manufactured goods from advanced countries. But trade of high-income countries—which constitutes the majority of world trade—is substantially different: most of these both export and import primary goods as well as manufactures, and they buy their imports from other advanced countries as well as from underdeveloped countries. Even if goods were classified in more detail than just into the two categories of primary goods and manufactures, it would be found that the composition of exports of most highly developed countries is quite similar to the composition of their imports. An important exception is the United Kingdom, which, almost alone among the major trading nations, exports manufactures almost exclusively, whereas it imports mainly primary goods. Because of its conspicuous place in world trade, the extreme case of Britain has often tended to be regarded as the rule rather than as an exception. In fact, however, the exchange of primary goods for other primary goods and of manufactures for other manufactures outweighs considerably the exchange of primary goods for manufactures. Likewise, the majority of world trade consists of transactions among highly developed countries rather than between these and the underdeveloped areas.
Concentration of trade
Highly developed and underdeveloped countries differ not only in the commodity composition of their trade but also in its commodity concentration. Most underdeveloped economies export primarily one good or very few goods, whereas advanced economies diversify their exports among goods of which none occupies an overwhelming share of the country’s total exports. This is explained by the nature of each country’s economy. In the underdeveloped economy, capital and labor skills are lacking; it specializes in goods for which it is best accommodated by nature, and these are usually very few. The capital and skills at the disposal of the advanced economy, on the other hand, qualify it for the production of and specialization in a large variety of goods. This does not imply, however, that the export of each primary good is concentrated in one country or among a handful of countries while the export of each manufactured good is distributed over a large number of countries. On the contrary, the export of primary goods is at least as diversified among countries as the export of manufactures. Apparently, the natural endowments required for the production of most of the raw materials and foodstuffs exist in a fairly large number of countries—although these countries are often found in geographic proximity. Thus, for instance, foodstuffs like rice, coffee, and cocoa are each produced in a fairly large number of countries, most of which will be found in the same geographic region. At the same time, it seems that the capital, human skill, knowledge, and organization required for the production of manufactures are much more concentrated among nations than might be expected from the fact that these, unlike natural resources, are factors which could conceivably be developed anywhere. Moreover, a high degree of export specialization prevails among industrial countries, each concentrating most of its exports in a certain selection of manufactured products. This specialization may well be as much a result of accidental “historical” developments— such as the role played by individual firms—as of the availability of certain factors of production in their broader definition. It may also result from differences in the size of the economy; the export of manufactured goods, such as aircraft or ships, whose production may profitably be undertaken only in an economy of a substantial size, tends to be concentrated in a small number of countries.
Imports of underdeveloped countries also tend to concentrate in a few commodities—although the measure of concentration is much lower, and the difference between underdeveloped and highly developed countries much less conspicuous, than in the case of exports. The consumption and investment requirements of an underdeveloped economy are not only lower, per capita, in absolute amounts but also less varied than those of an advanced country. Hence, the former is limited to a smaller variety of goods not only in its domestic production but also in its imports from abroad.
The place of Europe
Throughout modern times, Europe has been the major participant in international trade. Its quantitative importance has gradually declined, however, over the last few generations, particularly during the first half of the present century. The share of Europe (both Continental and non-Continental) in world exports, which was about 53 per cent in 1900-1913, dropped to close to 50 per cent in 1925-1938 and to about 38 per cent in 1948-1950 (excluding the exports of Soviet-bloc countries from both European and world exports). Part of the loss has been regained during the 1950s. Europe’s share increased to about 40 per cent in 1955 and 45 per cent in 1960. Approximately 40 per cent of Europe’s trade has normally been concluded within the region, the other 60 per cent being the trade of Europe with non-European countries. Thus, even at the low point of the early postwar years, over 60 per cent of world trade consisted of transactions in which either one of the participants in trade—the exporter or the importer—or both were European countries. During the interwar years this percentage was, of course, considerably higher—from 70 to 75 per cent; still earlier, in the period 1900-1913, it amounted to over 80 per cent. Thus, over most of the present century only some 20 to 30 per cent of world trade consisted of the exchange of goods between one non-European country and another.
A large portion of Europe’s trade with the outside world has traditionally been conducted with dependent countries—that is, European colonies or territories otherwise politically associated with a European power. This holds true particularly for the United Kingdom, whose trade with its dependencies constituted, in the interwar period, over half the total trade of Europe with its dependent territories, but it characterizes also the trade of France and of the smaller colonial countries in Europe. Altogether, this trade amounted in the interwar period to roughly one-half of Europe’s total trade with the outside world, and this share tended to increase during that period. This portion of Europe’s transactions consisted almost entirely of the export of manufactures in exchange for the import of primary goods. The combined trade of Europe and of its dependencies amounted during the interwar period to some 70 per cent of world trade; some 75 to 80 per cent of the trade of this combined group was conducted within the group, leaving only a slight portion for trade with the rest of the world. It should be noted that the increased tendency of the large European nations to trade with their associated territories came not only at the expense of countries outside Europe but also of countries within Europe, and in particular of the larger ones. The trade of the three major European trading nations—the United Kingdom, Germany, and France—among themselves, and particularly the exchange among them of manufactures, tended to decline during the interwar years.
Europe’s predominance in world trade, even in the postwar world, is outstanding not only in relation to the size of its population (about one-sixth of the world’s) but also in relation to its income. In the late 1950s, Europe’s share in the gross national product of the non-Soviet world amounted to some 27 per cent, while its share in world trade (exports and imports) came to about 47 per cent. In contrast, the United States, with close to 48 per cent of the world’s gross national product, contributed only 16 per cent of world trade. The ratio of trade to income was, thus, over five times higher in Europe than in the United States. Part of this difference is explained, of course, by the fact that Europe is divided into many independent nations, whereas the United States is a single political entity, with trade among its various segments by definition not constituting international trade. But the contrast does not disappear when intra-European trade is excluded, leaving only Europe’s trade with the outside world; this trade (some 60 per cent, to recall, of Europe’s total international trade) still amounts to 27 per cent of world trade—roughly three times that of the United States, in relation to the respective incomes of the two regions. No such sharp contrast appears between Europe and the rest of the world (that is, non-European countries other than the United States); the latter’s share in the world’s gross national product amounted to approximately 25 per cent, while its share in world trade reached 38 per cent, about one-third of it being conducted within the “region.” In relation to the size of its income, the trade of this region with the outside world appears to be of practically the same magnitude as Europe’s trade. The non-Soviet world may thus be viewed as consisting of three major “regions”: the United States, Europe, and the “rest of the world.” Whereas the first is predominantly self-contained, the last two tend to specialize, each complementing the economy of the other.
The decline of Europe’s weight in world trade during the first half of the century was not felt equally by all European nations. The chief losers were the United Kingdom—the largest trading nation in Europe (and, at the beginning of this century as well as during the two preceding centuries, in the world)—and France. The major gainers among non-European countries were the United States and Japan. The former overtook the United Kingdom as the largest trader during the interwar years, increasing its lead after World War II. In 1928, the U.S. share in world trade (exports and imports) was 14 per cent to the United Kingdom’s 13 per cent; in 1950 the respective shares were 17 per cent and 12 per cent, and in 1960 16 per cent and 10 per cent.
Relation of changes in commodity and geographic patterns
To a large extent, changes in the geographic pattern of trade have been conditioned by transformations in the commodity pattern and particularly by radical changes in the weight of various manufactures. Throughout the present century, the share of capital goods in the trade of manufactures has tended to increase and that of consumer goods to diminish. In some instances, a shift is also observed from a “lower” to a “higher” stage of manufacturing, such as from trade in metals to trade in machinery. The most conspicuous increase is found in the trade in motor vehicles; at the end of the last century this trade was insignificant, but by the middle of the present century it amounted to about 12 per cent of the total trade in manufactures. Another group whose share increased considerably is machinery, in particular electrical machinery. The heaviest loss, on the other hand, was suffered by textiles and apparel: the share of this group dropped from over 40 per cent of the total trade in manufactures at the end of the last century to less than 20 per cent by 1950. This trend has apparently been associated with the process of industrialization in formerly less developed economies. Industrialization leads to an increased demand for capital goods, on the one hand, and to the establishment of domestic industries—textiles being the most important case—which, on the other hand, substitute local production of consumer goods for imports.
Naturally, traditional specialization in relatively expanding industries should be conducive to an increase in a country’s share in world exports, while a country whose exports consist largely of relatively contracting goods may be expected to suffer from the changing commodity composition of world trade. The most important country in the former position is the United States, whose exports of manufactures have always included a particularly high share of relatively expanding goods. The outstanding case in contrast is the United Kingdom, whose exports at the beginning of the century consisted, in very large measure, of relatively contracting goods, particularly textiles. Observations of these two large trading countries have sometimes led to the conclusion that changes in the geographic pattern of exports have been entirely or mostly due to the changing commodity structure of trade. This conclusion is unwarranted in so extreme a form; it is not even accurate for these two specific instances, and particularly not for the United Kingdom, where the trends in commodity composition of world trade have been a minor factor in affecting the country’s share in world exports. Moreover, some of the countries whose trade in manufactures has expanded most have specialized in relatively stable, or even relatively contracting, industries. The most glaring example is Japan, whose exports before World War II—and to a gradually declining extent, also after it—have consisted largely of textiles; another important instance is Canada. Altogether, the correlation of countries whose shares in world trade have expanded with countries which specialize in relatively expanding industries, and vice versa, is rather weak. Changes in the commodity structure of trade have not been the major determinant of changes in the geographic pattern; this is true particularly for the first quarter of the present century, while during the second quarter the commodity structure did indeed play an important role in a few instances. Among the other factors which helped to pull down Europe’s share in world trade, the two world wars certainly loom large. Besides the direct damages inflicted by the wars, they have led to the breaking of some traditional ties of Europe with its customers. In normal situations, tradition tends to endure and to play an important role in determining the geographical pattern of world trade. Similarly, the wars have contributed to the tapering off of European investment in the outside world, a factor which is also partly responsible for the declining share of Europe in world trade.
To some extent, the high-income, industrialized countries have specialized not only in the export of certain manufactures but also in the import of certain primary goods. This characterizes particularly the United Kingdom and the United States. Thus, there are foodstuffs like meat, butter, and tea, in which the United Kingdom accounts for more than half of world imports; or raw materials, such as zinc, petroleum, and wool, of which Great Britain imports about one-third of the world total and in which the United States is a relatively unimportant customer. In other goods, such as silk, coffee, tin, and rubber, the reverse is true. The share of continental Europe, on the other hand, is more uniform; in most important primary goods, it amounts to some one-third to one-half of the total.
Multilateral trade and trading regions
International transactions may be bilateral, where two countries exchange goods (and services) between themselves, or multilateral, where one country exports its goods to another while receiving its imports from a third country. In effect, the large majority of the world’s transactions in goods are of a bilateral nature. During both the interwar and the postwar periods, multilateral transactions constituted only about 20 to 25 per cent of international exchanges of goods. The share of multilateral transactions is particularly low in the Soviet-bloc countries, where it amounted, during the 1950s, to merely some 10-12 per cent of total trade. It is also relatively low—about 20 per cent of trade—in the United States and Canada, in dollar countries in Latin America, in the United Kingdom, and in continental western Europe. Nondollar countries in Latin America, the “overseas sterling area,” and the “rest of the world” conduct a more multilateral trade: there the share of multilateral transactions amounted to some 35 per cent of these countries’ foreign trade in the 1950s.
Countries with a relatively high share of multilateral trade are almost exclusively, with the important exception of Japan, underdeveloped economies that export primary goods alone and whose individual shares in world trade are small. The highly developed countries, exporting mainly manufactures, may potentially maintain bilateral trade relations with other developed countries as well as with the underdeveloped. When one underdeveloped economy, on the other hand, happens to buy large quantities of primary goods from another, it cannot usually offer in exchange goods which the partner country may require. Trade relations of underdeveloped countries among themselves are therefore less likely to be bilateral than either the trade of developed countries among themselves or the trade between developed and underdeveloped economies.
It should be noted that a large amount of intraregional trade, within a given region, does not imply that this trade tends to be multilateral. On the contrary, within the three major trade regions that are commonly distinguished in the postwar world—the dollar bloc, the sterling area, and continental western Europe—intraregional trade tends to be less multilateral than the trade of the member countries with the outside world. This is particularly true for the dollar bloc. Here, each of the small trading countries conducts most of its trade with the United States; this trade is highly bilateral, and the small export or import surplus that results serves to finance (or is financed by) deficits (or surpluses) not in the trade with other countries in the region but in the trade with countries outside it. In the sterling area, too, multilateral balancing is considerably less significant in the trade of the area’s members among themselves than in their trade with nonmembers. Here, too, trade surpluses (deficits) with the central member of the region— the United Kingdom—serve more to offset deficits (surpluses) with nonmember than with member nations. In contrast to the dollar bloc, though, a large amount of multilateral trade that does not involve the region’s center sometimes takes place in the sterling area. Countries in continental western Europe, too, conduct their transactions among themselves somewhat more bilaterally than their trade with the outside world. Here, geographical distance is apparently of considerable importance: a particularly high share of both exports and imports of each-European country flows to and from countries in its immediate neighborhood.
During the interwar period, a regular worldwide pattern of regional multilateral settlements was discernible (League of Nations 1942, pp. 73-97). If the world, excluding a few countries, is divided into tropical countries, the United States, other regions of recent settlement in the temperate belts, continental Europe, and noncontinental Europe, each of these five regions had an export surplus with all the regions following it on the list and an import surplus with all the regions preceding it on the list (except for an export surplus in the trade of the last region with the first). Toward the end of the interwar period, however, this pattern became somewhat blurred. In the postwar era, although the geographical distribution of trade and of multilateral transactions has been rather stable over most of the period, no such clear-cut regional pattern has yet been established.
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The world has a long, rich history of international trade that can be traced back to early Assyrian, Babylonian, Egyptian, and Phoenician civilizations. These and other early civilizations recognized that trade can be tied directly to an improved quality of life for the citizens of all the partners. Today, the practice of trade among nations is growing by leaps and bounds. There is hardly a person on earth who has not been influenced in some way by the growing trade among nations.
WHY INTERNATIONAL TRADE?
Modern countries engage in international trade for numerous reasons. Some countries are deficient in critical raw materials, such as lumber or oil. To make up for these various deficiencies, countries must engage in international trade to obtain the resources necessary to produce the goods and/or services desired by their citizens. In addition to trading for raw materials, nations also exchange a wide variety of processed foods and finished products. Each country has its own specialties that are based on its economy and the skills of its citizens. Three common specialty classifications are capital, labor, and land.
Capital-intensive products, such as cars and trucks, heavy construction equipment, and industrial machinery, are produced by nations that have a highly developed industrial base. Japan is an example of a highly developed industrial nation that produces large quantities of high-quality cars for export around the world. Another reason Japan has adapted to producing capital-intensive products is that it is an island nation; little land is available for land-intensive product production.
Labor-intensive commodities, such as clothing, shoes, or other consumer goods, are produced in countries that have relatively low labor costs and relatively modern production facilities. China, Indonesia, and the Philippines are examples of countries that produce many labor-intensive products. Products that require large tracts of land, such as cattle production and wheat farming, are examples of land-intensive commodities. Countries that do not have large tracts of land normally purchase land-intensive products from countries that do have vast amounts of suitable land. The United States, for example, is one of the leading exporters of wheat. The combination of advanced farming technology, skilled farmers, and large tracts of suitable farmland in the Midwest and the Great Plains makes the mass production of wheat possible.
Over time a nation's workforce will change, and thus the goods and services that a nation produces and exports will change. Nations that train their workers for future roles can minimize the difficulty of making a transition to a new, dominant market. The United States, for example, was the dominant world manufacturer from the end of World War II (1939–1945) until the early 1970s. But, beginning in the 1970s, other countries started to produce finished products more cheaply and efficiently than the United States, causing U.S. manufacturing output and exports to drop significantly. Rapid growth in computer technology, however, began to provide a major export for the United States. Practically speaking, the United States has been slowly transformed from a manufacturing-based economy into a new information age-based economy that relies on exporting cutting-edge technology, as high-tech software and computer companies proliferate.
Each country varies regarding international trade and relocation of foreign plants on its native soil. Some countries openly court foreign companies and encourage them to invest in their country by offering reduced taxes or some other investment incentives. Other countries impose strict regulations that can cause large companies to leave and open a plant in a country that provides more favorable operating conditions. When a company decides to conduct business in another country, it should also consider the political stability of the host country's government. Unstable leadership can create significant problems in recouping profits if the government of the host country falls or changes its policy toward foreign trade and investment. Political instability is often caused by severe economic conditions that result in civil unrest.
Another key aspect of international trade is paying for a product in a foreign currency. This practice can create potential problems for a company, since any currency is subject to price fluctuation. A company could lose money if the value of the foreign currency is reduced before it can be exchanged into the desired currency. Another issue regarding currency is that some nations do not have the necessary cash. Instead, they engage in countertrade, which involves the direct or indirect exchange of goods for other goods instead of for cash. Countertrade follows the same principles as bartering, a practice that stretches back into prehistory. A car company might trade new cars to a foreign government in exchange for high-quality steel that would be more costly to buy on the open market. The company can then use the steel to produce new cars for sale.
In a more extreme case, some countries do not want to engage in free trade with other nations, a choice known as self-sufficiency. There are many reasons for this choice, but the most important is the existence of strong political beliefs. For example, the Soviet Union and its communist allies traded only with each other because the Soviet Union feared that Western countries would attempt to control their governments through trade. Self-sufficiency allowed the Soviet Union and its allies to avoid that possibility. These self-imposed trade restrictions, however, created a shortage of products that could not be produced among the group, making the overall quality of life within the Soviet bloc substantially lower than in the West since consumer demand could not be met. When the Berlin Wall came down, trade with the West was resumed, and the shortage of products was reduced or eliminated.
An important factor influencing international trade is taxes. Of the different taxes that can be applied to imported goods, the most common is a tariff, which is generally defined as an excise tax imposed on imported goods. A country can have several reasons for imposing a tariff. For example, a revenue tariff may be applied to an imported product that is also produced domestically. The primary reason for this type of tariff is to generate revenue that can be used later by the government for a variety of purposes. This tariff is normally set at a low level and is not usually considered a threat to international trade. When domestic manufacturers in a particular industry are at a disadvantage, vis-à-vis imports, the government can impose what is called a protective tariff. This type of tariff is designed to make foreign products more expensive than domestic products and, as a result, protect domestic companies. A protective tariff is normally very popular with the affected domestic companies and their workers because they benefit the most directly from it.
In retaliation, a country that is affected by a protective tariff will frequently enact a tariff of its own on a product from the original tariff-enacting country. In 1930, for example, the U.S. Congress passed the Hawley-Smoot Tariff Act, which provided the means for placing protective tariffs on imports. The United States imposed this protective tariff on a wide variety of products in an attempt to help protect domestic producers from foreign competition. This legislation was very popular in the United States, because the Great Depression had just begun, and the tariff was seen as helping U.S. workers. The tariff, however, caused immediate retaliation by other countries, which imposed protective tariffs of their own on U.S. products. As a result of these protective tariffs, world trade was severely reduced for nearly all countries, causing the wealth of each affected nation to drop, and increasing unemployment in most countries.
Realizing that the 1930 tariffs were a mistake, Congress took corrective action by passing the Reciprocal Trade Agreements Act of 1934, which empowered the president to reduce tariffs by 50 percent on goods from any other country that would agree to similar tariff reductions. The goal was to promote more international trade and help establish more cooperation among exporting countries.
Another form of a trade barrier that a country can employ to protect domestic companies is an import quota, which strictly limits the amount of a particular product that a foreign country can export to the quotaenacting country. For example, the United States once threatened to limit the number of cars imported from Japan. Japan, however, agreed to voluntary export quotas, formally known as "voluntary export restrictions," to avoid U.S.-imposed import quotas. The power of import quotas has diminished because foreign manufacturers—to avoid such regulations—started building plants in the countries to which they had previously exported.
A government can also use a nontariff barrier to help protect domestic companies. A nontariff barrier usually refers to government requirements for licenses, permits, or significant amounts of paperwork in order to allow imports into its country. This tactic often increases the price of the imported product, slows down delivery, and creates frustration for the exporting country. The end goal is that many foreign companies will not bother to export their products to those markets because of the added cost and aggravation. Japan and several European countries have frequently used this strategy to limit the number of imported products.
Before a corporation begins exporting products, it must first examine the norms, taboos, and values of the countries in which it wants to sell its products. This information can be critical to the successful introduction of a product into a particular country and will influence how it is sold and/or marketed. Such information can prevent cultural blunders, such as the one General Motors committed when trying to sell its Chevy Nova in Spanish-speaking countries. Nova in Spanish means "doesn't go"—and few people would purchase a car named "doesn't go." This marketing error—resulting simply from ignorance of the Spanish language—cost General Motors millions in initial sales, as well as considerable embarrassment.
Business professionals also need to be aware of foreign customs regarding standard business practices. For example, people from some countries like to sit or stand very close when conducting business. In contrast, people from other countries prefer to maintain a spatial distance between themselves and the people with whom they are conducting business. Thus, before businesspeople travel overseas, they must be given training on how to conduct business in the country to which they are traveling.
Business professionals also run into another practice that occurs in some countries—bribery. The practice of bribery is common in several countries and is considered a normal business practice. If the bribe is not paid to a businessperson from a country where bribery is expected, a transaction is unlikely to occur. Laws in some countries prohibit businesspeople from paying or accepting bribes. As a result, navigating this legal and cultural thicket must be done very carefully in order to maintain full compliance with the law.
Other factors that influence international trading activities are related to the physical environment. Natural physical features, such as mountains and rivers, and human-made structures, such as bridges and roads, can have an impact on international trading activities. For example, a large number of potential customers may live in a country where natural physical barriers make getting the product to market nearly impossible.
WORLD TRADE ORGANIZATIONS AND AGREEMENTS
After World War II, the world's leading nations wanted to create a permanent organization that would help foster world trade. Such an organization came into being in 1947 when representatives from the United States and twenty-three other nations signed the document creating the General Agreement on Tariffs and Trade (GATT), which now includes more than 100 countries as signatories. The threefold purpose of GATT was to:
- foster equal, nondiscriminatory treatment for all member nations;
- promote the reduction of tariffs by multilateral negotiations; and
- foster the elimination of import quotas.
GATT nations meet periodically to review progress toward established objectives and to set new goals that member countries want to achieve. The goals and objectives of GATT vary and change over time as trade issues based on domestic and world economies evolve.
Likewise, representatives from Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, and the United Kingdom came together to form the European Economic Community (EEC), sometimes called the Common Market, in 1958. The purpose of the EEC was to create equal and fair tariffs for all of the nations in the organization so that trade could flourish in Europe.
The United States and Canada signed the Canada-U.S. Free Trade Agreement in 1989, which provided for the removal of all trade barriers—such as tariffs, quotas, and other trade restrictions—between the two countries within a ten-year period. This act helped promote even more trade between the two countries, thus further strengthening an already strong trade relationship.
The United States, Canada, and Mexico signed the North American Free Trade Agreement (NAFTA) in 1994 in order to create a free-trade zone among the three countries. Leaders of these three countries realized that a large North American free-trade zone could compete effectively against the EEC and other trading blocs that might develop in the future. This competitive factor was a driving force in the nations' signing of the agreement, each believing that, over the long run, all three would benefit from the agreement.
In addition to feeling the impact of trade agreements and trade organizations per se, international trade is affected more indirectly by the financial stability and general economic well-being of all countries in the increasingly interconnected world. Thus two other international organizations ultimately affect the health of world trade.
To further promote trade among countries, the Allied nations of World War II met in 1944 in Bretton Woods, New Hampshire, to help set postwar global financial policies and thereby avoid future financial crises. The International Monetary Fund (IMF) was created as a result of that conference, its mission being to provide loans to countries that are in financial trouble. The IMF dictates the terms of the loans, which may include cutting domestic subsidies, privatizing government industries, and moderating trade policies. To fund these loans, IMF members make annual contributions, with each country's contribution determined by its size, national income, population, and volume of trade. Larger contributing countries, such as the United Kingdom and the United States, have more say as to what countries get loans and the terms of the loan.
The World Bank, with approximately 184 members, is another international organization to which the United States is a major contributor. The World Bank's mission is to help less-developed countries achieve economic growth through improved trade. It does so by providing loans and guaranteeing or insuring private loans to nations in need of financial assistance. The World Bank has been characterized as a last-resort lender, a facilitator of development projects so as to encourage the inflow of private banking funds, and a provider of technical assistance for fostering long-term economic growth.
The world has a long history of international trade—trading among nations can be traced back to the earliest civilizations. Trading activities are directly related to an improved quality of life for the citizens of nations involved in international trade. It is safe to say that nearly every person on earth has benefited from international trading activities.
WEB SITES OF INTEREST
For further information about tariffs, the Hawley-Smoot Tariff Act, and the Reciprocal Trade Agreements Act of 1934: http://economics.about.com/cs/taxpolicy/a/tariffs.htm, http://www.state.gov/r/pa/ho/time/id/17606.htm, and http://www.itds.treas.gov/tradelaws.html
For more information regarding import quotas: http://internationalecon.com/v1.0/ch10/10c060.html
For more information regarding nontariff trade barriers: http://www.dti.gov.ph/contentment/9/62/127/585.jsp
For more information regarding bribery: http://www.berrymoorman.com/articles/1199rmwbribery.html
For more information about the GATT: http://www.ciesin.org/TG/PI/TRADE/gatt.html
For more information regarding the EEC: http://www.infoplease.com/ce6/history/A0817889.html
For more information on the Canada-U.S. Free Trade Agreement of 1989: http://www.agr.gc.ca/itpd-dpci/english/trade_agr/fta.htm
For information regarding the World Bank: http://www.worldbank.org
see also International Business; International Marketing; Marketing
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Allen D. Truell