Economic Theories: Free Trade And Protection

In economics, social, and politics, the human experience an increasingly important role of International trade presented throughout much of history from the first images of East-West trade (so-called The Silk Road and Amber Road) to current globalization. In the new item, globalization often goes hand in hand with world trade, international investments, and currency exchanges and their adverse consequences on common people. Economic internationalists favour free trade which is a trade policy where international economies interact, import and export goods with minimal intervention by the government. Advocates typically argue that mutually beneficial trade relationships are established thanks to freer trade. Actually, the debate about how free a trading system should be is an old one, with positions and arguments evolving over time.

Tracing back the evolution of what today is recognized as the standard theory of international trade, one goes back to the years between 1776 and 1826, which respectively mark the publications of Adam Smith’s Wealth of Nations and David Ricardo’s Principles of Economics [1] . The two studies alert the formulation of a theory of free trade, based on the unprecedented success of England in the respective fields of industry and trade. The classical economist Adam Smith, who developed the theory of absolute advantage, was the first to explain why unrestricted free trade is beneficial to a country. Smith argued that ‘the invisible hand’ of the market mechanism, rather than government policy, should determine what a country imports and what it exports. Although Smith never fully developed the argument of free trade, later economists were able to find out it from the Wealth of Nations. Two theories inspired from Adam Smith’s absolute advantage theory include the English neoclassical economist David Ricardo’s comparative advantage and Hecksher-Ohlin’s factor abundance model. The Heckscher-Ohlin theory is preferred on theoretical grounds, but in real-world international trade pattern it turned out not to be easily transferred, referred to as the Leontief paradox. Another theory trying to explain the failure of the Hecksher-Ohlin theory of international trade was the product life cycle theory developed by Raymond Vernon. Central to trade theory was the concept of opportunity cost, that is, the loss of alternative returns if resources had been used in some other way. This theorizing constituted the supply side explanation of trade and, to a greater degree, represented actual trade patterns of the early 19th century.

This session provides a survey of the literature concerning theories on free trade and protection from the classical example of comparative advantage to the New Trade theories currently used by many advanced countries to direct industrial policy and trade. It is to clarify reasons when and why these issues have been raised in world politics.

2.1.1. Free trade

2.1.1.1. Classical trade theories

The classical trade theory, which forms the basis for economic integration theory, has its origins in the literature on political economy from over two centuries ago. These theories gave the early logic that free trade could be advantageous for countries and was rest on the concept of absolute advantages in production. The line of thinking was further developed to encompass the concept of comparative advantage as a basis for specialized production. Economics still admit so far the law of comparative advantage which means that free trade and exchange goods based on specialization was more beneficial to trade partners than protectionism. Also, it is noteworthy that the classical theory explicitly dealt with protection, i.e taxes and tariffs, hence demonstrates a connection between trade policy and trade patterns. This established the basis for the latter analyses, especially for the thinking behind the free market paradigm and welfare analysis. Classic theory of international trade based on comparative advantages does not, however, conclude that there will be no losers when tariff and non-tariff barriers are removed and trade increases. The point is that winners will be able to compensate losers and still be better off than in a situation with no trade at all. The problem is that classic trade theory assumes that both winners and losers will be situated within national borders owing to the relative (international) in-mobility of capital. With international mobility of capital, winners and losers will not only be lain in different industries or branches, they will also be situated different countries based on absolute advantages ( Kirkelund, p25).

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Adam Simith’s model

The Scottish economist, Adam Smith gave the trade theory of absolute advantage in 1776. The primary advantage of trade, he argued, was that it opened up new markets for surplus goods and also provided some commodities from abroad at a lower cost than at home. This was due to the fact that a country has an absolute advantage produces greater output of a good or service than other countries using the same amount of resources. Therefore, contrary to Mercantilism, Smith argued that a country should focus on production of goods in which it holds an absolute advantage. He wrote:

It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy. The tailor does not make his own shoes but buys them from the shoemaker… What is prudence in the conduct of every family can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. [2] 

Smith’s absolute advantage is determined by a simple comparison of labor productivities across countries. Nations can manufacture more quantities of goods in which they have absolute advantage with the labor time they save through international trade. Essentially, Smith argued that a firm supplying a larger market would be able to exploit more efficiencies from specialization than could a firm supplying a smaller market [3] . An implication of this is that larger scale producers can generally get lower per unit costs than a smaller scale producer, and larger domestic economies can get greater relative productivity [4] . The intuition translates directly to the case of international trade. Expanding the market through trade, in principle, should allow domestic firms to achieve greater specialization-induced economies of scale. This insight went with the observation that many similarly situated countries (with similar factor and technology endowments) in fact participate in trade, which often occurs across the same industry in two different countries, led a number of economists to consider how economies of scale bring countries to trade. In these models, countries specialize, not following any particular comparative advantage, but rather to achieve the efficiency gains of large scale production [5] . The upshot of these models from a welfare perspective, in the aggregate, is similar to that of the comparative advantage models. All countries will gain from trade in the presence of scale economies since worldwide production will increase as trade creates larger markets. No country would then need to produce all the goods it consumed. He argued that it was impossible for all nations to become rich simultaneously by following mercantilist prescriptions because the export of one nation is another nation’s import. International trade is a positive-sum game, because there are gains for both countries to an exchange. Unlike mercantilism this theory measures the nation’s wealth by the living standards of its people and not by gold and silver. Consequently, the theory of absolute advantage rejected the Mercantilistic idea that international trade is a zero-sum game. With that, Smith launched a succession of free-trade economists and paved the basis for David Ricardo’s and John Stuart Mill’s theories of comparative a generation later.

Moreover, embedded in Smith’s analysis of how markets develop dynamically over time, one finds another argument for free international trade. He demonstrated that freely initiated trade benefits both parties. Smith successfully established the case for free trade when a nation has the opportunity to practice free trade with a country specializing in accordance with absolute advantage [6] . It can be said that Adam Smith extended the theory of natural liberty to the realm of economics, formulating the classic statement in favor of free trade. In agriculture, in the home trade and in foreign commerce, the state had strived to regulate industry; these attempts, he thought, were all diversions of the course of trade from its “natural channels”; and he assumed that they were uniformly pernicious. Whether it acts by preference or by restraint, every such system “retards, instead of accelerating, the progress of the society towards real wealth and greatness; and diminishes, instead of increasing, the real value of the annual produce of its land and labour” [7] . When all such systems are swept away, “the obvious and simple system of natural liberty establishes itself of its own accord.” Because he regarded liberty as natural in contrast with the artificiality of government control; and the term “natural” plays an ambiguous part in his general reasoning, changing its shade of meaning, but always implying a note of approval. In this, he only used the language of his time-though Hume had pointed out that the word was treacherous [8] . Smith believed that free trade would change international commerce from a potential source of conflict into a foundation for the development of peaceful relations and mutual benefit. But this could only come about if governments were guided by the economic principles revealed by Smith and other economic theorists who were devoted to the common good. So, in support of free trade, Smith stated that tariffs and quotas should not restrict international trade; it should be allowed to flow according to market forces.

However, Smith was not a free-trade purist because while he extolled this “natural liberty” as the best thing for trade, he did not say that it was in all cases the best thing for a country. He saw that there were other things than wealth which were worth having, and that of some of these the state was the guardian. Security must take precedence of opulence, and, on this ground, he would restrict natural liberty, not only to defend the national safety, but, also, for the protection of individual traders. This means that Smith favored retaliatory tariffs in free markets. Retaliation to bring down high tariff rates in other countries, he thought, would work. “The recovery of a great foreign market,” he wrote “will generally more than compensate the transitory inconvenience of paying dearer during a short time for some sorts of goods” [9] .

There are potential problems with absolute advantage because the logic behind absolute advantage here is simple and intuitive. If our country can produce some set of goods at a lower cost than a foreign country and if the foreign country can produce some other set of goods at a lower cost than we can produce them, then clearly it would be best for us to trade our relatively cheaper goods for their relatively cheaper goods. In this way, both countries may gain from trade. Or if there is one country that does not have an absolute advantage in the production of any product, will there still be benefit to trade, and will trade even occur? The answer may be found in the extension of absolute advantage, the theory of comparative advantage.

David Ricardo’s model

David Ricardo (1772-1823) was a British political economist and one of the most influential of the classical economists. He is the first introduced the most basic concept in the whole of international trade theory, the principle of comparative advantage, in 1817. The idea appeared again in James Mill’s 1821 Elements of Political Economy and the concept became a key feature of international political economy upon the 1848 publication of Principles of Political Economy by John Stuart Mill. It remains influence on much international trade policy, thereby playing an important role in understanding the modern global economy. Basically, the theory of comparative advantage advances and refines Smith’s theory of absolute advantage. Ricardo agreed with Smith’s view that if there was no government interventions in commerce and if each individual was left to do what is in his or her self-interests, then there would be more goods and services available, prices would be reduced, and the wealth of each nation would increase. Ricardo’s comparative advantage theory extends Smith’s view to the case where one of the two countries has an absolute advantage in both commodities, and shows that even here trade is good for both countries.

Ricardo is the first economist [10] formalizing the idea that nations trade because each nation has her own comparative advantage in producing special products [11] . Country 1 has a comparative advantage in the production of good A relative to Country 2 if its opportunity cost of producing good A (i.e., how many units of good B it can no longer produce if it produces an additional unit of good A for a given stock of resources) is lower than Country 2’s opportunity cost of producing good A. Or, more succinctly, Country 1’s marginal rate of transformation between Good A and Good B is lower than that of Country 2. Here, unlike Smith, Ricardo (1817) referred to the static resource allocation problem when he defined the concept of comparative advantage, which is determined not by absolute values of labor productivity but by labor productivity ratios. Ricardo struggled for ending the Corn Laws, arguing that Britain ought to import corn from countries better equipped to produce it at lower cost. Because technological differences lead each to specialize in producing products in which it has a comparative advantage or relatively low cost compared with other countries. Out of such specialisation, it is argued, will accrue greater benefit for all. Thus, Ricardo’s theory of comparative advantage generates hope for technologically backward countries by implying that they can be a part of world trading system although their labor productivity in every good may be lower than that in the developed countries. It suggests that every nation should export the goods in which it had a comparative production cost advantage, and import those goods in which it holds a comparative disadvantage. This allows each nation to exchange with others that have specialized in other types of production, thus, ultimately all nations would enjoy gains from their specialization. Specifically, in a model in which there are two countries and two goods, Ricardo demonstrates that even if a country can produce one of the goods more cheaply than the other country, it still may import that good if doing so frees up its resources to produce a good in which its trading partner has an even greater cost disadvantage.

Ricardo offers an example in which England and Portugal both produce wine and cloth. If it takes 100 English workers one year to produce quantity X of cloth and 120 English workers one year to produce quantity Y of wine, and it takes 90 Portuguese workers to produce X units of cloth and 80 Portuguese workers to produce X units of cloth and 80 Portuguese workers to produce Y units of wine in the same time period, Ricardo claims that Portugal will import its cloth from England and export wine to the country. To see this, if Portugal puts its 90 cloth workers in wine-making, in principle, it can ship units of wine to England. In turn, England can now allocate its wine workers to cloth production, sending (6/5) X units of cloth in return to Portugal. After this trade, employing the same total amount of workers as before, Portugal has 20% more cloth than it previously produced (and the same amount of wine), and England has 12.5% more wine than it previously produced (and the same amount of cloth). While the exact split of the surplus generated by the trade will differ depending on the relative demands for wine and cloth in the two countries, [12] in Ricardo’s example both countries have the potential to expand their consumption of both goods without using more resources. Joint consumption of both goods across the two countries is guaranteed to rise even though Portugal can produce both goods more cheaply than England can. If Portugal is twice as productive in cloth production relative to England but three times as productive in wine, then Portugal’s comparative advantage is in wine, the good in which its productivity advantage is greatest. Similarly, England’s comparative advantage good is cloth, the good in which its productivity disadvantage is least. This means that to benefit from specialization and free trade, Portugal should specialize in and trade the good that it is “most better” at producing, while England should specialize in and trade the good that it is “least worse” at producing.

He assumed that the productivity of labor (i.e., the quantity of output produced per worker) varied between industries and across countries. However, instead of assuming, as Adam Smith did, that England is more productive in producing one good and Portugal is more productive in the other, Ricardo presumed that Portugal was more productive in both goods. On the basis of Smith’s intuition, then, it would seem that trade could not be advantageous, at least for England. Yet Ricardo pointed out numerically that if England specialized in producing one of the two goods and if Portugal produced the other, then total world output of both goods could rise! If an appropriate terms of trade (i.e., amount of one good traded for another) were then chosen, both countries could end up with more of both goods after specialization and free trade than they each had before trade. This means that England may nevertheless benefit from free trade even though it is assumed to be technologically inferior to Portugal in the production of everything.

In terms of modern micro-economic tools, by specializing in the good in which its comparative advantage lies, trade effectively allows both countries to shift their production possibility frontiers outward. Comparative advantage and free trade enable humans to produce goods more efficiently, thereby increasing profits as well as general access to commodities for the greatest number of people. In theory, producers will make more money producing and selling specific goods efficiently while consumers benefit from lower prices as a result of efficiency and lack of trade barriers. Thanks to the law of comparative advantage, mutually beneficial exchange is possible whenever relative production costs differ prior to trade. Therefore, in the Ricardian model, trade is a win-win situation, as workers in all trading countries are able to consume more of all goods. Arguably, comparative advantage and free trade are directly correlated as his following argument:

“Under a system of perfectly free commerce, each country naturally devotes its capital and labour to such employments as are most beneficial to each. This pursuit of individual advantage is admirably connected with the universal good of the whole. By stimulating industry, by rewarding ingenuity, and by using most efficaciously the peculiar powers bestowed by nature, it distributes labour most effectively and most economically: while, by increasing the general mass of productions, it diffuses general benefit, and binds together by one common tie of interest and intercourse, the universal society of nations throughout the civilized world. It is this principle which determines that wine shall be made in France and Portugal, that corn shall be grown in America and Poland, and that hardware and other goods shall be manufactured in England.” [13] 

Extensions of the Ricardian model increase the number of countries, the number of goods exchanged, and include transportation costs and tariffs. In general, for all of these extensions, the theory’s predictions are robust: trade continues to increase welfare among the trading partners in the way we already observed. While “in one and the same country, profits are, generally speaking, always on the same level; or differ only as the employment of capital may be more or less secure and agreeable.” [14] , “it is not so between different countries”. He predicted that “If the profits of capital employed in Yorkshire should exceed those of capital employed in London, capital would speedily move from London to Yorkshire, and an equality of profits would be effected; but if in consequence of the diminished rate of production in the lands of England, from the increase of capital and population, wages should rise, and profits fall, it would not follow that capital and population would necessarily move from England to Holland, or Spain, or Russia, where profits might be higher” [15] . Also, he argued that taxation would impede the growth. However, in the models including trading costs, it is possible to generate no-trading equilibria if transportation costs or tariffs are set too high even when trade would otherwise be beneficial.

Yet, the Ricardian trade theory cannot explain what determine comparative advantage. Because it is not enough if the Ricardian model only relies only differing technology to ground the concept of comparative advantage. One striking result here is that even when one country is technologically superior to the other in both industries, one of these industries would go out of business when opening to free trade. Thus technological superiority is not enough to guarantee continued production of a good in free trade. Current international trade proves a separate comparative advantage-based explanation for why nation’s trade relies on differing factor endowments across countries. Specifically, even if both countries have the same level of technology, they will still trade, given the opportunity, if the availability of productive inputs differs between the countries. The case of US-EU or EU-Japan bilateral trade can illustrate this point.

2.1.1.2. Neo-classical trade theory

The classical trade theory limited in their analysis by the labour theory of value and the assumption of constant costs can not foresee the rapid internationalization of the world economy, increasing foreign direct investments and the increasing transfer of production across national borders that resulted in trade of intermediate goods and among branches of corporations. In 1900s, the neo-classical trade theory was established and provided tools of analysis and studies on the patterns of trade around the world. The neo-classical trade theory had predicted in the 1950s and 1960s that specialization would increase in the world economy, leading to more inter-industry trade based on comparative advantage. However, this was later contradicted by empirical evidence as trade data showed no increase in inter-industry trade but rather in intra-industry trade. As a result, from the 1960s onwards, the neo-classical trade theory has elaborated on explaining intra-industry trade. Supply side analyses have applied the concept of “revealed comparative advantage” as a modified version of the original one. In the other approach based on demand factors, some theories try to explain trade in slightly differentiated goods by variations in consumer tastes, drawing on Linder’s (1961) essay on product differentiation and interrelationships among similar markets (Kettunen 2004: 27-28).

Besides, the arguments for trade liberalization are strong, and typical inform policy advice to governments from international institutions. These arguments are premised on Ricardian “conventional” or “neo-classical” trade theory, and in particular the theory of comparative advantage using general equilibrium models. The theory argues that differences in productivity and opportunity costs of production among countries form the underlying reasons why it is advantageous for countries to engage in trade. Many reasons explain why such differences occur. Climate is of obvious importance for agriculture as is the availability of extensive arable land and abundant water supply. The availability of other natural resources, such as large and easily accessible mineral deposits, and differential access to productive technologies give rise to varying labour productivities.

Heckscher-Ohlin theory

In the early 1900s, an international trade theory called factor proportions theory was developed by two Swedish economists, Eli Heckscher and Bertil Ohlin. This theory has subsequently been called the Heckscher-Ohlin theory (H-O model or so-called factor abundance model). This theory stresses that countries should produce and export goods that require resources (factors) that are abundant and import goods that require resources in short supply. This theory differs from the theories of comparative advantage and absolute advantage since these theory focuses on the productivity of the production process for a particular good. On the contrary, the Heckscher-Ohlin theory states that a country should specialise production and export using the factors that are most abundant, and thus the cheapest. Not produce, as earlier theories stated, the goods it produces most efficiently. In the Heckscher-Ohlin model the pattern of international trade is determined by differences in factor endowments. It predicts that countries will export those goods that make intensive use of locally abundant factors and will import goods that make intensive use of factors that are locally scarce.

The Heckscher-Ohlin model, formalized by Paul Samuelson, relies on differential factor abundance to generate trade among countries. In the simplest form of the model, two factors of production are assumed (labor and capital) to be used in the production of two different goods. One of the goods is assumed to be capital intensive and the other is assumed to be labor intensive, meaning that the marginal product of capital for good A exceeds the marginal product of capital for good B, while the marginal product of labor for good B exceeds the marginal product of labor for good A. Production functions are identical across countries, but one of the countries has a relative abundance of labor while the other has a relative abundance of capital. Before trade is practised (i.e., in a state of autarky), the domestic price of the capital intensive good will be lower in the country with an abundance of capital. Because the Heckscher-Ohlin model assumes perfect competition, the price of the capital intensive good will be competed down because of its relatively large supply owing to the abundance of capital in the country. The same will be true of the domestic price of the labor intensive good in the labor-abundant country. When trade is opened up, the capital abundant country will be induced to export the capital intensive good by the relatively high price of the good in the labor abundant country and vice versa.

In general, the Heckscher-Ohlin theory says that two countries trade goods with each other (and thereby reap greater economic welfare), if the following assumptions hold:

Labor and capital flow freely between sectors

The amount of labor and capital in two countries differ (difference in endowments)

Technology is the same among countries (a long-term assumption)

The citizens of the two trading countries have the same needs

The Heckscher-Ohlin theory is preferred to the Ricardo theory by many economists, because it makes fewer simplifying assumptions. As in the Ricardian model, in this model, trade generates increased aggregate consumption across and within countries. However, trade does causes domestic distributional problems as some residents win and some lose as a result of trade. Specifically, as demonstrated by the Stolper-Samuelson Theorem, originated from the Heckscher-Ohlin model, an increase in the relative price of the labor-intensive good generates an increase in the real return to labor in that country with a concomitant decrease in the real return to the country’s owner of capital. The opposite relationship occurs in the other country. Thus, in the movement from autarky to free trade, owners of the country’s abundant factor are made better off, while the owners of its relatively scarce factor are made worse off. Also, A corollary of this result is that as prices are equalized across countries, input prices (i.e., the return to capital and labor) will be equalized among countries.

The movement to free trade in the Heckscher-Ohlin model, however, is merely Kaldor-Hicks efficient at the micro-level. That is, while some individuals are left worse off after the change, the gains to the winners are large enough to offset the losses experienced by the owners of the relatively scarce factor of production. Whether the relevant compensation ever takes place is determined outside the trade model.

The Heckscher-Ohlin model is extended in many ways in the literature. Among the changes introduced are multiple goods and multiple factors of production (Vanek 1968). This extended theory is called the HOV theory, which allows the analyst to focus on implicit trade in factor services. Secondly, beginning in the 1970s, some economist began to question the extent to which economic approaches to trade helped to explain what was actually happening in the real world; for instance, countries with very similar factor endowments or similar technology levels tended to trade the most with each other, which is not exactly what comparative advantage-based theories would suggest (Black, 2003). By and large, the primary theorems that follow from the model are robust to these extensions. The Heckscher-Ohlin (and later Samuelson), in short HOS, version of free trade doctrine played down the otherwise overwhelming role of demand on market prices in order to bring resource endowments of nations to the center stage as the determining factor for mutually gainful trade. With this device, free trade theory moved away from the skill- or technology-based interpretations of the Ricard