International economics

International economics is concerned with the effects upon economic activity of international differences in productive resources and consumer preferences and the institutions that affect them. It seeks to explain the patterns and consequences of transactions and interactions between the inhabitants of different countries, including trade, investment and migration.

International trade

Scope and methodology

The economic theory of international trade differs from the remainder of economic theory mainly because of the comparatively limited international mobility of the capital and labour . In that respect, it would appear to differ in degree rather than in principle from the trade between remote regions in one country. However there is also a practical distinction, because governments have often sought to impose restrictions upon international trade. The motive for the development of trade theory has often been a wish to determine the consequences of such restrictions.

The branch of trade theory which is conventionally categorized as "classical" consists mainly of the application of deductive logic, originating with Ricardo’s Theory of Comparative Advantage (for an explanation of which, see the article on comparative advantage) and developing into a range of theorems that depend for their practical value upon the realism of their postulates. "Modern" trade theory, on the other hand, depends mainly upon empirical analysis of available statistics.

Classical theory

The law of comparative advantage provides a logical explanation of international trade as the rational consequence of the comparative advantages that arise from inter-regional differences - regardless of how those differences arise. Since its exposition by John Stuart Mill the techniques of neo-classical economics have been applied to it to model the patterns of trade that would result from various postulated sources of comparative advantage. However, extremely restrictive (and often unrealistic) assumptions have had to be adopted in order to make the problem amenable to theoretical analysis. The best-known of the resulting models, the Heckscher-Ohlin theorem (H-O) depends upon the assumptions of no international differences of technology, productivity, or consumer preferences, no obstacles to pure competition or free trade and no scale economies. On those assumptions, it derives a model of the trade patterns that would arise solely from international differences in the relative abundance of labour and capital (referred to as factor endowments). The resulting theorem states that, on those assumptions, a country with a relative abundance of capital would export capital-intensive products and import labour-intensive products. The theorem proved to be of very limited predictive value, as was demonstrated by what came to be known as the "Leontief Paradox" (the discovery that, despite its capital-rich factor endowment, America was exporting labour-intensive products and importing capital-intensive products ) Nevertheless the theoretical techniques (and many of the assumptions) used in deriving the H-O model were subsequently used to derive further theorems. The Stolper-Samuelson theorem , which is often described as a corollary of the H-O theorem, was an early example. In its most general form it states that if the price of a good rises (falls) then the price of the factor used intensively in that industry will also rise (fall) while the price of the other factor will fall (rise). In the international trade context for which it was devised it means that trade lowers the real wage of the scarce factor of production, and protection from trade raises it. Another corollary of the H-O theorem is Samuelson's factor price equalization theorem which states that as trade between countries tends to equalize their product prices, it tends also to equalize the prices paid to their factors of production. Those theories have sometimes been taken to mean that trade between an industrialized country and a developing country would lower the wages of the unskilled in the industrialized country. (But, as noted below, that conclusion depends upon the unlikely assumption that productivity is the same in the two countries). Large numbers of learned papers have been produced in attempts to elaborate on the H-O and Stolper-Samuelson theorems, and while many of them are considered to provide valuable insights, they have seldom proved to be directly applicable to the task of explaining trade patterns.

(See also the Rybczynski theorem )

Modern theory

Modern trade theory moves away from the restrictive assumptions of the H-O theorem and explores the effects upon trade of a range of factors, including technology and scale economies. It makes extensive use of econometrics to identify from the available statistics, the contribution of particular factors among the many different factors that affect trade. The contribution of differences of technology have been evaluated in several such studies. The temporary advantage arising from a country’s development of a new technology is seen as contributory factor in one study . Other researchers have found research and development expenditure, patents issued and the availability of skilled labor to be indicators of the technological leadership that enables some countries to produce a flow of such technological innovations. and have found that technology leaders tend to export hi-tech products to others and receive imports of more standard products from them. Another econometric study also established a correlation between country size and the share of exports made up of goods in the production of which there are scale economies . It is further suggested in that study that internationally-traded goods fall into three categories, each with a different type of comparative advantage:

• goods that are produced by the extraction and routine processing of available natural resources – such as coal, oil and wheat, for which developing countries often have an advantage compared with other types of production – which might be referred to as Ricardo goods;
• low-technology goods, such as textiles and steel, that tend to migrate to countries with appropriate factor endowments - which might be referred to as Hecksher-Ohlin goods; and,
• high-technology goods and high scale-economy goods, such computers and aeroplanes, for which the comparative advantage arises from the availability of R&D resources and specific skills and the proximity to large sophisticated markets.

The effects of trade

Gains from trade

There is a strong presumption that an exchange that is freely undertaken must benefit both parties, but under the special circumstances of international trade between mixed economies, that proposition is subject to some qualifications. One is that there it creates losers as well as gainers. However, on certain assumptions, including constant returns and competitive conditions, Paul Samuelson has proved that it will always be possible for the gainers to compensate the losers . Moreover, in that proof, Samuelson did not take account of the additional gains resulting from wider consumer choice, from the international specialisation of productive activities - and consequent economies of scale, and from the transmission of the benefits of technological innovation. Those findings and others have contributed to a broad consensus among economists that trade confers very substantial net benefits, and that government restrictions upon trade are generally damaging. (One study estimated that import restrictions cost the United States over $3 billion in 1971 .) Nevertheless there have been widespread misgivings, shared by some economists, about the effects of international trade upon wage earners in developed countries and upon the general welfare of developing countries.

Factor price equalisation

Samuelson‘s factor price equalisation theorem indicates that, if productivity were the same in both countries, the effect of trade would be to bring about equality in wage rates. As noted above, that theorem is sometimes taken to mean that trade between an industrialised country and a developing country would lower the wages of the unskilled in the industrialised country. However, it is unreasonable to assume that productivity would be the same in a low-wage developing country as in a high-wage developed country. A 1999 study has found international differences in wage rates to be approximately matched by corresponding differences in productivity . (Such discrepancies that remained were probably the result of over-valuation or under-valuation of exchange rates, or of inflexibilities in labour markets.) It has been argued that, although there may sometimes be short-term pressures on wage rates in the developed countries, competition between employers in developing countries can be be expected eventually to bring wages into line with their employees' marginal products. Any remaining international wage differences would then be the result of productivity differences, so that there would be no difference between unit labour costs in developing and developed countries, and no downward pressure on wages in the developed countries.

Terms of trade

Influential studies published in 1950 by the Argentine economist Raul Prebisch and the British economist Hans Singer suggested that there is a tendency for the prices of agricultural products to fall relative to the prices of manufactured goods; turning the terms of trade against the developing countries and producing an unintended transfer of wealth from them to the developing companies. Their findings have been confirmed by a number of subsequent studies, although it has been suggested that the effect may be due to quality bias in the index numbers used (as explained in the article on the price index) or to the possession of market power by manufacturers (see the article on competition) . The Prebisch/Singer findings remain controversial, but they were used at the time - and have been used subsequently - to suggest that the developing countries should erect barriers against manufactured imports in order to nurture their own “infant industries” and so reduce their need to export agricultural products.

Infant industries

The term "infant industry" is used to denote a new industry which has prospects of becoming profitable in the long-term, but which would be unable to survive in the face of competition from imported goods. That is a situation that can occur because time is needed either to achieve potential economies of scale, or to acquire potential learning curve economies. Successful identification of such a situation followed by the temporary imposition of a barrier against imports can, in principle, produce substantial benefits to the country that applies it – a policy known as “import substitution industrialization”. Whether such policies succeed depends upon governments’ skills in picking winners, and there might reasonably be expected to be both successes and failures. It has been claimed that North Korea’s automobile industry owes its existence to initial protection against imports , but a study of infant industry protection in Turkey reveal the absence of any association between productivity gains and degree of protection, such as might be expected of a successful import substitution policy. . Another study provides descriptive evidence suggesting that attempts at import substitution industrialisation since the 1970s have usually failed , but the empirical evidence on the question has been contradictory and inconclusive . It has been argued that the case against import substitution industrialisation is not that it is bound to fail, but that subsidies and tax incentives do the job better . It has also been pointed out that, in any case, trade restrictions could not be expected to correct the domestic market imperfections that often hamper the development of infant industries