2020-2021 International Trade Theory

If a country is gaining from free trade, then firms must be maximizing their profits.

The statement is valid. Free trade between countries means fewer trade restrictions like tariffs and import duties on exports and imports. There will be higher trade volumes due to the easiness of conducting trade. There is a positive relationship between the volume of international trade and a country’s economic activity. Higher trade volumes translate to higher economic activity levels like production. Higher production levels by the companies in that country mean that they are maximizing profits. The neo-classical model supposes that by reducing trade barriers, both tariff and non-tariff, the economy moves along its PPF in a manner that the export and production of labor-intensive goods will increase and the efficiency will be enhanced.

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Assuming the trade terms were previously at equilibrium at point E. Country A is gaining more from international trade; hence it will want to trade more. On the other hand, if the trade terms equilibrium changes to E’, country B wants to trade more. Offer curves indicate a country’s imports and exports combinations defined by the Production Possibilities of that particular economy and the indifference curves.

Offer curves indicate a country's imports and exports combinations

Moreover, the neoclassical brings in the comparative advantage phenomenon that was initially developed by David Ricardo. The neoclassical theory states that due to comparative advantage, free trade is advantageous. In this case, comparative advantage means that a country will specialize in producing goods that need fewer inputs of a factor of production. It bases its reasoning on the opportunity cost phenomenon and states that every country stands to benefit from international trade, even for the economies poor at producing any product. Therefore, trade helps countries attain consumption and utilities above the possibilities attained when producing goods under autarchy. It means that the production possibilities of a country will improve as it approaches efficiency. Production possibilities illustrate a country’s production point that it is efficiently producing goods and services through efficient resource allocation. As such, the production of a country reflects the aggregate production by various agents in the economy. Thus, if the point improves significantly, various companies’ production possibilities will consequently improve, leading to optimal firm profits. A country will gain if the relative price offered in global trade differs from its autarky prices. Hence, if a country generates gains from free trade, the firms operating from that economy will maximize their profits, holding all other factors constant.

Given its assumptions, the Heckscher-Ohlin model confirms the observed fact that larger countries trade more.

The Heckscher-Ohlin model assumes that there are two-factor inputs, labor, and capital, that can freely move between industries. It also assumes there are two sectors, one is labor-intensive, and the other is capital-intensive. Capital earnings are rental rates, and labor earnings are wages. The third assumption of the model is that the level of resource endowment differs between the countries. It means that home has a higher portion of one factor of production than foreign does, say labor, and the foreign has a higher portion of one-factor input than home does, say capital. Moreover, the model assumes that the two goods produced are traded freely in the international markets. There are no trade barriers, both tariff and non-tariff barriers. The countries have the same technical ability, the technology used in production. A certain production factor amount will yield an equal output for either of the goods traded between them. Lastly, the model assumes that in a two-country, two factor, and two goods situation, the home and foreign markets have similar characteristics regarding their tastes. The demand for the two goods traded is identical.

Heckscher-Ohlin model thus argues that trade will benefit the two countries as each has a factor input that is more endowed than the other. Therefore, trade tends to increase these factors’ flow in the goods, factors, and national markets. The model assumes that any country’s abundant factor will attract lower prices in the domestic markets than in the foreign markets. As a result, relative factor prices in international markets are higher than in home markets. However, this is among the limitations of the Heckscher-Ohlin model. The assumption that there are just so many volumes of goods traded between the two countries is inapplicable in the real economic world. Besides, it assumes that for trade to take place, the two countries must be endowed differently. Further, the assumption that factor prices depend on factor abundance and ignoring factor demand is inapplicable in the real world. Even in countries with surplus capital and the demand happens to be high, the factor prices will be high. Lastly, the assumption that the taste is similar and will incline towards the goods traded is false. Consumer preferences differ. Thus, the model does fall short in explaining why larger countries trade more.

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In each country, the abundant factor earns more than the total gains from free trade.

The statement is true. Heckscher-Ohlin model of trade, also known as factor proportions, builds on Ricardian’s theory of the neoclassical model of trade. It introduces a second production factor, the 2-by-2-by-2 variant model, which indicates two factors, two goods, and two countries, in the equilibrium model. In this sense, these factors allow interactions between the factor markets, national markets, and goods markets concurrently. Hecksher-Ohlin describes how shifts in demand and supply forces of one market can simultaneously influence factor and goods markets both at home and foreign markets through trade, for the case of national markets. It shows the interconnectivity of all global markets.

Hecksher-Ohlin model reveals that international trade can enhance economic efficiency. The model assumes that in a two-country, two factor, and two goods situation, home, and foreign markets have similar characteristics regarding their tastes. The demand for the two goods traded is identical. Moreover, they have the same technical ability, the technology used in production. It means that a certain amount of production factor will yield an equal output for either of the goods traded in the two countries. The two countries only differ in resource endowment. It means that home has a higher portion of one factor-input than foreign does, say labor, and the foreign has a higher portion of the other factor input than home does, say capital. Without trade, labor will earn less at home than in foreign markets, and capital will earn more.

Similarly, in foreign environments, capital will earn less and labor more. Abundant labor at a country will attract a relatively lower price of goods using more labor, say cloth, than in capital abundant country, foreign. The disparity in relative prices of goods produced indicates significantly larger price relativity in factors of production. However, international trade causes goods’ relative prices to converge, causing the factor price to also converge and equalize. There is an income redistribution between production factors. Some will gain, others will lose, but there is a high likelihood the net effects will still be positive. Thus, it confirms the statement’s deductions that the abundant factor earns more than the total gains from free trade. This situation follows equalization that occurs when the abundant factor gains cover the scarce factor’s negative gains, causing a net effect lower than the initial returns by the abundant factors.

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