Economists Case

In 1817, David Ricardo produced his theory of comparative advantage, an attempt to strengthen Adam Smith's theory of absolute advantage which dismissed the Mercantilist zero sum view of trade. Many other economists have since come up with alternating trade theories and in this essay I will be briefly focusing on the Gravity model of trade and the aforementioned Ricardian Model before moving on to a more thorough analysis of the Heckscher-Ohlin Trade theory.

Ricardo's theory of comparative advantage states that differential labour productivity between countries is the prime cause of international trade, a statement that has been proven to have many limitations. Krugman (1993) states that trade cannot only be explained by comparative advantage and despite comparative advantage due to difference in resources and exogenous differences in technology being important, specialisation propelled by external economies and economies of scale is equally as relevant. Additionally, Borkakoti (1998, p.75) points out another limitation that the theory only focuses on labour productivity as the main source of trade and not on any other variable such as capital and technological innovation. The combination of these two fundamental weaknesses of the theory proves that it has real limitations when applied to the real world.

Tinburgen (1962) introduced the Gravity model of trade. The Gravity model utilises Newton's Law of Gravity as an analogy to explain the volume of trade between countries, determining the volume by GDP, distance and population. This model has been proven to be empirically strong and offers a suitable base which can be easily built on when attempting to explain trade.

According to the Heckscher-Ohlin theory, ‘a nation will export the commodity whose production requires the intensive use of the nation's relatively abundant and cheap factor and import the commodity whose production requires the intensive use of the nation's relatively scarce and expensive factor' (Salvatore, 2010, p.85). The theory singles out the difference in relative factor abundance between nations as the determinant of comparative advantage and trade.

The diagram above demonstrates the Heckscher-Ohlin model. Due to the assumption of equal tastes, indifference curves I and II are common to both countries. The no-trade equilibrium is defined where the indifference curve meets the production frontier for each country, points A and A', thus resulting in a price of PA = ½ in Nation 1 and PA' = 2 in Nation 2. As PA < PA', Nation 1 has comparative advantage in commodity X while Nation 2 has it in commodity Y. Therefore with trade, Nation 1 produces at B, reaching point E by trading 40X for 45Y while Nation 2 produces at B' and reaches point E by trading 45Y for 40X. As a result, both nations gain as they are now consuming on a greater indifference curve, II.

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