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

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 also moves away from the mainly deductive methods of classical theory to make extensive use of econometrics to identify from the available statistics, the contribution of a particular factor among the many 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

There is a strong presumption that an exchange that is freely undertaken must benefit both parties – whether or not they are in different countries. For international trade, however, there has been much controversy concerning possible indirect effects on others. 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, that theorem is sometimes taken to mean that trade between an industrialized country and a developing country would lower the wages of the unskilled in the industrialized 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. For those reasons, there may be short-term pressures on wage rates, but in the long run, competition between employers in the developing country can be expected to bring wages in line with their employees' marginal products so that productivity differences will be matched by wage differences, thus eliminating international differences in unit labour costs.