Essay on the Modern Theory of International Trade

In recent years, the traditional “comparative costs theory” has been replaced by the “factor-proportions analysis” of Ohlin, known as the ‘modern theory of international trade.’ It is also called “the General Equilibrium Theory.”

Before examining Ohlin’s theory, it is worth the while to consider Ohlin’s objections to the theory of comparative costs. Ohlin criticised the theory of comparative costs on the following counts:

(i) that the comparative costs principle is applicable to all trades, and international trade is no exception to it;

(ii) that immobility of factors is not a special feature in international trade as assumed by the classicists but is also prevalent within the different regions of the same country.

This is evident from the different levels of wages and interest rates prevailing in different regions of the same country. The larger the size of the country, the greater might be the differences in wages and interest rates, as also between different trades in the same region. Secondly, just as labour and capital can move – even if in a limited way – within a country, they can also move, though, less speedily and freely, as between countries.

For instance, countries like, Australia, Canada, U.S.A., U.K., etc., have definitely encouraged influx of labour and capital from many other countries. The immobility of factors of production is, therefore, a question of difference of degree only, rather than of kind when applied to international trade.

Ohlin further states: “International trade is but a special case of inter-local or inter-regional trade”; that there is not much substantial difference between domestic trade and foreign trade, as he classicists assumed. Ohlin held that it is not cost of transport which differentiates foreign trade from domestic trade (as thought by classicists), for cost of transport is always there in home trade also.

He, therefore, opines that there is no need for a separate theory of international trade. Even the existence of differing currencies does not necessitate a new theory of international trade as different currencies are connected with each other through the system of foreign exchange rates, which is the value of one currency in terms of another, reflecting the purchasing power of the two currencies.

Hence, there is no basic distinction between the phenomena of inter-regional trade and international trade. To him, nations are only regions distinguished from one another by such obvious demarcations as national frontiers, tariff barriers and different tongues, customs etc. But such differences can only be temporary and not permanent obstacles to a free flow of trade between countries. With territorial expansion and for other political reasons, frontiers change and tariff barriers collapse.

Thus, regions may be very well identified with nations and inter-regional trade may be the same as international trade. Hence, no separate theory of international trade is needed but the existing general theory of value as applied to inter-regional trade can be easily extended to the phenomenon of international trade.

In Ohlin’s view, the same fundamental principle of general value theory, as propounded by the Austrian school, holds good for all trade, whether, it is trade within a country or between different countries.

According to Ohlin, therefore, the most natural and advantageous approach to the theory of international trade is to start from the mutual interdependence price theory (i.e., the general theory of value).

According to the value theory, the price of a commodity is determined by the total demand and supply forces in the market. At the point of equilibrium, demand is equal to supply and the price of the commodity equals its average cost of production. However, cost of production is composed of prices paid to factors of production employed in producing the commodity.

These factor prices determine the consumers’ income (for consumers receive their income by acting as agents of production) from this arises the demand for the commodity. Thus, there is mutual interdependence of price of commodities, the price of the required factors, the demand for the commodities, and the demand for and supply of factors. This is the fundamental fact analysed by the General Theory of Value.

This general equilibrium analysis is applicable to a single market in a region or a country. In fact, the general theory of pricing is a one-market theory. Ohlin observes that it considers only the time element but ignores the space factor.

According to him, however, space is very important in economic life at least for two reasons: (i) the factors of production are to some extent confined to certain localities and move only with difficulty; and (ii) costs of transport and other impediments prevent a free movement of commodities.

Ohlin thus, said that taking the space factor into consideration with regard to the general theory of value, it can be extended to determine the values in many markets involved in trade between different countries or regions. Thus, the theory of international trade is simply a ‘multi-market theory of value.

It is interesting to note that it was Eli Heckscher who pointed out first that when trade between countries arises, the mutual interdependence theory of pricing comes into action. Bertil Ohlin accepted this lead and more emphatically and scientifically developed a new theory of international trade based on the general equilibrium analysis. As such the modern theory of international trade is often referred to as ‘Heckscher-Ohlin Theorem.’