Following the American Psychological Association’s Guidelines
Classic Free Trade Theory: Comparative Advantage Theory
Economists have claimed that free trade or no intervention in international trade is good for everybody. According to them, free trade help all sides of international trade. Seller countries develop their production skills and they can specialize on certain goods. Buyer countries can receive some products that they are not specialized in.
There is a main stream theory in explaining how international trade occurs: Comparative advantage theory in international trade. Basically this theory claims that each country has some adavantages in production technologies, expertise, educated human resource, and other required resources for certain products, thus they can produce these products cheaper comparatively in the international markets. A country decides to produce the products that this country is much more experienced and prefers to import other products not produced in the country. Therefore, each country specializes in certain products and they trade in the international markets. Every country in the world benefits from this free trade.
There are three main assumptions in this theory: 1) Each country has at least one advantage that enables this country to survive, 2) There is perfect competition in the international markets, and 3) Decreasing returns to scale condition holds for every country.
Also there are other assumptions: There is no cost of logistics; people are not mobile; only goods are carried between countries; each product is produced with the same technology without depending on where it is produced; labor and capital has the same productivity level in each country; capital and labor prices are equalized after international trade, and some other minor assumptions. These assumptions are very strict and under these conditions theoretically every country involving international trade as an exporter or an importer at the same time benefits from the trade.
Is Really Free Trade Good for Everybody?
Theoretically, according to comparative advantage theory in international trade, each country benefits from the trade and any intervention might interrupt countries' benefits from trade. Basically, the best strategy for all the countries is to follow a free trade policy and create an international mechanism to protect free trade.
As we know, in 1947, the International Trade Organization - ITO (today we call it the World Trade Organization - WTO) has prepared a base for an free trade agreement between countries: General Agreement on Tarrifs and Trade – GATT. In the first meeting, in Geneva, 23 countries have reached an agreement and they have decided to decrease the international trade barriers between countries. In 2001, after eight summits with the participations of more countries every time, WTO organized one summit in Doha and hundred fifty nine countries participated to this summit. Each time they have developed new ideas how to improve free trade between countries.
Beside GATT, there are also bileteral and multiliteral trade agreements between countries such as NAFTA and European Union. These agreements create some advantages among its members, however, they are not global unions and they form some barriers for non-member countries in trade.
The main question is that “Is free trade truly good for every country?”. The classical theory has said “Yes” to this question and many regulations and forces globally forced the free trade agreements to every country. However, we observe that every country is not benefiting from the international free trade at an equal level, and even some less developed and developing countries are having loss by involving international trade. For example, many African countries and some Latin American countries are mostly specialized in just on agricultural product and they do not have the capacity to process their products or to produce another product to be comptetive in the international markets. They sell their raw agricultural products at a cheaper price and they buy other many products from other countries and they lose in the trade.
Suspicions on Perfect Competition and Decreasing Returns to Scale
Perfect competition in international markets is a dream for many economists. They call this assumption, however, if it does not hold the classical international trade theories on which an international trade design works in our modern times can be falsified easily. We all know that the market structure in the international markets each country tries to differentiate their products to be more competitive and that indicates us that there is a monopolistic competition in the markets. Even though countries do not apply forbidden promotion actions according to the free trade agreements, they follow strategies to have monopolistic power in the markets temporarily. To do this, they use foreign exchange currency policies, advertisements, political agreements with other countries on international trades and bileteral and multiliteral trade agreements. Subsequently, no one can claim that there is a perfect competition in the international markets.
Decreasing returns to scale assumption is also not a realistic assumption. The developed economies are importing raw materials from the less developed and developing countries and after processing these products they sell them back to other countries. The less developed and developing countries sell raw materials at cheaper prices to the developed countries and they import the processed products at a higher price from the developed countries. Also considering that the less developed and developing countries do import many other high technology products from these countries, they always lose and the developed countries always wins. Also the developed countries technology level is much higher relatively. All these facts prove us that there is increasing returns to scale for the developed countries while there is a decreasing returns to scahle for the less developed and developing countries.
New Generation of International Trade Theories
Classical international trade theories are mostly falsified by the facts in some studies and we know that the assumptions under classical theories are not true in the real world. Because of that, comparative advantage theory cannot explaing the international trade well today.
New theories try to cancel some assumptions of the classical theories and this way develop new ways to explain the international trade. Most of them uses a general equilibrium approach. With their settings and assumptions, they create a general equilibrium and run the model. Another eminent improvement in the new theories is the use of monopolistic competition market structure in modelling. Also the assumption of constant returns to scale for all the countries are not included in the new theories and each country is evaluated by its dynamics in the modelling processes.
Game theory is a new technique used for modelling. International trade economists have recently contributed to the literature of game theory and international trade theory by developing new things in the game theory.
Also another improvement is that many different subfields of economics are considered together. The economic growth theory, microeconomics theory, production technologies theory and many other theories are utilized to create a new modelling for explaining the international trade.
Anonymous. (n.d.). Critics and Extensions of Conventional Trade Theory. Retrieved from http://archive.unu.edu/unupress/unupbooks/uu34ee/uu34ee05.htm.
Trefler, D. and Zhu, S. C. (2000). Empirical Testing of Trade Theories. AEA Papers and Procedings.