The basis of trade

Abstract

This chapter reviews basic theories to explain the difference in price ratios between countries before trade. The Ricardian explanation assumes that labor cost ratios, and therefore price ratios, differed between countries before trade. According to the Heckscher–Ohlin theory, any differences in price ratios between countries must also be due to differences in demand and/or supply conditions in those countries. As far as demand conditions are concerned, the Heckscher–Ohlin theory postulates that income levels and taste patterns are the same in different countries and therefore different price ratios cannot be explained by differences on the demand side. On the supply side, the Heckscher–Ohlin theory also assumes that technology is the same in different countries. An important implication of the Heckscher–Ohlin theory is that trade tends to increase the price of the abundant factor of production in each country and to decrease the price of the scarce factor. The reason is simply that foreign demand for the export commodity raises its output and that in turn increases the demand for the abundant factor, which is used intensively in the production of the export commodity.