Chapter 1 A REVIEW ON INTERNATIONAL TRADE THEORY AND THE IMPORTANCE OF INTERNATIONAL TRADE IN THE GLOBALISE WORLD
International trade between countries occurs by exchanging goods and / or services with their counterparts. Economic interaction between parts of the world has expanded over the centuries and has significant impact on the worlds' economic development. Adam Smith (1776), a founding father of classical economic, in his influential masterpiece ‘an inquiry into the nature and causes of the wealth of nations' mentions that:
It is the maxim of every prudent master of the family, never to attempt to make at home what is costing him more to make than to by... What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. If a foreign country can supply us with commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. (Smith, 1776: 401)
It is important to understand Smith argument, as mentioned above. Preceding his writing on wealth of nations, most of the writing on the international trade theory during the seventeenth and eighteenth centuries advocated to an economic philosophy known as mercantilism. In order to become a rich and strong nation, mercantilists suggested that the nation must export their products than import it. The resulting export surplus would then be settled by an inflow of bullion, or precious metals, primarily gold and silver. They also suggested that government should impose strict government control of all economic activity including trade between nations (Kalbasi, 1995).
Smith argument on the reason of international trade, as reactions to the mercantilists' views on trade and the role of the government led into his argument into free trade based on the theory of absolute advantage or absolute cost. Understanding this view and flow of trade theory are very important in order to construct the reason why the nation trade with their counterparts.
Taking into account to the above statement, this chapter discusses the theory of international trade by focusing on the law of comparative advantage in section 2. Section 3 discusses empirical measures and indicator of comparative advantage. An analysis of the regionalism and globalisation effect into the international trade is discussed in section 4. Final section in this chapter is specified on the Muslim countries economic cooperation discussion.
Theory of International Trade: A Review on Law of Comparative Advantage
As previously mentioned, according to Smith (1776) trade between two nations occurs when each country has an absolute advantage. By this, it means that, when one nation is more efficient than (or has an absolute advantage over) another in producing one commodity but is less efficient than another in producing a second commodity, then both countries can specialize on their advantage and exchange part of its output with the other nation for the commodity of its absolute advantage.
In addition, as to the Smith's notion on the specialisation in economy, in his argument on international trade there have been nothing more than the application of specialization and the division of labour on a global scale (Gomez, 1987). All in all, Smith argument on absolute cost advantage is that, a country will produce goods or services of it has more efficiency in producing those particulars goods or services than other nation.
Nevertheless, Smith's argument has been challenged since then. As criticised by Kennedy in his argument to the Smith's absolute advantage, ‘What if there is nothing you can produce more cheaply or efficiently than anywhere else, except by constantly cutting labour costs?' (taken from Marrewijk, 2002: 34). It means that, it is possible for a country to have absolute advantage than its counterpart especially in the current modern globalise world. On the other way around, if a country has absolute advantage in all production of goods than its partner, it is possible to trade with the counterparts (Carbaugh, 1985: 14).
In addition to that, Salvatore (1997: 36) suggests that the absolute advantage trade theory ‘could not explain trade among developed countries as the theory is suitable to explain only very small part of the world trade such as some of the trade between developed and developing countries'. In response to the Smith's argument on absolute advantage, David Ricardo (1817), a classical British economist in the nineteenth century, forms a major part of international trade theory so-called the law of comparative advantage.
Ricardo's theory of comparative advantage
Law of Comparative advantage was characterised by the famous Corn Laws, which happens when there was a restriction of grain imports in Britain between 1815 and 1846 (Marrewijk, 2002: 41). David Ricardo (1817) is recognised as among of the contributor in introducing the law of comparative advantage. He argued that, mutual trade could occur even a country has absolute advantage in all goods than its trading partner by emphasising on the comparative cost or relative cost.
Ricardo (1817: 147 - 148) used England and Portugal as examples in his illustration of the comparative advantage theory. He illustrated that Portugal and England were producing two goods (wine and cloth). Ricardo assumed that Portugal is more efficient in the production of both wine and cloth over England. To make the pure example more concrete and closely related to this study, Table 2-1 summarises assumption about the cost conditions in the two countries based on comparative advantage argument by using Malaysia and Oman as example.
Modified from Ricardo's illustration of comparative advantage
As is clear in the Table 2-1, Oman is more efficient in the production of both goods; it requires 12 units of labour rather than 36 units of labour to produce one unit of wine and 3 units of labour rather than 6 units of labour to produce one unit of cloth. Thus, based on the theory of absolute advantage Malaysia would not be able to trade with Oman.
Nevertheless, according to the principle of comparative advantage, even there is no absolute advantage for a nation (as illustrated in Table 2-1, where Malaysia has absolute disadvantage) mutually beneficial trade may still exist. The theory argues that comparative costs are important for determining a nation's production advantage. Table 2-2 gives the opportunity costs of producing malt and cloth in Oman and in Malaysia, constructed based in the information given in Table 2-1.
Table 2-1 and Table 2-2 shows that Malaysia is twice as inefficient as Oman in producing cloth (it requires 6 unit of labour, rather than 3) but three times as inefficient as Oman in producing malt (it requires 36 units of labour, rather than 12). Thus, it is suggested that Malaysia should specialise in producing the cloth and exchange it with the malt from Oman. According to Bhagwati and Balasubramaniam (1998) Ricardian theorem stated that, a country will export or import that commodity in which her comparative factor productivity is higher or lower. Thus, Oman has a comparative advantage in the production in malt and exports it in exchange to cloth from Malaysia. While, Malaysia has a comparative advantage in the production in cloth and exchange it to malt from Oman.
To make this thing clear, as discussed by Marrewijk (2002: 44) here is how the comparative cost works. Suppose Malaysia produces one unit of malt less. This frees up to 36 unit of labour. These 36 units of labour can be utilised in Malaysia to produce 36/6= 6 units of cloth. The opportunity costs of producing malt in Malaysia are 6 unit of cloth. Malaysia now produced 1 unit of Malt less and 6 units of cloth more. Suppose, however, that Malaysia wants to consume the same quantity of Malt as before. It must then import 1 unit of malt from the Oman. To produce 1 extra unit of malt, Oman needs 12 units of labour. These labours must come from the cloth industry, where production therefore drops by 12/3 = 4 units of cloth, reflecting the opportunity costs of producing malt in Oman. Now, in reflection of the above labour reallocation, the production from these two countries will be also affected. Malaysia produces 1 unit malt less, but 6 units of cloth more, while Oman produces 4 units of cloth less, but 1 unit of malt more. In consequent, the total production of the malt remains unchanged while production of cloth rises by 2 units. If both countries specialise in producing of the good that they have a comparative advantage, in this case cloth for Malaysia and malt for Oman, the extra 2 units of cloth could be the potential gains from specialisation.
Basically, the Ricardo's theory of comparative advantage is based upon a number of simplifying assumptions as follows (Bhagwati and Balasubramanyam, 1998, Salvatore, 1997: 36):
One factor of production i.e: labour
- there are only two countries and two commodities involve in trade,
- differences in labour productivity between nations
- there has been a perfect mobility of labour between industries within a nation but immobility between countries,
- constant costs of production
- the commodities have no transportation costs or technical cost such as tax etc (no barrier to trade)
Although this principle of comparative advantage has a number of restrictive assumptions, it is useful to understand the international trade theory, and the production patterns. In fact, 'it is the most famous and influential principles of economics' (Carbaugh, 1985: 15). Marrewijk (2002) concluded that, from the Ricardian trade theory, the opportunity for trade between countries occur whenever the comparative productivity ratios differ between them and they do not depend on absolute advantage productivity level.
The Heckscher-Ohlin Model
The Ricardian's theory of comparative advantage as discussed above provides basic understanding on international trade. It, however, does not explain in detail the reasons of comparative costs discrepancies (Carbaugh, 1985) and differences in factor productivities between commodities and countries (El-Agraa, 1983: 76). In addition Marrewijk (2002: 59) states that there are three important issues associated with the theory, there are: technological difference, trade pattern between countries may also effected by other economic forces, e.g: prices, and the comparative advantage take into account only on factor of production (labour).
These gaps in the Ricardian model has been improved and extended by the two neo-classical economists from Sweden, Heckscher (1919) in collaboration with his student Ohlin (1933). They, eventually, developed the so-called the Heckscher-Ohlin (H-O) model of comparative advantage in the 1930s. This theory argues that trade results from the fact that different countries have different factor endowments. Some prominent economists claimed that the H-O model is a dominant trade theory today, for example Helpman (1998, p. 574) described the theory as the “workhorse of the profession” and according to Leamer and Levinsohn (1995) the theory has served as the “backbone of traditional trade theory” more than 60 years.
Basically, the H-O model's Heckscher-Ohlin (H-O) theorem suggested that a country will have a comparative advantage in and export the commodity, which uses its relative factor abundance intensively (Heckscher, 1919, p. 285; Ohlin, 1933 pp. 12 and 19). Hence, Salvatore (2001: 129) in his book mentions that, the Heckscher-Ohlin theorem can be clarify as follows:
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.
According the definition of the Heckscher-Ohlin theory, we can define that, the determinant factor of comparative advantage and trade among the nations based on relative factor abundance or factor endowments. For that reason, the H-O model is also known as the factor proportions or factor endowment theory (Salvatore, 2001: 130). Carbaugh (1985: 47) emphasises that in the factor endowment model, differences in relative national supply condition explains the pattern of trade for a country. The H-O trade theory is usually formulated within this framework, “there are two commodities (commodity X and commodity Y), two factors of production, and two countries which have identical tastes; a country will export the good which intensively uses the relatively abundant factor of productions” (Marrewijk, 2002: 115). In addition to that, there are essential assumptions of the Heckscher-Ohlin trade theory that should bear in mind:
- there are no transportation costs or other impediments to trade;
- there is perfect competition in both commodity and factors of production markets;
- fixed endowment quantities of two homogeneous factors of production, capital and labour, which are fully employed in each country (commodity X is labour intensive and commodity Y is capital intensive in both countries);
- there is no technological difference in production for both countries;
- the production functions are constant return to scale for both commodities and countries;
- Movement for factors of production are perfect and costless between industries within a country, but are immobile between countries (internationally);
There are basic grounds behind these assumptions as were discussed by Salvatore (2001: 121). General assumption on (two nations, two commodities and two factors) illustrates that the theory is made with a two dimensional figures. The assumption of no transport cost or other obstruction to the trade flow implies that commodity prices under trade will be the same in both countries. The perfection competition means that factors of production will be allocated in an optimal way. There is no technological differences means that both countries use and have access to same general production techniques.
As discussed, Heckscher-Ohlin (H-O) model depends on the factor abundance: there two definitions of factor abundance; that is relative factor prices and physical units (quantity). The former means that a country's rental price and the price of labour time are relatively lower than another country. This definition says that country A is capital-rich compared with country B if capital is relatively cheaper in country A than in country B. The second definition compares overall amount of capital and capital in each country. It says that country B is relatively capital abundant if it has higher ratio of the total amount of capital to the total amount of labour than another country (country A).
Krugman and Obstfeld (2006), however argue that there is no country has a factor abundant in everything. Although, home country has 50 million workers more than foreign country, it does not mean, home country is a labour abundant. However, it depends on land that the country has. If, a home country has 70 million workers and 140 million acres of land (a labour to land ration is 1:2) while foreign country has 20 million workers and 20 million acres of land (a labour to land ratio is 1:1). We consider that foreign country to be labour-abundant even though it has less total labour than the home country and home country is relatively capital-abundant. (2006: 61)
The most important thing that the H-O trade theory attempts to address the patterns of trade among the nations that involve in the free trade. The H-O theory has also attempted to establish the reasons for importing and exporting certain commodities as well as the nature of the countries involved in the exchange process. Importantly, since the early part of the 20th century, the H-O trade theory has widely been used to explain the pattern of trade.
The model, then, has been improved through seminal contributions by Samuelson (1948; 1949; 1953; 1956; 1967) and others. On the other hand, the Heckscher-Ohlin-Samuelson (H-O-S) model has been argued empirically in several researches. The first and famous empirical study has been conducted by Wassily Leontief (1953). He examined import and export data from the United States in 1947 and discovered that US exports were on average relatively labour intensive while imports are relatively more capital intensive by thinking that the USA was a capital abundant country. The finding seems contradicting the H-O-S model. This has become known as the “Leontief Paradox” (taken from Marrewijk, 2002: 122).
In addition to that, Bowen et al. (1987) have carried out a study on twenty seven countries and concluded that the “Heckscher-Ohlin propositions that trade reveals gross and relative factor abundance are not supported by these data”. Besides this, Deardorff (1984: 512) in his work on trade theories evaluation asserts that, the H-O trade model is remarkably well in understanding trade theory and the basic model is useful in understanding the commodity composition of international trade, but is otherwise “fairly helpless”.
All in all this theory determines trade by comparative advantages derived from different factor endowments, besides the pattern of specialisation. According to Wilson (1977: 105) a country's factor endowment is an important factor that determine country's trade as well as investment. Moreover, the H-O model is designed to incorporate two goods, two factors, and two countries (Mikie, 1998). Nevertheless, as critics says, 'this theory leaves a great deal of today's international trade unexplained' (Kalbasi, 1995). As suggested by Deardorff (1984) there is a need to have new development on trade theories that consider factor proportion, economies of scale, degrees of product differentiation, imperfect competition, and differences in technological changes among nations which. These factors are then blended together to determine countries' trade patterns, trade composition and partners. Thus, this new development leads to the new trade theories.
The above aforementioned trade theories is explained the perfect competition markets, ‘that is markets in which the firms do not perceive they have any market power' (Marrewijk, 2002). Thus, in response to the imperfect market competition and economies of scale, Dixit and Stiglitz (1977) have carried out an analysis of trade under this market circumstances, such as trade under monopoly and oligopoly markets.
The previous discussion mainly focused on trade between countries in different products - for example, the exchange of cloths for food. These types of trade pattern are known as 'inter-industry' trade. We now attempt to discuss about trade between countries in similar products, this theory is 'called intra-industry' trade. The simultaneous importation and exportation of food or cars by a country are among the example. On the other hand, intra-industry trade can be defined as a simultaneous exchange of similar but differentiated goods or services of the same industry or broad product group. The existence of intra-industry trade is mainly to take advantage of important economics of scale in production (Salvatore, 2001).
There are several conditions why intra-industry trade occurs between countries. According to Perdikis and Kerr (1998), intra-industry trade arises in seasonal good's production, for example, agricultural products. In one season a country may produce a country may produce and export a good, whereas in another it might import it. Canada exports fruit during the southern hemisphere's winter and imports fresh fruit from the southern hemisphere's during its winter.
Moreover, Grubel and Lloyd (1975) found that intra-industry the government policies and legal constraints can give rise to intra-industry trade. A government might subsidise the domestic production of a good and give a domestic producer a comparative advantage. As a result, the firm has an opportunity to sell the product not only domestically but also abroad.
Although, the intra-industry trade was first acknowledged by Ohlin (1933) it was not seriously studied until the mid 1960s (Perdikis and Kerr, 1998) because of the argument that claimed the traditional trade theories, based on comparative advantage, cannot be accounted as intra-industry trade (Davis, 1995a). This argument has been emphasized by several economist such as Lancaster (1980), Helpman and Krugman (1985), Balassa and Bauwens (1988). They claimed that, the traditional trade theories have difficulty to explain a large number of trades in similar factor endowments and technology that occurred between countries (Davis, 1995a).
Krugman and Obstfeld (2006) suggested that, intra industry trade contributes extra gains from international trade, over and exceed those from comparative advantage. According to him, by engaging to the intra-industry trade, a country will benefit from a larger market by reducing the number of products which has been produced and increase the variety of goods available to domestic consumer (Krugman and Obstfeld, 2006: 129).
According to (Salvatore, 2001: 179), there are several interesting consideration of implementation the intra-industry trade models developed by the economists since 1979. As has been discussed, although trade in the H-O model is based on comparative advantage among nations, intra-industry trade is based on product differentiation and economies of scale. Consequently, trade among nations based on comparative advantage is likely to be larger when the difference in factor endowments among nations is greater and intra-industry trade is likely to be larger among economies of similar size and factor proportions.
He also argued that, with the products produced under economies of scale, pre trade-relative commodity prices might no longer accurately predict the pattern of trade. By this it means that, in the absence of trade, a large country with abundance of factor proportions may produce a product at lower cost than a smaller country because of economies of scale. However, with the existence of trade, all countries have same advantage of economies of scale. As a result, the smaller country could conceivably undersell the larger nation in the same commodity.
Importantly, Salvatore (2001: 179), has pointed out that, intra-industry trade increases the economic cooperation among nation in order to minimize their costs of production and also provides greatly employment opportunities in some developing nations.
There are several models explain the intra-industry trade including Krugman (1979, 1980), Lancaster (1980), Brander (1981), Falvey (1981), Helpman (1981), Eaton and Kierzkowski (1984), Shaked and Sutton (1984) , Helpman and Krugman (1985) and Flam and Helpman (1987). Each of the models provides an explanation of intra-industry trade in different way, (for example, in product differentiation, monopolistic competition, oligopolistic competition, and the existence of economies of scales.
However, interestingly, some extensions to the theory of intra-industry trade have been developed. Davis (1995b) demonstrate that intra-industry trade can occur on the basis of comparative advantage deriving from differences in technology between countries. This model also has a challenging feature that increasing returns are not necessary to explain intra-industry trade.
EMPIRICAL MEASURE OF COMPARATIVE ADVANTAGE (REVEALED COMPARATIVE ADVANTAGE)
Previous section has intensively discussed trade theory that lays the reason for a country to open their market to the global world and get involve into international trade. In order to assess trade patterns in the context of Malaysia and Gulf Cooperation Council revealed comparative advantage measurement is employed. In the meantime, the idea is also to investigate Malaysia's actual exports which reveal the country's strong sector / products. This procedure is known as establishing Malaysia's revealed comparative advantage over its trading partner. This approaches particularly done by taken the post trade data.
In this section, an analysis of Balassa (1965) Revealed Comparative Advantage, which has been intensively used for analysing trade advantage between countries to its partner with regard to the world trade, is discussed. The concept of revealed comparative advantage (RCA) is grounded in conventional trade theory. Originally, it is founded by the David Ricardo in his theory of comparative advantage, which is discussed in the first chapter of this thesis. However, the theory evolved and numbers of economist have conducted an empirical work to the theory and offered the way to calculate this theory. Balassa, for example has done significant work to reveal a country comparative advantage, and introduced his famous index, which is then known as Balassa index in 1965. It is also widely known as Revealed Comparative Advantage Index (RCA Index). However, Liesner (1958) had already contributed to the empirical literature of RCA before Balassa popularised this famous index (taken from Marrewijk, 2002: 36). Originally, Liesner's proposal for this simple measure of RCA is the following:
Where X represents exports, i is a country, j is a commodity (or industry), and n is a set of countries (e.g. the GCC).
As mentioned, the theory and index has evolved, and Balassa (1965) has later presented a comprehensive and advance measure of RCA index. This index, then, is widely accepted for measuring RCA in the literature. The index can be wrtitten as:
Where X represents exports, i is a country, j is a commodity (or industry), and n is a set of countries. Literally, RCA2 measures a country's exports of a commodity j (or industry j) and to coressponding exports of a set of countries, e.g. the GCC. The above index of revealed comparative advantage (RCA2) has a relative simple interpretation. Its critical level of the indicator is 1, means the product neither has advantage nor disadvantage. A comparative advantge is revealed, if RCA2>1 (higher than 1). If it is less than unity, it reveals a comparative disadvantage or the country is said to have a comparative disadvantage in the particular commodity/industry.
The above index is used to analyse country's comparative export perfomance with respect to the set of country or the world only. In order to make a reference to bilateral revealed comparative advantage, an alternative Balassa (1965) index is then usefull to be analysed. A bilateral RCA is defined as:
Nevertheless, Greenway and Milner (1993), argue that the above RCA2 index is biased as imports of the particular country is not taken into account especially when country-size is important (Utkulu and Seymen, 2004).
Therefore, Utluku and Seymen (2004) proposed an alternative RCA index (RCA3 of equation 3) which country's import is taken into account in order to refer to the “own” country trade perfomance. It is believed that this measurement of country's revealed comparative advantage recognises possibility of simultaneous exports and imports within a particular commodity (Utkulu and Seymen, 2004).
Equation 3 above (RCA3) has slightly different interpretation from the previous index. The index ratio ranges from -1 (Xij = 0 and revealed comparative disadvantage) to +1 (Mij = 0 and revealed comparative disadvantage).
Another version of Balassa Index (1965) can be derived as the following equation:
Where X and M represent exports and imports respectively, i is a country, j is a commodity or industry, t is a set of commodities or industries.
It is agreed that, this index has some advantages in analysing product advantages for a country. It is strongly believed that, the RCA index considers fundamental advantage of a particular export commodity and it is independent of size and overall trade surplus/deficit situation (Batra and Khan, 2005). Some has also argued that this index is consistent with Ricardo's finding that there is no absolute advantage or disadvantage, but there is relative comparison with other goods or sectors (Pascha, 2002). On the other hand, this index is widely accepted to analyse a country's advantage in exporting their goods to its counterpart. Numbers of studies has been done by using this index in assessing such opportunities.
Despite the advantages, few things should be bear in mind. According to Pascha (2002), the RCA only covers actual performance and some information such subsidies that may cause high RCA is not taken into account. The index also cannot distinguish improvement in factor endowments and it is can be distorted by government policies and interventions (Ferto and Hubbard, 2002). Therefore, it may misrepresent underlying comparative advantage. With these considerations in mind, since this study is interested in analysing Malaysia's competitiveness within the Gulf cooperation council (GCC) context, the analysis of RCA is conducted based previous RCA discussion with respect to the GCC as the comparator both on global (RCA2) and bilateral levels (BRCA, RCA3 and RCA4). On the global level, the global competitiveness of Malaysia and the GCC are compared assuming that both Malaysia and the GCC are exporting to and importing from the world. In the mean time, trade between Malaysia and the GCC are taken into account for the bilateral level analysis.
On the other hand, in order to have a clear view on both Malaysia and GCC members' competitiveness with respect to the world, analyses on RCA of all countries in questioned are also carried out. The RCA2 index is used to measure of relative export performance by country and industry/commodity. It is defined as a country's share of world exports of a commodity divided by its share of total world exports. This analysis is helpful to understand each country's competitiveness relatively to the world exports. All the data and analyses are presented in Chapter 6.
The importance of International Trade in the globalise world
A number of researches that have been done by the economists have highlighted the importance of trade between countries. International trade has enjoyed a long, continuous, and rich development over the past few centuries, with contributions from the some of the world's most distinguished economists, including Adam Smith, David Ricardo, John Stuart Mill, Alfred Marshall, John Meynard Keynes, and Paul Samuelson (Salvatore, 2001). Generally, they have agreed that a nation gains benefits from the international trade. Nevertheless, they disagreed in some point of view which has led to the development of several theories in the field of international trade. In some cases, the major trade models differ by varying four types of assumptions. These assumptions relate to: i) number of factor production, ii) technology, iii) factor mobility and iv) the nature of competition (Lewis, 2006).
Moreover, the international trade among nations has increased over the years as measured by the rapid growth of world trade than world population (Salvatore, 1997). Many countries have involved the international trade as a tool to accelerate their economic growth. As pointed out by (Frankel and Romer, 1999: 394), the international trade has relatively raised national income and the larger countries which participate in international trade have higher income. He also suggested that, trade appears to raise income by spurring the accumulation of physical and human capital.
As has been noted by (Krugman and Obstfeld, 2006), the range of circumstances which International trade is beneficial is much wider than most people imagine. It is impossible to the country create all their needs on its own, for example, before 1983 Malaysia didn't have a technology to make a car, therefore they imported cars from another countries especially from Japan to fulfil the demand. On the other side, Japan imported rubber and others raw material from Malaysia to support their industrials development.
These kinds of activities are a part of international trade which has become of the main factors affecting the economic development process, and has associated economic growth of the country, beside its ability to improve the standard of living and the national incomes for the participating countries.
Many writers like Leornard Gomes (1990), Krugman (1995), Salvatore (2001) and O'Rourke and Williamson (1999) have documented the evolution and development of trade theory over the last century and have come out the conclusion which international trade has affected national income. Furthermore, as pointed out by Krugman (1995), the determinants of international trade include the repeated liberalisation of trade practices, the technological improvements in communication and transportation and, most importantly, the distribution of national income among the industrialised nations.
Determinants of World Trade Flows
The determination of international trade flow has become an ever-debated issue in international economics. The argument, however, is related to the method of estimation and specifically related to the specification of import and export equations.
Empirical studies of international trade flows generally estimate demand relationship for imports and exports. Supply relationships are often omitted by assuming that a single country faces infinite export and import price elasticity (see for example, Houthakker and Magee, 1969). A number of studies have assumed that relative prices in the imports and exports demand function are homogenous. Houthhakker and Magee, (1969), for instance, have used this assumption in estimating the trade flows of both developing and developed countries.
Moreover, Rauch (1991) argue that, the theory of comparative advantage (Ricardian and H-O) model of trade is capable to predict only the pattern of trade between countries in more than two commodities but not the volume of trade in each commodity. In his argument, he stated that the fundamental reason is; potential domestic producers are never able to gain a share of the domestic market for any importable, regardless how slight is their comparative advantage. Specifically, the theory of comparative advantage predicts only the pattern of trade in term of its complete specialisation of a country's productions in its exportable.
On the other hand, it has been suggested, both empirically and theoretically, that the gravity equation may be an appropriate description of trade patterns for groups of countries of all levels (see for example, Hassan, Jensen, 2000, Paas, 2000). Some of the studies on the determinants of trade focused primarily on the relation between distance and trade. In general, it has been well established that distance is a strong determinant of the intensity of trade flows that occur between nations; nations that are geographically proximate will tend to trade relatively more than will nations that are further apart (Frankel and Romer, 1999). Therefore, by using gravity model estimation, a strong relation has been found between distance and trade flows among nations.
Trade and Growth
The relationship between trade and development is one of the most arguments in international economics. However, the issue of the impact of international trade on economic development has been discussed since the proposition of Adam Smith's trade theory and also has been raised by Islamic Economist such as Ibn Khaldun about the issues involved (Wilson, 1995: 147).
In the western economic theory, Smith (1776) was the first to point out the positive effects of international trade on economic growth. He suggested that, by increasing market size, international trade would improve economic performance. He also argued that, when foreign trade widens the extent of the market and permits greater division of labour, it also raises the skills of labour force. As a result of trade increase, labour skills will improve and the productive capacity of the economy expands (Ingham, 2004: 93). This was widely recognised by the classical economists as a dynamic benefit of trade.
By opening a more extensive market for whatever part of the produce of their labour may exceed the home consumption, trade encourages them to improve its productive powers, and to augment its annual produce to the utmost, and thereby to increase the real revenue and wealth of society (Smith, 1776).
It also has been argued that, international trade can impact on GDP and has supported export-led growth theory. It also gives an incentive improved economic well being and societal prosperity. According to Frankel and Romer (1999), they pointed out that countries that are larger have more opportunities for trade within their borders and consequently gain more income. Furthermore, Abdel-Malek (1969) emphasized that exports are connected with sustainable rates of economic growth through the balance of payments. Consequently, in most cases, they consider that trade raises income of the country and creates a diversity of demands, which may not be in favour of local output. In addition, standard trade and development theory (Chenery et al., 1986) suggests that a poor country opening to trade tends to specialise in the export of primary products and will switch to the manufactured products which is more labour-intensive. This circumstance is closely related in most of developing countries in the early 1980's including Malaysia and East Asia countries. Indeed, they were success to bring an economic prosperity that is observed among the East Asian regions.
As suggested by (Sachs and Warner, 1995), international trade promotes growth through increasing specialisation, efficient resource allocation, diffusion of international knowledge, and heightened domestic competition. Furthermore, as noted by (Brett, 2000) a number of empirical studies have proved the positive relationship between trade and growth in the per capita GDP in both the developed and the developing countries. Most importantly, most of the empirical studies have found a positive relationship between trade and income growth, and yet there has been substantial controversy about the robustness of such results. Furthermore, international trade empirically has been proved as an engine of growth. The most recent studies by Coe and Helpman (1995), Jonsson and Subramaniam (2000), Noguer & Siscart (2005), also obtained the same conclusion which they agreed that trade raises income.
Moreover, a substantial number of empirical studies have been conducted in the past decades to identify the factors that drive economic growth. Grossman and Helpman (1991) have analysed the link between trade, innovation and growth on the foundations of the Dixit-Stiglitz model. They concluded that, with the involvement of Research & Development (R&D), the country will typically have some market power. They then introduce the possibility of R&D contribution to the stock of available knowledge capital, a public good, as well as to the development of privately appropriate blueprint for new products. This then enables the economy to sustain permanent rate of growth (Smith, 1994). Meanwhile, Alasdair Smith (1994: 62) claim that trade may impede economic growth in a country that exports goods intensive in human capital as the exporting sector draws human capital away from research. From these two arguments, we can conclude that the specialisation of human capital in R&D and in high-tech manufacturing lead to a faster growth rate of output to the country.
In addition, in accordance with the gains from trade, countries that involve in international trade benefited either from static or dynamic gain from trade. According to Thirlwall (2006: 518) static gains are those which accrue from international specialisation according to the doctrine of comparative advantage. While dynamic gains are those which result from the impact of trade on production possibilities at large. The examples of dynamic gains are Economies of Scale, international investment, and the transmission of technical knowledge. Meanwhile, according to (Kenen, 2000), the term of trade is a major determinant factor that determines the distribution of the gains from trade. Furthermore, the static gains from trade are still little compared to the dynamic gains owing to an increase growth rate, and the quantity of extra resources employed by the trading country (Kreinin, 1991).
As indicated by Baldwin (1992), economic growth can happen merely if the economy consists of at least two sectors. Therefore, the normal economy has consumption and investment sectors, plus a reproducible and fixed factor; whereas one-sector growth models ignore critical elements in the development process. Moreover, according to him, the dynamic effect of liberalised trade explains the gains from trade in Europe due to capital accumulation.
The Growing Importance of Developing Countries in World Trade
In 1996, World Bank indicated that, developing countries will have a greater impact on the global economy as a result of trade between developing and the industrial countries and cross-border capital mobility increases. Furthermore, the economic prospects of the developing countries have long been heavily dependent on the industrial economies. However, the share of the output pf world trade, and the capital flows that can be attributed to developing countries, have been increasing over the past few decades. As a result, the impact of the developing countries on industrial countries is becoming more significant. Therefore, as stated by the World Bank (1996), the growth of the output of the developing countries and their trade share has accelerated over the past few years. Hence, if that trend continues over the next years, the developing countries will be more likely to play a much greater role in the world economy, and they would have a much larger impact on industrial countries. However, the developing countries currently import roughly one-quarter of the products of the industrial countries, with the possibility of that increasing to more than one-third by the year 2010. The main factors behind this increase in trade are the reduction of trade barriers through the introduction of trade reforms such as the liberalisation of trade, lower transport and communication costs, and relatively a high GDP growth in the developing world.
However, according to UNCTAD (2004), over the past three decades world trade has witnessed the growing participation of the developing countries. Therefore between 1970 and 1999 merchandise exports of the developing countries have grown at an average annual rate of 12 per cent, compared to an overall world growth rate of 10 per cent. Likewise during this period, the bilateral trading activities among the developing countries have become increasingly important. This is emphasized by the fact that the share of trade among the developing countries reached 40 per cent of their total exports at the end of the 1990s.
The participation of the developing countries demonstrates that, with the exception of the new industrial economies (NIEs), which have already become closely integrated with the global trading system, the exports of developing countries are still focused on the exploitation of natural resources or unskilled labour.
In 1999, however, the developing countries accounted for 65 per cent of total world exports, of which 43 per cent is agricultural in nature. That change is reflected in the increase in the value of the annual exports of the developing countries by 6.0 percent compared to a world average of 5.2 percent. Moreover, the exports of the manufacturing sector have increased by 10.3 per cent, as compared to 7.8 per cent representing the total world trade exports.
Regionalism is a way to increase trade
Effect of regionalism
Muslim countries and INTERNATIONAL trade
There have been many of empirical studies related to the international trade in various points of view, especially study on the bilateral trade activities between countries. However, to date, there has been no academic study or project focusing on the bilateral trade flow between Malaysia and the Middle Eastern countries, specifically Gulf Cooperation Council. As Malaysia and GCC have a strong indigenous factor that encourage them to enhance their trade relation.
Therefore the present, study is the first effort to discuss the evolution of trade relationship between Malaysia and the GCC countries. As Malaysia and GCC are the Muslim countries and part of the OIC member, this study lies with its contribution to international studies involving the Arab and Muslim countries. Furthermore, it is hoped that this study will inspire further research in relation to the issue of international trade, especially with regard on the developing nations.
This chapter is a theoretical background study on the area of international trade. It briefly reviews some major models of trade and their assumptions particularly on theory of comparative advantage which is a main theory why country do trade. Chapter 2 is important in the context of the thesis as it will facilitate a better understanding of the various explanations of trade patterns. The trade theories that were examined include the traditional theory of comparative advantage, the vent for surplus theory, which is more suitable for the “oil-economy”, and the intra-industry trade.
From the revision of the major theories of trade, we have found that there are various explanations of trade patterns and recognise of these are relevant in the context of this thesis, which attempts to explore Malaysia's trade pattern with Gulf Cooperation Countries. We emphasized that the two models of comparative advantage, namely, the textbook Ricardian and Heckscher-Ohlin models, which conceive that trade occurs between countries due to differences in technologies (production function) and in factor endowments, respectively.
There is also a review on intra-industry trade that involves simultaneous exchange of similar but differentiated goods (or services) of the same industry. This type of trade takes place among countries that are almost identical in a number of factors, for example, in factor endowments, which was contrary to what the H-O model would predict. Importantly, we have recognised that intra-industry trade increases the economic cooperation among nation.
A section discusses the determinant of international trade flows in international economy, mainly discussion about the mechanism to assess the trade flow between countries. There are various models to evaluate the trade flows, however, we have identified that the gravity model is an appropriate model to determine trade pattern between Malaysia and GCC especially to determine the major factor of trade between them. There have been many of empirical studies related to the international trade in various points of view, especially study on the bilateral trade activities between countries. However, to date, there has been no academic study or project focusing on the bilateral trade flow between Malaysia and the Middle Eastern countries, specifically Gulf Cooperation Council. As Malaysia and GCC have a strong indigenous factor that encourage them to enhance their trade relation.
Therefore the present, study is the first effort to discuss the evolution of trade relationship between Malaysia and the GCC countries. As Malaysia and GCC are the Muslim countries and part of the OIC member, this study lies with its contribution to international studies involving the Arab and Muslim countries. Furthermore, it is hoped that this study will inspire further research in relation to the issue of international trade, especially with regard on the developing nations.
The theoretical issues on the major trade theories that were explored in this chapter are important in the sense to evaluate the trade pattern between Malaysia and GCC countries.
- “The ability of an economic actor (an individual, a household or a firm) to produce some particular good or service with a smaller total input of economic resources (labor, capital, land, etc.) per unit of output than other economic actors.” (Johnson, 2005)
- Hence the H-O model is sometimes referred to as the Heckscher-Ohlin-Samuelson (H-O-S) model.
- The biletaral RCA compares to what extent an exporting country's specifcation in its overall trade of industry s goods is similar in its trade with a particular importing country. For instance, if machinery makes up 25 percent of i's trade with j (the numerator in the formula above), but only 10 percent in its overall trade (the denominator), then goods s enjoys certain comparative advantagein i's exports to j. The bilateral RCA's value in this case is 2.5 (namely 20% / 10 %) and emphises this very fact.
- Note that, n might be represented world (w).
- In this study, this index may also be written as: Where: Xmj = Malaysia's exports of commodity j Xgccj = GCC exports of commodity j Xmt = Malaysia's total exports Xgcct = GCC total exports
- Assume that i is Malaysia and s is GCC members' country, the equation can be written as: