International Business

Criticism Of Modern Theory Of International Trade

The modern theory (or factor endowment theory or factor comparison theory) though makes a considerable improvement over the classical theory of comparative costs. It is not completely free from defects. The theory has been criticized on the following grounds

1. Unrealistic Assumptions. The theory is based on certain unrealistic assumptions such as perfect competition, full employment of productive resources, absence of transport costs, similarity of production functions in two countries etc. These assumptions do not hold good for all countries for all times. A theory based on such unrealistic and over simplified assumptions cannot bear any relationship to reality. For example, perfect competition is a myth and not found in any economy. Similarly, the condition of full employment is found only in developed countries and not in under developed or undeveloped countries.

2. Only a Partial Equilibrium Analysis. Though the theory is an expansion of equilibrium theory of value to international trade but it provides only a partial explanation of the equilibrium theory, According to the Modern Theory, the trade between the two counties takes places due to differences in relative commodity prices which are the result of the differences in factor prices. Factor prices are attributed to differences in factor-endowment. Thus, international trade ultimately is the result of differences in factor endowment in two countries. Differences in relative commodity prices, according to critics, are not only due to factor-endowment only but due to several other cause to which the theory makes no reference.

3. International Trade is Possible even with Identical Factor-Endowment. The modern theory explains that international trade takes place due to differences in factor-endowments. But it is not correct in all the cases. International trade can take place even when factor-endowments are similar in two countries. If the tastes and preferences of the consumers in two countries differ, the trade between two countries will take place despite the identical nature of their factor endowments.

4. Commodity Prices Determine Factor Prices. The modern theory holds that international trade ultimately takes, place due to differences in factor endowments. Factor-endowments result in factor prices and factor prices are the results of the differences in relative commodity prices. In other words factor prices determine the relative commodity prices as established in the theory. But, it is not correct. Prof. Wijanhold, however, holds that it is commodity prices that determine the factor prices and not the factor prices that determine the commodity prices.

5. Highly Static in Nature. The theory is highly static in nature and therefore, unsuitable to explain a dynamic situation. The theory assumes that the factor endowments in two countries are fixed and unchanging in quantum: This is quite an unrealistic assumption because productive resources in` any country, are not fixed in quantity.

6. Qualitative Differences in Productive Factors have been ignored. The theory does not consider the qualitative differences in productive factors. It considers that all productive factors are homogeneous in the two countries whereas it is not true because productive factors are not homogeneous even within a country. How can they be, then, homogeneous in the two countries?

7. Mobility of Productive Factors. The theory is based on the assumption that the factors of production are perfectly immobile between two countries. But the critics do not agree with this assumption. According to them there is no such thing that proves that factors of production are totally immobile.

8. Product Differentiation. The modern theory assumes that the two products in the two countries are ‘identical. This is rather, an unrealistic assumption. The products in the two countries may be differentiated despite the similarity in factor-endowments and the international trade may take place due to differences in products.

9. Production Functions are not identical. The assumption that production functions of a commodity are identical in two countries is also not correct. Tastes and preferences of the people of the two countries imply different product functions of a commodity.

The theory suffers from a number of drawbacks and shortcomings. But still it offers a satisfactory explanation of the phenomenon of international trade.

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