As humans, it seems like we were made to trade with each other. It’s in our DNA. From novel ideas to building materials to fidget spinners, we have constantly figured out ways to exchange stuff with each other. Sometimes, we do it without even knowing we’re doing it. Whenever we go to work, we are exchanging with each other. We give hours of our time, effort and skills (sometimes called labor), in exchange for an agreed upon price per hour (sometimes called a wage). We pay to go to college in exchange for the education, network, and experience we expect to obtain.

A simpler illustration is going to the local grocery store. We go to the grocery store to trade money for food. What’s important to note is that we go to the grocery store because we don’t grow our own Oreo’s nor do we have a milking cow in our backyards. Well, most of us, at least. Likewise, the grocery store needs money, but it does not have a money-printing machine, so it does what it’s good at — selling food.

The main reason for going to the grocery store.

This illustration is at the root of what the Swedish economist Bertil Ohlin won the Nobel prize for in 1977. Ohlin, along with James Meade, won the prize “for their pathbreaking contribution to the theory of international trade and capital movements.” The main idea behind the development of Ohlin’s theory is that, like people, countries are most efficient when they export stuff they can make easily or what they have in abundance, thus importing stuff that they are not so good at making and what they lack in resources. Countries with say, cheap workers should produce stuff that is more efficient by using cheap labor, e.g. fidget spinners and I ❤ NY t-shirts are made in China. Countries with tons of oil, like Saudi Arabia, should produce oil and export it out to the world in exchange.

We can see the implications of not adhering to this theory play out in the real world. In the 1970’s, after making a ton of money off of exporting oil, Saudi Arabia attempted to grow their own Oreos…err wheat, as a way to become more self-sufficient. But, due to Saudi Arabia being a desert climate, the cost of producing wheat was much more expensive; so expensive that they were exporting wheat at a price that was close to five times more than the going price for wheat. To trade wheat at the market price, this required tons of government subsidies and an inefficient use of water and other resources. Imagine buying and bringing a milking cow into your studio apartment, so that you don’t have to buy milk from anyone ever again. That is equivalent to what the Saudis did by trying to be wheat exporters. By the`90s, Saudi Arabia realized their costly mistake and gave up on this endeavor.

If this sounds familiar, you’ve probably heard of David Ricardo’s theory of comparative advantage, which was also used for Paul Samuelson’s work on trade. Check him out here.

Hello madam, what’s your comparative advantage? I ask because you sure have some fine new resources!

At the surface, this is a basic concept that is easy to understand. When looking at how countries exchange goods and services with each other, we are essentially looking at thousands of individuals trading with each other. However, when we combine all these individual trades we see the effects it has on wages, currencies, and other industries. Think of it like the butterfly effect, which is the idea that a small impact in one area can have large effects in many other areas.

Well, Ohlin tried to model how these effects of combined exchanges play out in the real world, mathematically. The Heckscher-Ohlin model, as it’s called, attempts to incorporate the differences in the cost of labor and capital. It also addresses what happens when countries decide to manipulate their money in different ways through changes in interest rates and investments. Though, in some cases the model can help explain how countries trade in the real world, it would still miss the mark. The real world gets hairy, very quickly. There is just too much happening at the same time and we don’t have the adequate knowledge to predict with any kind of meaningful accuracy.

For example, in economics we’re taught early on that if there is a huge increase in the supply of workers, there will be a decrease in wages. This is absolutely correct in what economists call “partial equilibrium” or when we’re looking at one industry alone. However, the real world is made up of a bunch of industries that are interconnected like an ecosystem. This ecosystem is referred to as “general equilibrium.” So, the theory that a bunch of workers that flood a market will decrease wages turns out to not be all that accurate, because the labor shock will be absorbed in other markets in different forms.

Leonard Read, the founder of the Foundation for Economics Education, is famously known for highlighting the ecosystem-likeness of markets in his, thought-provoking, genealogy of a pencil exposé, “I, Pencil.” To make a pencil, it involves hundreds of thousands of people to come together, with no initial grand plan of producing a writing utensil. From the workers that cut down the trees, to the makers of chainsaws, to the refiners of oil for the chainsaw, to the oil tanker drivers, to the producer of rubber for not only the wheels on the tankers but for the erasers, to the miners of graphite, to the steel producers, and so on and so forth — all go into making the pencil. These spontaneous interactions that go into making a simple pencil are just trades. However, trying to measure this would be quite the feat. Adding the other factors like costs and such would make it an impossible feat.

Screenshot from the I, Pencil Video

Nonetheless, the Heckscher-Ohlin model is still used and can be found in even the most recent international trade and economics textbooks. It’s a simple, yet elegant, way of illustrating how countries are supposed to trade with each other. Some of the criticisms have come out saying that countries don’t necessarily trade in the way the model predicts. Instead of countries trading based on their most used “factors of production” like capital or labor, they trade based on other factors like interest rates, income levels, and relationships. To go back to the grocery store example, most grocery stores will have milk and Oreos, but sometimes, we go to the grocery store that has nicer cashiers or is in a nicer part of town. We’re not trading for just the milk and Oreos but for the ambiance as well. The same thing is applied at the international level, to an extent.

Though Bertil Ohlin couldn’t make any kind of real world calculations on predicting how countries trade, his model has helped economists in teaching how countries trade with each other. If anything, it’s just like going to the grocery store…well kinda.

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