THEORIES OF INTERNATIONAL

TRADE

L. 2
 IMPLICATIONS OF TRADE THEORIES

 Trade theories provides the conceptual base for

• international trade and
• shifts in trade patterns.

 They also facilitate in understanding the basic reasons behind the evolution
of a country as a supply base or market for specific products.
  THEORY OF MERCANTILISM

The theory attributes and measures the wealth of a nation by the size of its accumulated

treasures.

It aims at accumulating financial wealth in terms of gold by encouraging exports and

discouraging imports.

Copyright @ Oxford University Press International Business R. M. Joshi 3

 THEORY OF MERCANTILISM

 Mercantilism refers to the views of a heterogeneous group of influential people (merchants,

bankers, government officials and even philosophers) as to how a nation could regulate its
domestic and international affairs to promote its own interests.

 The principal assertion of mercantilism was that a nations wealth and prosperity reflected in
its stock of precious metals, gold and silver.

 At that time, as gold and silver were the currency of trade between nations, a country could
accumulate gold and silver by exporting more and importing less
 THEORY OF MERCANTILISM

 In other words, according to mercantilism economic activity was a zero-sum game (i.e. one’s
gain is the loss of another).

 The mercantilists, therefore, argued that government should do everything possible to

maximise exports and minimise imports. Imports were to be restricted by such measures as
tariffs and quotas and exports were to be subsidized.
  FLAWS OF MERCANTILISM

 Suppose that country A has a favourable trade balance. This will result in an inflow of
gold and silver resulting in an increase in the money supply in country A.

 This will cause an increase in price and wages in that country and will adversely affect
exports and encourage imports, ultimately wiping out the trade surplus.

 On the other hand, consequent to the outflow of gold and silver from the country with
trade deficit, prices and wages will fall in that country, thus increasing its international
competitiveness which will eventually restore the equilibrium.
 FLAWS OF MERCANTILISM

 Another flaw of mercantilism is that it viewed trade as a zero-sum game. This view was
challenged by Adam Smith and David Ricardo who demonstrated that trade was a positive
sum game in which all trading nations can gain even if some benefit more than others.
  THEORY OF ABSOLUTE ADVANTAGE (ADAM SMITH)

Absolute advantage may be defined as ability of a nation to produce the goods more efficiently and

cost effectively than any other country.

According to the theory, each country should specialize in producing those goods that it can produce

more efficiently, instead of producing all products. Thus, a country should use increased production

to export and acquire more goods by way of imports which in turn would improve living standards of

its people.

Copyright @ Oxford University Press International Business R. M. Joshi 8

  THEORY OF ABSOLUTE ADVANTAGE


According to his theory, trade between two countries would be mutually beneficial if one country could produce
one commodity at an absolute advantage (over the other country) and the other country could, in turn, produce
another commodity at an absolute advantage over the first.

 The basis of international trade is the absolute difference in the cost of production of different
commodities between nations.
  THEORY OF COMPARATIVE COST OR COMPARATIVE ADVANTAGE
(DAVID RICARDO )

 The comparative cost theory was first systematically formulated by the English economist David Ricardo

 Comparative Advantage may be defined as the inability of a nation to produce a good more efficiently

than other nations, but its ability to produce one good more efficiently compared to the other good.

 Thus, the country may be at an absolute disadvantage with respect to both the commodities but the

absolute disadvantage is lower in one commodity than another.

 Therefore, a country should specialize in the production and export of a commodity in which the absolute

disadvantage is less than that of another commodity or in other words, the country has got a comparative

advantage in terms of more production efficiency.

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  THEORY OF COMPARATIVE ADVANTAGE
 Two-country-two-commodity model.
 Labour is perfectly mobile between various industries.
 Free and unrestricted trade among countries

 Portugal will gain if it can get anything more than 0.88 units of cloth in exchange for one unit of wine, and
England will gain if it has to part with less than 1.2 units of cloth against one unit of wine
 • CRITICISM OF THEORY OF COMPARATIVE ADVANTAGE

 As the theory is based on the labour (cost) theory of value, it has inherited all the defects of the labour
theory of value. Labour is certainly not the only element of cost.

 In a money economy it is not proper to express the cost of production in real terms (labour units).
Differences in wages may alter the price ratios from the ratios of labour units expended, particularly
between countries. Indeed, wage differences is the reason for an important part of the global trade.

 The assumptions about the mobility and homogeneity of labour are also incorrect. There rarely is perfect
mobility of labour from one branch of production to another.
 The assumptions of full employment and perfect competition, which are characteristics of classical
economic theories, are also wrong.
 Similarly, it is highly unrealistic to assume that international trade is free and does not involve cost of
transport.
 By taking a two-country-two-commodity model, Ricardo has over simplified the situation
  FACTOR ENDOWMENT ( HECKSCHER-OHLIN THEORY )

 The factor endowment theory was developed by Swedish economist Eli Heckscher and his student

Bertil Ohlin.

 The classical theory demonstrated that the basis of international trade was comparative cost

difference. However, it made little attempt to explain the causes of such comparative cost difference.

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  FACTOR ENDOWMENT ( HECKSCHER-OHLIN THEORY)

 Factor Endowment theory attribute international (and inter-regional) to differences in comparative costs
to:

Factor Endowments:
The theory starts with the assumption that countries differ in their factor endowments, particularly in terms
of labor and capital. Some countries have abundant labor relative to capital, while others have abundant
capital relative to labor.

Factor Intensity:
Different industries have varying factor intensities, meaning they use factors of production (labor and
capital) in different proportions. Some industries are labor-intensive, meaning they require a relatively
large amount of labor compared to capital.
 FACTOR ENDOWMENT
( HECKSCHER-OHLIN THEORY)

 In the above example, even though Country A has more capital in absolute terms, Country B is more
richly endowed with capital because the ratio of capital to labour in Country A (0.8) is less than in
Country B (1.25).
 FACTOR ENDOWMENT
( HECKSCHER-OHLIN THEORY

 A nation will export the goods whose production requires intensive use of the nation’s relatively abundant and

cheap factors and import the goods whose production requires intensive use of its scarce and expensive factors.
  THE LEONTIEF PARADOX

 Wassily Leontief carried out an empirical test of the Heckscher-Ohlin Model in

1951 and found that the US exported more labour-intensive commodities and
imported more capital intensive products which was contrary to the results of
Heckscher-Ohlin Model of factor endowment.

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  COUNTRY SIMILARITY THEORY

Trade occurs between nations that have similar characteristics, such as economic,

geographic, cultural, etc. However, in case of manufactured goods, cost was determined

by similarity in product demands across countries rather than by relative production costs

or factor endowments.

Similarity Attracts Trade: Countries in same cultural trade more amongst themselves:

Cultural and Economic Factors: Developed countries trade more with developed countries

Countries in similar geo-features trade more:

Copyright @ Oxford University Press International Business R. M. Joshi 18

  THE NEW TRADE THEORY

The theory elucidates that international trade enables a firm to increase its output due to

specialization by providing larger markets, resulting into enhancing its efficiency. It

helps explain the trade patterns when markets are not perfectly competitive or when

economies of scale are achieved by production of specific products.

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 .
New trade theory (NTT) refers to modern economic theory that explains international trade based on
economies of scale, network effects, and first-mover advantage. It helps decipher the main reason behind
globalization and intensive trading between similar economies. In addition, it paves the way for the
government’s role in the industrialization of a country.
  INTERNATIONAL PRODUCT LIFE CYCLE THEORY

The theory explains the variations and reasons for change in production and consumption

pattern among various markets over a time period.

The Product Life Cycle (PLC) theory of trade is a concept that extends the traditional

Product Life Cycle theory to explain how international trade patterns evolve over time.

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  PRODUCT LIFE CYCLE THEORY


 • PRODUCT LIFE CYCLE THEORY

Stage 1: Introduction - Product Launch

Stage 2: Growth - Sales start to grow rapidly

Stage 3: Maturity - Peak level of sales

Stage 4: Decline - Sales and Profits begin to decline

  STAGES OF INTERNATIONAL PRODUCT LIFE CYCLE
(DEVELOPED BY RAYMOND VERNON AND LEWIS T WELLS )

This models explain international trade based on technological change:

The IPLC has four distinct identifiable stages that influences demand structure,
production, marketing strategy, and international competition as follows:
Stage 1: Introduction

Stage 2: Growth

Stage 3: Maturity

Stage 4: Decline

Copyright @ Oxford University Press International Business R. M. Joshi 24

 PRODUCT LIFE CYCLE OF TRADE

 According to this model an innovative product is often first introduced in an advanced

country like the USA (because of certain favourable factors such as a large market,
ease of organising production etc).

 The product is then exported to other developed countries. As the markets in these
developed countries enlarge, production facilities are established there. These
subsidiaries, in addition to catering to the domestic markets, export to the developing
countries and to the United States.

 Later, production facilities are established in the developing countries. They would
then start exports to the United States (TV receiving sets is one such example).

 PRODUCT LIFE CYCLE OF TRADE

 Until the point of time, t1, the US is the only producer and consumer of the product.
 At t1 USA starts producing more than the domestic consumption requirement and other developed countries start importing it
from the US. At point t3 these developed nations become net exporters.
 As the production in other countries grows, exports of US fall and the US eventually becomes a net importer. The developing
countries start consumption only at a later stage than the developed countries, and they are net importers until t4. As
developing countries net exports grow, the developed countries find their exports falling
  REVEALED COMPARATIVE ADVANTAGE

It is measured by a country’s share of world exports of a commodity divided by its share in total exports .

RCA = (Xij / Xi) / (Xwj / Xw)

Where
Xij = ith country’ export of commodity j
Xwj = world exports of commodity j
Xi = total exports of country i
Xw = total world exports

If RCA > 1, it implies that the country has a revealed comparative advantage in producing that product.

Copyright @ Oxford University Press International Business R. M. Joshi 28

  REVEALED COMPARATIVE ADVANTAGE

 Export Patterns: RCA is based on observed export patterns, not just the potential for production. It looks
at what a country is actually exporting, rather than what it could potentially produce

 Interpretation: RCA > 1: The country has a revealed comparative advantage in producing and exporting
the product. This suggests that the country is relatively more efficient in producing that product compared
to other countries.
• RCA = 1: The country's export share for the product is in line with the global average, indicating no
strong advantage or disadvantage.
• RCA < 1: The country has a revealed comparative disadvantage in producing and exporting the product. it
suggests that the country may not be competitive in that product on the global market.

 Policy Implications: Governments and policymakers can use RCA analysis to identify sectors in which
their country has a competitive advantage. This can inform trade policies, investment decisions, and
resource allocation to support the growth of industries where the country has a revealed comparative
advantage.
  REVEALED COMPARATIVE ADVANTAGE

 RCA can change over time due to shifts in technology, production processes, labor costs, and
global demand patterns.