Unit II, III, & IV –

International Trade
Theory

Day and Date:

Unit Highlights…
 Introduction
 Mercantilism
 Trade based on absolute advantage
 Trade based on Comparative advantage and
concept of Opportunity Cost
 Heckscher Ohlin Theory
 Technological gap theories
 Product life cycle theory
 Theories of economies of scale
 Linder’s hypothesis
Text book reference chapters…
 International Economics by Dominick
Salvatore – Chapter 2

 International Economics by Francis

Cherunilam – Chapter 6
Let us recapitulate…
International trade theory helps us assimilate,

• Why nations trade?

• What are gains from trade?
• What is the pattern of trade?
Mercantilism: Origin…

Essays and pamphlets written by merchants,

bankers, government officials, and
philosophers in the 17th and 18th centuries in
England, Spain, France, Portugal, and
Netherlands.
Mercantilism: Basic tenets
 Maintain EXPORT SURPLUS (i.e.,
Export>Imports)
 Export Surplus = inflow of bullion
 More bullion --»»»» More global power
Since all nations cannot simultaneously have
export surplus, one nation’s gain implied
another’s loss – ECONOMIC NATIONALISM
The dilemma…

If a nation lost in trade why would it trade???

Trade based on absolute
advantage - Adam Smith

A nation can gain by SPECIALIZING in the

production of a commodity of its ABSOLUTE
ADVANTAGE and exchanging it with another
nation for a commodity of its ABSOLUTE
DISADVANTAGE.
Trade based on absolute
advantage…basic postulates

 Free trade

 Laissez-faire

However, protection extended to industry

crucial for national defense.
Trade based on absolute
advantage – Benefits…

 Efficient utilization of world resources

 Maximum world welfare

The dilemma…

Trade restrictions for national welfare???

Trade based on Comparative
advantage – David Ricardo
If two countries want to benefit from
specialization and free trade, country 1
should specialize and trade the commodity in
which it is MOST BEST at producing, while
country 2 should specialize and trade the
commodity in which it is LEAST WORSE at
producing.
What is comparative advantage?

The ability of a country to produce a

commodity at lower cost, relative to other
commodities, compared to another country.
Comparative advantage and
Opportunity Cost…Gottfried Haberler
 Cost of something in terms of opportunity
foregone.

 Opportunity cost to a country of producing a

unit more of a good, such as for export or to
replace an import, is the quantity of some
other good that could have been produced
instead.
The dilemma…simplistic
assumptions

 Two nations; two commodities

 Free trade
 Perfect mobility of resources
 No transportation costs
 No technological advancement
 Constant costs of production
Heckscher Ohlin Theory…basic
postulate
 Countries trade because they differ with
respect to the availability of the factors of
production.

 Capital-abundant country will export the

capital-intensive good, while the labor-
abundant country will export the labor-
intensive good.
The dilemma…

All international trade happens because of

resource advantage? Do the trends reflect
that???
Technological gap theories

 International Trade is governed by relative

technological sophistication of nations.

 Competitive trade advantage is a function of

ability to innovate
Product life cycle theory…
Raymond Vernon

 There are four stages in a product’s life cycle –

introduction, growth, maturity and decline
 Early in a product's life-cycle resources are acquired
domestically. Once it becomes adopted in the world
markets, production gradually moves away from the
point of origin.
 In some situations, the product becomes an import
item for the country of invention.
Theory of economies of scale
 Production at a larger scale (more output)
can be achieved at a lower cost (i.e. with
economies or savings).

 When production within an industry has this

characteristic, specialization and trade can
result in improvements in world productive
efficiency and welfare benefits that accrue to
all trading countries.
Linder’s hypothesis…Staffan
Burenstam Linder
 The more similar are the demand structures
of countries the more they will trade with one
another.

 International trade will still occur between two

countries having identical preferences and
factor endowments.
To conclude…
Markets have been going global, and
everyone knows it. Theoretical reasons
include,
 Differences in Technology
 Differences in resource endowments
 Differences in demand
 Economies of Scale
You should now know…

 Why nations trade?

 What are the theoretical foundations of

international trade?