Comendador, Princess Arren B.

BSA- 2A

Adam Smith and David Ricardo gave the classical theories of international trade.
According to the theories given by them, when a country enters in foreign trade, it benefits from specialization
and efficient resource allocation.
The foreign trade also helps in bringing new technologies and skills that lead to higher productivity.
The assumptions taken under this theory’ are as follows:
a. There are two countries producing two goods.
b. The size of economies of these countries is equal
c. There is perfect mobility of factors of production within countries
d. Transportation cost is ignored
e. Before specialization, country’s resources are equally divided to produce each good
Theory of Mercantilism:
Mercantilism is the term that was popularized by Adam Smith, Father of Economics, in his book, The Wealth of
Nations. Western European economic policies were greatly dominated by this theory. The theory of
mercantilism holds that countries should encourage export and discourage import.
It states that a country’s wealth depends on the balance of export minus import. According to this theory,
government should play an important role in the economy for encouraging export and discouraging import by
using subsidies and taxes, respectively. In those days, gold was used for trading goods between countries.
Thus, export was treated as good as it helped in earning gold, whereas, import was treated as bad as it led to the
outflow of gold. If a nation has abundant gold, then it is considered to be a wealthy nation. If all the countries
follow this policy, there may be conflicts, as no one would promote import. The theory of mercantilism believed
in selfish trade that is a one-way transaction and ignored enhancing the world trade. Mercantilism was called as
a zero-sum game as only one country benefitted from it.
Theory of Absolute Advantage:
Given by Adam Smith in 1776, the theory of absolute advantage stated that a country should specialize in those
products, which it can produce efficiently. This theory assumes that there is only one factor of production that is
labor.
Adam Smith stated that under mercantilism, it was impossible for nations to become rich simultaneously. He
also stated that wealth of the countries does not depend upon the gold reserves, but upon the goods and services
available to their citizens.
Adam Smith wrote in The Wealth of Nations, ”If a foreign country can supply us with a 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”.
He stated that trade would be beneficial for both the countries if country A exports the goods, which it can
produce with lower cost than country B and import the goods, which country B can produce with lower cost
than it.
An example can be used to prove this theory. Suppose there are two countries A and B, which produce tea and
coffee with equal amount of resources that is 200 laborers. Country A uses 10 laborers to produce 1 ton of tea
and 20 laborers to produce 1 ton of coffee. Country B uses 25 units of laborers to produce tea and 5 units of
laborers to produce 1 ton of coffee.
This is shown in Table- 1:

It can be seen from Table-2 that country A has absolute advantage in producing tea as it can produce 1 ton of
tea by using less laborers as compared to country B. On the other hand, country B has absolute advantage in
producing coffee as it can produce 1 ton of coffee by employing less laborers in comparison to country A.
Now, if there is no trade between these countries and resources (in this case there are total 200 laborers) are
being used equally to produce tea and coffee, country A would produce 10 tons of tea and 5 tons of coffee and
country B would produce 4 tons of tea and 20 tons of coffee. Thus, total production without trade is 39 tons (14
tons of tea and 25 tons of coffee).
Table-2 shows the production without the trade between country A and country B:

If both the countries trade with each other and specialize in goods in which they have absolute advantage, the
total production would be higher. Country A would produce 20 tons of tea with 200 units of laborers; whereas,
country B would produce 40 tons of coffee with 200 units of laborers. Thus, total production would be 60 units
(20 tons of tea and 40 tons of coffee).
The production of tea and coffee after trade is shown in Table-3:

Without specialization, total production of countries was 39 tons, which becomes 60 tons after specialization.
Therefore, the theory of absolute advantages shows that trade would be beneficial for both the countries.
Theory of Comparative Advantage:
Many questions may come in mind after reading the absolute advantage theory that what would happen if a
country has absolute advantage in all the products or no absolute advantage in any of the product. How such a
country would benefit from trade? The answers of these questions was given by David Ricardo in his theory of
comparative advantage, which states that trade can be beneficial for two countries if one country has absolute
advantage in all the products and the other country has no absolute advantage in any of the products.
According to Ricardo, “…a nation, like a person, gains from the trade by exporting the goods or services in
which it has its greatest comparative advantage in productivity and importing those in which it has the least
comparative advantage. ”
This theory assumes that labor as the only factor of production in two countries, zero transport cost, and no
trade barriers within the countries. Let us understand this theory with the help of an example.
Suppose there are two countries A and B, producing two commodities wheat and wine with labor as the only
factor of production. Now assume that both the countries have 200 laborers and they use 100 laborers to
produce wheat and 100 laborers to produce wine.
Table-4 shows the production of wheat and wine in Country X and Country Y before trade:

Table-4 depicts that country X can produce 20 units; whereas, country Y can produce 15 units of wheat by
using 100 laborers. In addition, country X can produce 40 units; whereas, country’ Y can produce 10 units of
wine by employing 100 laborers.
Thus, country X has absolute advantage in producing both the products. As already discussed, country X
employs same number of laborers (100 laborers in production of each good) in producing both wine and wheat;
however, the production of wine is more than the production of wheat.
It shows that country’ X has comparative advantage in producing wine. Similarly, country Y also employs same
number of laborers (100 laborers in production of each good) in manufacturing wheat and wine; however, its
production of wheat is more than the wine. It indicates that country Y has comparative advantage in
manufacturing wheat.
For example, country X has decided to produce 60 units of wine by employing 150 laborers. It uses 50 laborers
to produce 10 units of wheat. On the other hand, country Y has decided to use all the 200 laborers to produce 30
units of wheat. It would not produce any unit of wine.
This data is represented in Table-5:

Now, country X exchanges 14 units of wine with 14 units of wheat produced by country Y.
The situation of both the countries after trade is shown in Table-6:

It can be observed from Table-6 that both the countries have gained from trade. Before trade, country X has 20
units of wheat and 40 units of wine; however, after trade, country Y has 24 units of wheat and 46 units of wine.
On the other hand, country Y has 15 units of wheat and 10 units of wine before trade; however, it has 16 units
of wheat and 14 units of wine after trade. Therefore, comparative advantage explains that trade can create
benefit for both the countries even if one country has absolute advantage in the production of both the goods.

Heckscher-Ohlin Theory (Factor Proportions Theory)

The theories of Smith and Ricardo didn’t help countries determine which products would give a country an
advantage. Both theories assumed that free and open markets would lead countries and producers to determine
which goods they could produce more efficiently. In the early 1900s, two Swedish economists, Eli Heckscher
and Bertil Ohlin, focused their attention on how a country could gain comparative advantage by producing
products that utilized factors that were in abundance in the country. Their theory is based on a country’s
production factors—land, labor, and capital, which provide the funds for investment in plants and equipment.
They determined that the cost of any factor or resource was a function of supply and demand. Factors that were
in great supply relative to demand would be cheaper; factors in great demand relative to supply would be more
expensive. Their theory, also called the factor proportions theory, stated that countries would produce and
export goods that required resources or factors that were in great supply and, therefore, cheaper production
factors. In contrast, countries would import goods that required resources that were in short supply, but higher
demand.
For example, China and India are home to cheap, large pools of labor. Hence these countries have become the
optimal locations for labor-intensive industries like textiles and garments.
Leontief Paradox
In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US economy closely and
noted that the United States was abundant in capital and, therefore, should export more capital-intensive goods.
However, his research using actual data showed the opposite: the United States was importing more capital-
intensive goods. According to the factor proportions theory, the United States should have been importing
labor-intensive goods, but instead it was actually exporting them. His analysis became known as the Leontief
Paradox because it was the reverse of what was expected by the factor proportions theory. In subsequent years,
economists have noted historically at that point in time, labor in the United States was both available in steady
supply and more productive than in many other countries; hence it made sense to export labor-intensive goods.
Over the decades, many economists have used theories and data to explain and minimize the impact of the
paradox. However, what remains clear is that international trade is complex and is impacted by numerous and
often-changing factors. Trade cannot be explained neatly by one single theory, and more importantly, our
understanding of international trade theories continues to evolve.
Modern or Firm-Based Trade Theories
In contrast to classical, country-based trade theories, the category of modern, firm-based theories emerged after
World War II and was developed in large part by business school professors, not economists. The firm-based
theories evolved with the growth of the multinational company (MNC). The country-based theories couldn’t
adequately address the expansion of either MNCs or intraindustry trade, which refers to trade between two
countries of goods produced in the same industry. For example, Japan exports Toyota vehicles to Germany and
imports Mercedes-Benz automobiles from Germany.
Unlike the country-based theories, firm-based theories incorporate other product and service factors, including
brand and customer loyalty, technology, and quality, into the understanding of trade flows.
Country Similarity Theory
Swedish economist Steffan Linder developed the country similarity theory in 1961, as he tried to explain the
concept of intraindustry trade. Linder’s theory proposed that consumers in countries that are in the same or
similar stage of development would have similar preferences. In this firm-based theory, Linder suggested that
companies first produce for domestic consumption. When they explore exporting, the companies often find that
markets that look similar to their domestic one, in terms of customer preferences, offer the most potential for
success. Linder’s country similarity theory then states that most trade in manufactured goods will be between
countries with similar per capita incomes, and intraindustry trade will be common. This theory is often most
useful in understanding trade in goods where brand names and product reputations are important factors in the
buyers’ decision-making and purchasing processes.
Product Life Cycle Theory
Raymond Vernon, a Harvard Business School professor, developed the product life cycle theory in the 1960s.
The theory, originating in the field of marketing, stated that a product life cycle has three distinct stages: (1)
new product, (2) maturing product, and (3) standardized product. The theory assumed that production of the
new product will occur completely in the home country of its innovation. In the 1960s this was a useful theory
to explain the manufacturing success of the United States. US manufacturing was the globally dominant
producer in many industries after World War II.
It has also been used to describe how the personal computer (PC) went through its product cycle. The PC was a
new product in the 1970s and developed into a mature product during the 1980s and 1990s. Today, the PC is in
the standardized product stage, and the majority of manufacturing and production process is done in low-cost
countries in Asia and Mexico.
The product life cycle theory has been less able to explain current trade patterns where innovation and
manufacturing occur around the world. For example, global companies even conduct research and development
in developing markets where highly skilled labor and facilities are usually cheaper. Even though research and
development is typically associated with the first or new product stage and therefore completed in the home
country, these developing or emerging-market countries, such as India and China, offer both highly skilled labor
and new research facilities at a substantial cost advantage for global firms.
Global Strategic Rivalry Theory
Global strategic rivalry theory emerged in the 1980s and was based on the work of economists Paul Krugman
and Kelvin Lancaster. Their theory focused on MNCs and their efforts to gain a competitive advantage against
other global firms in their industry. Firms will encounter global competition in their industries and in order to
prosper, they must develop competitive advantages. The critical ways that firms can obtain a sustainable
competitive advantage are called the barriers to entry for that industry. The barriers to entry refer to the
obstacles a new firm may face when trying to enter into an industry or new market. The barriers to entry that
corporations may seek to optimize include:
research and development,
the ownership of intellectual property rights,
economies of scale,
unique business processes or methods as well as extensive experience in the industry, and
the control of resources or favorable access to raw materials.
Porter’s National Competitive Advantage Theory
In the continuing evolution of international trade theories, Michael Porter of Harvard Business School
developed a new model to explain national competitive advantage in 1990. Porter’s theory stated that a nation’s
competitiveness in an industry depends on the capacity of the industry to innovate and upgrade. His theory
focused on explaining why some nations are more competitive in certain industries. To explain his theory,
Porter identified four determinants that he linked together. The four determinants are (1) local market resources
and capabilities, (2) local market demand conditions, (3) local suppliers and complementary industries, and (4)
local firm characteristics.
Local market resources and capabilities (factor conditions). Porter recognized the value of the factor
proportions theory, which considers a nation’s resources (e.g., natural resources and available labor) as key
factors in determining what products a country will import or export. Porter added to these basic factors a new
list of advanced factors, which he defined as skilled labor, investments in education, technology, and
infrastructure. He perceived these advanced factors as providing a country with a sustainable competitive
advantage.
Local market demand conditions. Porter believed that a sophisticated home market is critical to ensuring
ongoing innovation, thereby creating a sustainable competitive advantage. Companies whose domestic markets
are sophisticated, trendsetting, and demanding forces continuous innovation and the development of new
products and technologies. Many sources credit the demanding US consumer with forcing US software
companies to continuously innovate, thus creating a sustainable competitive advantage in software products and
services.
Local suppliers and complementary industries. To remain competitive, large global firms benefit from
having strong, efficient supporting and related industries to provide the inputs required by the industry. Certain
industries cluster geographically, which provides efficiencies and productivity.
Local firm characteristics. Local firm characteristics include firm strategy, industry structure, and industry
rivalry. Local strategy affects a firm’s competitiveness. A healthy level of rivalry between local firms will spur
innovation and competitiveness.
In addition to the four determinants of the diamond, Porter also noted that government and chance play a part in
the national competitiveness of industries. Governments can, by their actions and policies, increase the
competitiveness of firms and occasionally entire industries.
Porter’s theory, along with the other modern, firm-based theories, offers an interesting interpretation of
international trade trends. Nevertheless, they remain relatively new and minimally tested theories.
Which Trade Theory Is Dominant Today?
The theories covered in this chapter are simply that—theories. While they have helped economists,
governments, and businesses better understand international trade and how to promote, regulate, and manage it,
these theories are occasionally contradicted by real-world events. Countries don’t have absolute advantages in
many areas of production or services and, in fact, the factors of production aren’t neatly distributed between
countries. Some countries have a disproportionate benefit of some factors. The United States has ample arable
land that can be used for a wide range of agricultural products. It also has extensive access to capital. While it’s
labor pool may not be the cheapest, it is among the best educated in the world. These advantages in the factors
of production have helped the United States become the largest and richest economy in the world. Nevertheless,
the United States also imports a vast amount of goods and services, as US consumers use their wealth to
purchase what they need and want—much of which is now manufactured in other countries that have sought to
create their own comparative advantages through cheap labor, land, or production costs.
As a result, it’s not clear that any one theory is dominant around the world. This section has sought to highlight
the basics of international trade theory to enable you to understand the realities that face global businesses. In
practice, governments and companies use a combination of these theories to both interpret trends and develop
strategy. Just as these theories have evolved over the past five hundred years, they will continue to change and
adapt as new factors impact international trade.

Advantages of International Trade:

(i) Optimal use of natural resources:
International trade helps each country to make optimum use of its natural resources. Each country can
concentrate on production of those goods for which its resources are best suited. Wastage of resources is
avoided.
(ii) Availability of all types of goods:
It enables a country to obtain goods which it cannot produce or which it is not producing due to higher costs, by
importing from other countries at lower costs.
(iii) Specialisation:
Foreign trade leads to specialisation and encourages production of different goods in different countries. Goods
can be produced at a comparatively low cost due to advantages of division of labour.
(iv) Advantages of large-scale production:
Due to international trade, goods are produced not only for home consumption but for export to other countries
also. Nations of the world can dispose of goods which they have in surplus in the international markets. This
leads to production at large scale and the advantages of large scale production can be obtained by all the
countries of the world.
(v) Stability in prices:
International trade irons out wild fluctuations in prices. It equalizes the prices of goods throughout the world
(ignoring cost of transportation, etc.)
(vi) Exchange of technical know-how and establishment of new industries:
Underdeveloped countries can establish and develop new industries with the machinery, equipment and
technical know-how imported from developed countries. This helps in the development of these countries and
the economy of the world at large.
(vii) Increase in efficiency:
Due to international competition, the producers in a country attempt to produce better quality goods and at the
minimum possible cost. This increases the efficiency and benefits to the consumers all over the world.
(viii) Development of the means of transport and communication:
International trade requires the best means of transport and communication. For the advantages of international
trade, development in the means of transport and communication is also made possible.
(ix) International co-operation and understanding:
The people of different countries come in contact with each other. Commercial intercourse amongst nations of
the world encourages exchange of ideas and culture. It creates co-operation, understanding, cordial relations
amongst various nations.
(x) Ability to face natural calamities:
Natural calamities such as drought, floods, famine, earthquake etc., affect the production of a country adversely.
Deficiency in the supply of goods at the time of such natural calamities can be met by imports from other
countries.
(xi) Other advantages:
International trade helps in many other ways such as benefits to consumers, international peace and better
standard of living.

Disadvantages of International Trade:

Though foreign trade has many advantages, its dangers or disadvantages should not be ignored.

(i) Impediment in the Development of Home Industries:

International trade has an adverse effect on the development of home industries. It poses a threat to the survival
of infant industries at home. Due to foreign competition and unrestricted imports, the upcoming industries in the
country may collapse.
(ii) Economic Dependence:
The underdeveloped countries have to depend upon the developed ones for their economic development. Such
reliance often leads to economic exploitation. For instance, most of the underdeveloped countries in Africa and
Asia have been exploited by European countries.
(iii) Political Dependence:
International trade often encourages subjugation and slavery. It impairs economic independence which
endangers political dependence. For example, the Britishers came to India as traders and ultimately ruled over
India for a very long time.
(iv) Mis-utilisation of Natural Resources:
Excessive exports may exhaust the natural resources of a country in a shorter span of time than it would have
been otherwise. This will cause economic downfall of the country in the long run.

(v) Import of Harmful Goods:

Import of spurious drugs, luxury articles, etc. adversely affects the economy and well-being of the people.
(vi) Storage of Goods:
Sometimes the essential commodities required in a country and in short supply are also exported to earn foreign
exchange. This results in shortage of these goods at home and causes inflation. For example, India has been
exporting sugar to earn foreign trade exchange; hence the exalting prices of sugar in the country.
(vii) Danger to International Peace:
International trade gives an opportunity to foreign agents to settle down in the country which ultimately
endangers its internal peace.
(viii) World Wars:
International trade breeds rivalries amongst nations due to competition in the foreign markets. This may
eventually lead to wars and disturb world peace.
(ix) Hardships in times of War:
International trade promotes lopsided development of a country as only those goods which have comparative
cost advantage are produced in a country. During wars or when good relations do not prevail between nations,
many hardships may follow.