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Theories of International Trade – Explained & Examples

February 7, 2022

Content of International Trade Theories

1. Overview of trade theories

2. 8 Trade theories 

3. Download PPT 

PPT is Available at the End of this Topic

1. Intro- International Trade Theories

Trade theories are simply different types of theories to explain international trade. The meaning of
International Trade is exchanging or trading goods & services between Countries. International Trade
theories help to explain how goods are traded among various nations & which goods are
advantageous for trading.

For example- To export goods, the USA has the advantage in car manufacturing, India in spices, etc.
so they both can export their advantages to other countries.

2. International Trade Theories

These are the types of International Trade Theories.

1. Mercantilism Trade Theory

2. Absolute Advantage Theory

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3. Comparative Advantage Theory

4. Factor Endowment Theory

5. Leontief Paradox Theory

6. Product Life Cycle Theory

7. New Trade Theory

8. Porter’s Diamond Theory

1. Mercantilism Theory

a) This theory was given by Thomas Mun and Popular in the 16th and 18th Centuries.

b) During that time, the Wealth of nations was measured by the stock of gold and other kinds of
metals. The primary goal is to increase the wealth of the nation by acquiring gold.

c) This theory says that a country should increase gold by promoting exports and discouraging
imports.

d) It is based on a zero-sum game. Zero-sum means only one nation gets benefits by exporting and
the other gets a loss by importing goods.

Assumptions

1. There is a limited amount of wealth i.e. Gold in the world.

2. A nation can only grow when other nations do expenses or importing goods.

3. A nation should try to achieve & maintain a favorable trade balance ( exporting more than its
import).

Disadvantages

1. Mercantilism theory only thinks about producing and exporting goods. This hardly paid attention to
welfare of workers which leads to the exploitation of workers.

2. Mercantilism was one-way traffic. It focuses on export but not import, it is not easy to be self-
sufficient. Many countries of Europe fails to be self-sufficient which increased their miseries.

2. Absolute Advantage Theory

a) This theory was given by Adam Smith in 1776. He argued mercantilist theory & said that theory
doesn’t expand trade.

b) This trade theory is based on positive-sum game and expansion of trade. A positive-sum game
means both countries get benefits in trade. In this, both countries export absolute advantage goods to

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each other.

c) Absolute advantage means when a country can produce a product more effectively ( less cost, more
natural resources to produce easily ) than other countries.

d) Both nations should export goods of production advantage and import goods of production
disadvantage.

Example – India has an absolute advantage in producing cotton and brazil has in producing coffee. In
this, both countries should supply production advantage to each other.

Disadvantage

1. This theory Fails to explain how free trade can be advantageous to two countries when one country
can produce all goods.

2. Any nation not having absolute advantage can’t gain from free trade. 

3. Differences in climatic conditions & natural resources in nations won’t lead to absolute advantage.

3. Comparative Advantage

a) It is developed by David Ricardo in 1817.

b) This theory is the extension of absolute advantage theory. i.e. If a country has an advantage in the
production of two commodities, then compare the efficiency of both goods.

c) Produce and Export the good which can be produced more efficiently.

Example – India can produce both trucks and cars efficiently but for export, India needs to compare
these goods with each other to find which goods have more efficiency. If car production has more
efficiency then India should produce and export manufactured cars.

Disadvantages

1. This theory was based on only two countries & only two commodities, but international trade is
among many countries with many commodities.

2. The Assumption of full employment helps theory to explain comparative advantage. The cost of
production in terms of labor may change when the employment level increases or decreases.

3. Even if any country stopped production, nobody in the industry wants to lose their job.

4. Another disadvantage is that transportation costs are not considered in determining comparative
cost differences.

4. Factor Endowment Theory

a) Given by Eli Heckscher and Berlin Ohlin in 1993.

b) Also known as factor Proportion theory or Heckscher & Ohlin theory.

c) This theory is based on a country’s available production factors i.e. land, labor, capital, etc. in the
country.

d) It stated that countries would produce and export those goods which make intensive use of factors
that are locally available in large quantities. In contrast, import those factors that are in short supply or
locally scarce.

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For example – India has large quantities of labor so India should export labor-intensive goods i.e.
coal mining, large production, and import capital-intensive goods i.e. oil.

Disadvantages

1. Assumes that there is no unemployment

2. Gives more importance to supply and less importance to the demand of that commodity.

3. Ignores price differences, transport costs, economies of scale, external economies, etc.

5. Leontief paradox Theory

a) In this theory Findings were contradictory to predictions of Heckscher-Ohlin’s theory and Given by
Wassily Leontief in 1973.

b) He found out that the United States (US) – The most capital-abundant country in the world.
Exported commodities that were more labor-intensive than capital-intensive.

c) Leontief concludes from this result that the US should adopt its competitive policy to match its
economic realities.

Disadvantages

1. Leontief considered only capital & labor inputs, leaving out natural resource inputs But in reality,
capital & natural resources are used together in the production of commodity.

6. Product Life Cycle Theory

a) It is given by Raymond Vernon in Mid 1960s and Theory consists of technology-based products.

b) A product goes through the life cycle i.e. Introduction, Growth, Maturity, Decline.

c) Country where the product is first launched is Innovator and At the end of the cycle, the innovator
becomes the importer.
d) This theory says that an innovator country should produce goods according to the product life
cycle of goods. When the demand grows, that country should move production factories to a
developing country to meet demands at less cost.

e) Now that innovator country should export goods from developing country and completes demand.
So this will beneficial for both countries.

Example- America has started production of any new product that is introduction phase after some
time company has reached into growth phase where the demand has increased and starts export. In
last, that product becomes a global standard product so to meet global demand and to decrease the
cost of goods. America starts to produce goods in a developing country like India for mass production
and starts importing goods from India to meet demand.

Disadvantages

1. Most appropriate for technology-based products

2. Another disadvantage is some products are not easily characterized by stages so it’s become
difficult to follow this theory.
3. Most relevant to products produced through mass production.

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7. New Trade Theory

a) It is given by Paul Krugman in 1980.

b) This theory tells about some of the necessary factors. A country having one of these factors can
become an exporter.

Those three necessary factors are

Economies of sale –  Making production at a large scale for Reduction in per-unit cost 

Product differentiation – Difference in color, durability, brand, etc.

First mover advantage – Capturing the market by introducing a new product or market.

Disadvantages

1. Only applicable when there are many firms with different production processes so it can change
product easily.

2. Assumes that all firms are well-formed, which may not be true in every case.

8. Porter’s Diamond Theory

a) Introduced by Michael Porter in his book ‘The Competitive Advantage of Nations’ in 1990.

b) It is also known as National Advantage Trade Theory.

c) Explains factors that are available to a nation. These factors can give a competitive advantage to the
economy of a country.

d) Four factors together form “PORTER’S DIAMOND MODEL”.

1. Factor Condition – Factor available like labour, capital, land, etc

2. Related & Supported Industries – Supporting companies to get raw material, transportation, etc

3. Strategy, Structure, Rivalry- How many Comptetitors and what structure they are using in the
sale, marketing, etc

4. Demand Condition- How much demand of goods are there, what are needs of people, country, etc

e) Export goods from that industry where the diamonds are favorable.

Disadvantages

1. In his book, Porter was optimistic about the future of Korea & less optimistic about the future of
others.

2. Other factors may influence success – there may be events that could not have been predicted, such
as new technological developments or government interventions.

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