OLCBIBT01 – INTERNATIONAL BUSINESS AND TRADE

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CHAPTER 1- CLASSICAL INTERNATIONAL TRADE THEORIES

Objectives:
a.) Discuss various classical internal trade theories;
b.) Describe the implications of classical trade theories; and
c.) Identify the criticisms of classical trade theories.

A. INTRODUCTION
- International trade plays an important role in the formulation of the world economy.
One should know how monetary systems work because they relate directly to the
ability of overseas customers to buy from an international marketer. One should also
be aware of how various governments and international organisations seek to
regulate international trade because this affects how and where one’s goods may be
exported.
- Why do nations trade? A nation trades because it expects to gain something from its
partner. One may ask whether trade is like a zero-sum game, in the sense that one
must lose so that another will gain. The answer is no, because though one does not
mind gaining benefits at someone else’s expense but no one wants to engage in a
transaction that includes a high risk of loss. For trade to take place both nations must
anticipate gain from it. In other words, international trade is a positive sum game.
There are basically two sets of theories of International Trade: The Classical Trade
Theories, explaining how inter-country trade takes place; and theories of International
Trade, explaining inter-country investment in manufacturing and service activities and
the management of these activities. In this unit, we will cover the classical trade
theories.

B. THEORY OF MERCANTILISM (1500-1700)

- Mercantilism became popular in the late seventeenth and early eighteenth centuries
in Western Europe and was based on the notion that governments (not individuals
who were deemed untrustworthy) should become involved in the transfer of goods

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between nations in order to increase the wealth of each national entity. Wealth was
defined, however, as an accumulation of previous metals, especially gold.
- Consequently, the aims of the governments were to facilitate and support all exports
while limiting imports, which was accomplished through the conduct of trader by
government monopolies and intervention in the market through the subsidization of
domestic exporting industries and the allocation of trading rights. Additionally, nations
imposed duties or quotas upon imports to limit their volume. During this period
colonies were acquired to provide sources of raw materials or precious metals. Trade
opportunities with the colonies were exploited, and local manufacturing was
repressed in those offshore locations. The colonials were often required to buy their
goods from their mother countries.
- The concept of mercantilism incorporates two fallacies. The first was the incorrect
belief that old or precious metals have intrinsic value, when actually they cannot be
used for either production or consumption. Thus, nations subscribing the
mercantilism notion exchanged the products of their manufacturing or agricultural
capacity for this non-productive wealth. The second fallacy is that the theory of
mercantilism ignores the concept of production efficiency through specialisation.
Instead of emphasizing cost-effective production of goods, mercantilism emphasises
sheet amassing of wealth with acquisition of power.

a. Theory of Economic Development

▪ The trade structure is also sought to be explained in terms of scale
economies. According to this theory, there is a relationship between the
size of the internal market and average unit cost of production and
export competitiveness. A firm operating in a country where the
domestic market is large will be able to reach a high output level thereby
reaping the advantage of largescale production. The lower cost of
production will increase its competitiveness enabling the firm to make
an easy entry to the export market. While prima-facie this logic appears
to be valid, this hypothesis cannot be generalized because it is possible

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that the pull of the domestic market will be so strong that the export
would not be promoted, as is the case with India in certain products.

b. Rostow’s Stages of Economic Growth Theory

▪ Walter W. Rostow, who attempted to outline the various stages of a
nation’s economic growth and based his theory on the notion that shifts
in economic development coincided with abrupt changes within the
nations themselves. He identified five different economic stages for a
country traditional society, preconditions for take off, take off the drive
to maturity, and the age of high mass consumption.

i. Stage 1: Traditional Society

• Rostow saw traditional society as a static economy, which he
likened to the pre-1700s attitudes and technology experienced
by the world’s current economically developed countries. He
believed that the turning point for these countries came with the
work of Sir Isaac Newton, when people began to believe that the
world was subject to a set of physical laws but was malleable
within these laws. In other words, people could effect change
within the system of descriptive laws as developed by Newton.

ii. Stage 2: Preconditions for Takeoff

• Rostow identified the preconditions for economic takeoff as
growth or radical changes in three specific, non-industrial
sectors that provided the basis for economic development: 1.
Increased investment in transportation, which enlarged
prospective markets and increased product specialisation
capacity. 2. Agricultural developments providing for the feeding
and nourishing of larger, primarily urban, population. 3. An
expansion of imports into the country. These preconditioning

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changes were to be experienced in concert with an increasing
national emphasis on education and entrepreneurship.

iii. Stage 3: Takeoff

• The takeoff stage of growth occurs, according to Rostow, over a
period of twenty to thirty years and is marked by major
transformations that stimulate the economy. These
transformations could include widespread technological
developments, the effective functioning of an efficient
distribution system, and even political revolutions. During this
period barriers to growth are eliminated within the country and
indeed the concept of economic growth as a national objective
becomes the norms. To achieve the takeoff, however, Rostow
believes that three conditions must be met: 1. Net investment as
a percentage of net national products must increase sharply. 2.
At least one substantial manufacturing sector must grow rapidly.
This rapid growth and larger output trickles down as growth in
ancillary and supplier industries. 3. A supportive framework for
growth must emerge on political, social and institutional fronts.
For example, banks, capital markets, and tax systems should
develop and entrepreneurship should be considered a norm.

iv. Stage 4: The Drive to Maturity

• Within Rostow’s scheme, this stage is characterised as one
where growth becomes self-sustaining and a widespread
expectation within the country. During this period, Rostow
believes that the labour pool becomes more skilled and more
urban and that technology reaches heights of advancement.

v. Stage 5: The Age of Mass Consumption

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• The last stage of development, as Rostow sees it, is an age of
mass consumption when there is a shift to consumer durables in
all sectors and when the populace achieves a high standard of
living as evidenced through the ownership of such sophisticated
goods as automobiles, televisions and appliances. Since its
introduction in the 1960s, Rostow’s framework has been
criticized as being overly ambitious in attempting to describe the
economic paths of many nations. Also, history has not proved
the framework to be true.

C. THEORY OF ABSOLUTE ADVANTAGE

a. Principle of Absolute Advantage
▪ Adam Smith was the first economist to investigate formally the rationale
behind foreign trade. In his book, Wealth of Nations, Smith used the
principle of absolute advantage as the justification for international
trade. According to this principle, a country should export a commodity
that can be used at a lower cost than can other nations. Conversely, it
should import commodity that can only be produced at a higher cost
than can other nations.

b. Principle of Relative Advantage

▪ In 1776, Adam Smith noted that, if a country could produce a good
cheaper than other countries, it had an absolute advantage in the
production of that good; he then argued that, in order to maximize
national income, countries should produce and export surpluses of
what they have absolute advantage in, and buy whatever else they
need from the rest of the world. In this way, be theorized, specialization,
and hence efficiency, would be encouraged as a result of the increased
competition and scale economies. Of course, the question that was left
unanswered was, “what if a country had absolute advantage in all

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products; or even worse, in no products at all?” the theory would imply
that the former country need not trade, while the latter could not trade!

D. THEORY OF COMPARATIVE ADVANTAGE

- This question was considered by David Ricardo, who developed the important
concept of comparative advantage in considering a nation’s relative production
efficiencies as they apply to international trade. In Ricardo’s view, the exporting
country should look at the relative efficiencies of production for both commodities and
make only those goods it could produce most efficiently.

E. FACTOR ENDOWMENT THEORY

- The Eli Heckscher and Bertil Ohlin theory of factor endowment addressed the
question of the basis of cost differentials in the production of trading nations. They
posited that each country allocates its production according to the relative allocates
its production according to the relative proportions of all its production factor
endowments – land, labour and capital on a basic level, and, on a more complex
level, such factors as management and technological skills, specialized production
facilities, and established distribution networks.
- Thus, the range of products made or grown for export would depend on the relative
availability of different factors in each country.

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REFERENCES:

Adhikary, Manab, Global Business Management, New Delhi: Macmillan

Bhattacharya B., Going International Response Strategies for Indian

Sector, New Delhi: Wheeler Publishing Co.

Black and Sundaram, International Business Environment, New Delhi:

Prentice Hall of India

Vasudeva, P. K. (2010), International Trade: Text and Cases, New Delhi:

Excel Books

LINKS
TOPICS LINKS FOR VIDEO
Theory of Mercantilism https://youtu.be/gMYo07DESRs

Theory of Economic Development https://youtu.be/o4olZrhQxOg

Theory of Absolute Advantage https://youtu.be/KDiL1HKFmDc

Theory of Comparative Advantage https://youtu.be/HneRNVtahYw

Factor Endowment Theory https://youtu.be/QLVF0ZkeijM

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