Chapter One: Economic Principles

1.1 INTERNATIONAL TRADE

International trade is defined as economic transactions made between countries.

TRADE THEORIES

1. Mercantilism, associated with French politician, Jean-Baptise Colbert, was developed in

the 1600’s and 1700’s. It is based on the idea that a nation’s wealth and power were best
maintained by increasing exports and reducing imports. It sees international trade as a
zero-sum game.
2. Absolute Advantage was advocated for by Adam Smith. It claims that markets can
function well without government interference. Countries gain by specializing in
producing only what the can produce more efficiently than other countries. Free trade is
considered a win-win.
3. Comparative Advantage, associated with David Ricardo in 1817, suggests that an
economy’s ability to produce a good or service at a lower opportunity cost than its
trading partners gives them an advantage.
Opportunity cost is the potential benefits a country misses out on when choosing one
alternative over the other. It is the value of the next best opportunity FORGONE for the
choice made.
4. Factor Endowment Theory, developed by Eli Heckcher and Bertil Ohlin, suggests that
countries derive comparative advantage from factor endowments such as land, location,
natural resources, energy, labor and population size. Countries export goods that make
use of the factors they have in abundance. It is the relative abundance of inherited factors
that count.
5. New Trade Theory suggests that being the first to innovate creates an important
advantage for a country called first mover advantage through monopolistic competition,
patents and rights, learning effects and economies of scale (a proportionate saving in
costs gained by increased levels of production).
6. Porter’s Five Factors, developed by Michael Porter, suggests that sustained industrial
growth occur in clusters (groups of interconnected firms, suppliers and related industries
in a particular location). Governments invest more in the maintenance of clusters. This
prioritization encourages closely-linked companies to set up nearby.
THE DIAMOND MODEL explains how governments and firms can build export
industries by creating competitive advantage.
The four facets of the diamond are:
1 Firm strategy, structure and rivalry – direct competition between firms boosts
innovation and productivity.
2 Demand conditions – demanding customers put pressure on firms to constantly
innovate, improve quality and become more competitive.
3 Related and supporting industries – having these nearby helps with the
communication of ideas, innovation and improvements.
4 Factor conditions – Porter argues that the key factors are created, not inherited. They
are such things as skilled labour, capital and infrastructure.