Theories of Free Trade

Tuesday, March 8, 2022 8:55 AM

TRADE THEORY
There are two divisions of trade theory: Classical Theories and Modern Theories

CLASSICAL THEORIES
1. Mercantilism
a. It viewed trade as a ZERO SUM GAME
b. It advocated that the government intervene in a surplus in BOT
c. This would be done so that the country could accumulate gold and silver
d. Huge Flaw: The country would eventually accumulate so much wealth that it would result in
inflation of its own currency
e. Therefore, the host country's goods would be too expensive to buy
f. Eg: China deliberately kept its currency value low against the US Dollar to sell more goods to
the US and maintain a trade surplus
2. Absolute Advantage
a. A country has an absolute advantage in the production of a particular good/service when it
more efficiently than any other country.
b. Devised by Adam Smith in (1776)
c. According to him:
i. Trade is not a zero sum game
ii. Countries should only produce the goods that it has an absolute advantage in
3. Comparative Advantage
a. A country should produce those goods that it produces most efficiently and import those
that it produces less efficiently
b. This stands true when a country has an absolute advantage in the production of all goods
c. Assumptions
i. There are only two goods in the economy
ii. There are only two countries
iii. Zero transportation costs
iv. Similar prices and values
v. Constant returns to scale
vi. Resources are mobile within goods, not within countries
vii. Fixed stock of resources
4. Heckscher-Ohlin
a. It is a general equilibrium mathematical model wherein the country decides the import and
exports of goods based on its factor proportions
b. A country which has great benefits in terms of capital, would export capital goods and vice
versa for labor.
c. The theory asserts that the differences in comparative advantage comes from the difference
in factor endowments
d. This theory has more of a common sense appeal
5. The Leontief Paradox
a. The paradox roots from the US and China Imports-exports
b. The US is a capital surplus country, and keeping the Heckscher-Ohlin Theory in mind, the
country should export capital extensive goods and import labor intensive goods from China
c. Leontief found that US imports capital extensive goods more than the exports
d. The possible explanation for this would be:
i. The US has special advantage in products made with innovative technology
ii. Differences in technology lead to differences in productivity and drives trade patterns
MODERN THEORIES
1. Country Similarity Theory
a. The theory proposed that countries that have similar or same stages of development would
have the same consumer preferences
b. Therefore, for a country like China, the favorable consumer base would be a country like
Taiwan
c. The theory suggests that countries first produce for domestic consumption
2. Product Life Cycle Theory
a. The theory suggests that as products mature, both, the location of sales and optimal
production location, will change affecting the flow of trade
b. Four main stages: Introduction, Growth, Maturity, Decline

c.

3. Global Strategic Rivalry

a. It explores the notion that in order to stay viable, firms should exploit their competitive
advantage globally and try to keep it sustainable.
b. According to this view, firms struggle to develop some sustainable competitive advantage,
which they can then exploit to dominate the global marketplace.
c. It focuses, however, on strategic decisions that firms adopt as they compete internationally.
d. These decisions affect both international trade and international investment. Companies
such as Caterpillar and Komatsu, Unilever and Protect & Gamble, and Toyota and Ford
continually play cat-mouse games with one another on a global basis as they attempt to
leverage their own strengths and neutralize those of their rivals.
4. Porter's Diamond: Competitive Advantage