INTERNATIONAL TRADE

International Trade Theories

analysis the patterns of
international trade

The theories explain how

goods are traded among
various nations and which
goods are advantageous for
trading

For example: USA have

advantages in car
Exchange goods and service beyond the
geographical area of our country is
called International Trade.

It gives opportunities to customers to

purchase those goods which are not
available in their country.
For Ex: I Phone
THEORIES OF INTERNATIONAL
TRADE
International theories explain
the pattern of International
Trade and also tell which goods
will be advantageous for trading
Traditional Trade Theory
1. Mercantilism Theory
2. Absolute Advantage Theory
3. Comparative Advantage Theory
4. Factor Endowment Theory
 1. MERCANTILISM THEORY

❖ It is the oldest theory.

❖ This theory is given by Thomas Mun.
❖ It is based on ZERO SUM GAME.
❖ Emerged in England in the mid 16th century.
❖ It assumes GOLD as a measure of country’s wealth.
❖ Primary goal is to increase the wealth of the nation by
acquiring gold.
 MERCANTILISM THEORY (continue….)

Country should increase gold by Promoting

exports and discouraging imports (Surplus in
BOT)
BOT (Balance of Trade) = Export- Import
(If is positive then surplus, and if BOT is
negative it will be Deficit)
Drawback: This theory did not recognize
anything except gold as a measure of
country’s wealth
 MERCANTILISM THEORY (continue….)

According to David Hume’s Price Special Flow Mechanism….

A country can not benefit in long run by only exporting or

importing.
After some time, there will be disequilibrium in Balance of Trade

David Hume showed that due to increase in inflow of gold in a country,

there will be increase in money supply leading to increase in prices
which would discourage exports and encourage imports
 Country A Export Country B

Gold (will increase)

Money Supply (will increase)

Every person have money (Consequences)

Price of goods (will increase)

Situation of Inflation (Consequences)

So there is an
inverse relationship
between Price and Price of goods is high, so you can’t export, because
Export rest country is not in a condition to purchase just high
price, (So export will down and import will high)
2. ABSOLUTE ADVANTAGE THEORY

► Based on Productivity and efficiency

► Trade is POSITIVE SUM GAME
► Given by Adam Smith in 1776
► Adam wrote a book in 1776 “Wealth of Nation”
► Absolute advantage is when a country can
produce a product more efficiently than other
country.
 ABSOLUTE ADVANTAGE THEORY (Continue….
)

► Export goods of production advantage and import

goods of production disadvantage.
► Sources of Absolute Advantage
a) Natural Advantage
b) Acquired Advantage
 NATURAL ADVANTAGES

According to condition or environment of host country,

manufacturer has to export only those goods in which
they have efficiency and import to those goods which we
do not have advantages.

INDIA BRAZIL
 ACQUIRED ADVANTAGES

In this case the country has to acquire technology and then produce product
easily
For example : Cow Milk Extraction Machine

DISADVANTGE: No explanation where a nation may have advantage in

producing both commodities
3. COMPARATIVE ADVANTAGE THEORY

► It is the extension of Absolute Advantage Theory

► Given by David Ricardo in 1817.
► Trade is POSITIVE SUM GAME
► If a country has advantage in production of both
commodities then compare the efficiency of both goods
► Compare between 2 goods of the host company
► Produce and Export the good which can be produced
more efficiently
COMPARATIVE ADVANTAGE THEORY (Cont…)

Suppose in India, there is a efficiency to product truck and

car both, then it must to see in which product (car & Truck)
there is more efficiency.
Suppose there is more efficiency in producing car then
India has to export the car.
4. FACTOR ENDOWMENT THEORY

► Also known as Factor Proportion Theory or Heckscher & Ohlin Theory

► Given by Eli Heckscher and Bertil Ohlin in 1933
► It Explains international trade in terms of available factors in the country.
► Assumption: Constant Technology across the world.
► It is also known two factor theory.

For example: India is a country where labor (factor) is easily available. So we

can produce the product by using our labor intensive technique.
FACTOR ENDOWMENT THEORY(Cont….)
► Countries will export the goods which make
intensive use of factors that are locally available in
large quantities and import goods that make
intensive use of factors that are locally scarce.
For Example: US is a Capital intensive technique, while
India is a labor intensive technique.
► Trade between the countries having economic
structure differences.
For Example: India and China both labor intensive
country. So both can’t be exporter for each other.
Heckscher-Ohlin
theory
A nation will export a goods of the production of
which require the intensive use of a factor this
nation has in abundant.

Intensive: Involving a lot of work or care in a

short period of time (with a available
resources)like labor, land and other factors.
(Labor intensive, and Capital Intensive)

Abundant: Existing in a very large quantity;

more than enough.
► Heckscher and Ohlin - comparative advantage
arises from differences in national factor
endowments (the extent to which a country is
endowed with resources such as land, labor, and
capital)

► The more abundant a factor, the lower its cost.

► Countries will export goods that make
intensive use of those factors that are locally
abundant, and import goods that make
intensive use of factors that are locally scarce
ASSUMPTION OF HECKSCHER-OHLIN’S
THEORY
► There is two countries e.g. A & B
► There is two goods e.g. X & Y
► There is two factor of production e.g. Capital (K) and Labor (L)
► That is why this model is called 2*2*2 model.
► Goods X is capital intensive
► Goods Y is Labor intensive
► Technology is same between countries
► Taste and Preferences are same of the consumer in both country
► There is a perfect competition (no monopoly situation)
► Perfect mobility of product with in the country but no international
movements.
► No Transport cost, no trade barrier (means no govt. intervention)
► International trade is balance (Export = Import)
 Resources US (Aircraft) China (Textile)
Capital (K) 100 (Machine) 20 (Machine)
Labor (L) 200 (Labor) 1000 (Labor)

US Capital & Labor Ratio= K/L= 100/200 = .5 China Capital & Labor Ratio= K/L= 20/1000 = .05

It shows in US there is .5 machine per labor while China

have .05 machine per labor. Machine is more in US so
they will produce aircraft and China will produce textile
and export accordingly
MRT- Marginal Rate of Terms of Trade= Common relative price line
Transportation
PPC- Production Possibility It shows where they will equalize their price
PORTER’S DIAMOND
MODEL
► Porter’s Diamond Model OR Diamond Model OR
National Competitive Advantage Theory
► Porter (1990) tried to explain why a nation achieves
international success in a particular industry
► Porter identified four attributes he calls the diamond
that promote or impede the creation of competitive
advantage
1. Factor Condition (endowments)
2. Demand conditions
3. Related and supporting industries
4. Firm strategy, structure, and rivalry
► In addition, Porter identified two additional variables
(chance and government) that can influence the
diamond in important ways
► In this theory Porter tells why some company have
competitive advantage and depend upon factors.
► According to Porter, “Any companies abilities to
compete to international arena is based mainly on the
inter related set of location advantages.”
► Porter says, develop some factors for the competitive
advantages.
► It is a pro-active model.

For example: Saudi Arabia have competitive advantage

of oil (natural)
1. Firm Strategy, Structure and
Rivalry
► Strategy: Strategy should be make to seeing the rival
strategy, so that it can help you to beat your
competitors.
► Structure: it should be supportive to your organization
► Rival: Should to considerate because rival are the most
big threat for any organization.

For Example: In Germany BMW’s big competitor is

Mercedes.
2. Demand Conditions

► This factor depend upon local condition and local consumer.

► influence the development of capabilities
► Sophisticated and demanding customers pressure firms to be more
competitive and to produce high quality, innovative products
► If … Consumer will increase, then Demand will increase.
► If … Demand will increase, then quality and product will grow,
► If … Quality and product will go, you will get competitive advantages of
production and able to compete at international market.
► Basically it depends upon innovation. If innovation and production
will increase then the company will get competitive advantages.
3. Related and Supporting Industries

In this factor, Porter says that Relative industry should

be supportive.
There are up-ward stream and down-ward stream.
Upward related to customers and down-ward related
to firms.
If you produce your product with the help of upward
and downward streams then you can take competitive
advantage of international market.

For Example: Bread and flour.

4. Factors Condition

► A nation's position in factor endowments (factors of

production) can lead to competitive advantage.
► The factors and resources are available in the country.
► These factors can be either basic (natural resources,
climate, location) or advanced (skilled labor, efficient
workforce, infrastructure, technological know-how)
► In above three factors of model are not controllable but in
this factor we can enhance the advance factors like skill of
labor, improve our infrastructure, technology etc.

For example: Japan have no more natural resources, but by

using the upgraded technology and working on infrastructure
 Government and Chance
► Except the 4 factors of porter’s model there are 2 more factors which is very
important. It is Government and Chance
► Government: The role of government as a catalyst as well as challenger.
a) Catalyst means government give the assistance to firm or local competitor more
strong.
b) Challenger means government helps to companies so that it can take a
challenge at international level.

► According to porter there is neither free market nor complete govern by

government. Leave business at market force but government should to help or
encourage the company.

► Chance: “Chance means how to convert the opportunities in to Success”.

► At the international level, there is a relation between two countries or
companies of other countries.
► Many time due to some factors like recession, war, natural disaster etc. leaves a
Topic: Level of Economic Integration
 Meaning of Economic Integration

When regional economies agree on integration, trade

barriers fall and economic and political coordination
increases.

❖ Economic integration, or regional integration, is an agreement

among nations to reduce or eliminate trade barriers and agree
on fiscal policies.
❖ The European Union, for example, represents a complete
economic integration.
❖ Strict nationalists may oppose economic integration due to
concerns over a loss of sovereignty.
 The advantages of economic integration

1) Trade Benefits
2) Employment
3) Political Cooperation
4) Mutual Understanding
5) Peace and Harmony among Nations
1. Free Trade Area: It is an agreement between member nation who remove
trade barrier and it is lowest form of economic integration.
For Ex:
a) NAFTA (North America Free Trade Agreement) member nation are US, Canada,
Mexico etc.
b) EFTA (European Free Trade Association) Member nations are Norway, Iceland,
Switzerland etc.
 2. Customs Union: It is an agreement between member nation who remove trade
barrier and it is lowest form of economic integration as well as there is a
establishment of common trade policy for Non-member nations
For Ex:
a) CACM (Central American Common Market) member nation are Costa Rica, El
Salvador, Guatemala, Honduras, and Nicaragua etc.
b) CARICOM(Caribbean Community and Common Market) member nations are Bahamas,
Barbados, Jamaica, Haiti, Saint Vincent, Suriname etc.
 3. Common Market: It is an agreement between member nation who remove trade
barrier and it is lowest form of economic integration as well as there is a
establishment of common trade policy for Non-member nations. There is a free
mobility of factor of production like Labor, Capital, Machinery.
For Ex:
a) MERCOSUR (MERCOSUR is an economic and political bloc of South American States
which has been compared to the European Union.) Member nations are Argentina,
Brazil, Paraguay and Uruguay.
4. Economic Union: In this economic union there is a common market where unified
fiscal and monetary policies are applicable and there is a common currency and
harmonized tax rate.
For Ex:
EU (European Union, Euro is a common currency) Member nations are Austria,
Belgium, Republic of Cyprus, Denmark, Finland, France, Germany, Greece, Hungary,
etc (Total 27 countries)
5. Political Union: In this political union there is a common parliament and other
political institutions that coordinates economic. Social and foreign policies of member
states.
For Ex:
EU (European Union) is headed toward at least partial Political Union.
US (United State) is an example of even closer to Political Union.
 Practice Questions

Which of the following is the general argument in support of

economic integration?

1. It helps poor countries.

2. It helps rich countries.
3. It helps international organizations such as the United Nations and
World Bank.
4. It will eventually lead to an equalization of wealth among nations.
THANK YOU