INTERNATIONAL TRADE THEORIES

WHAT IS TRADE?
• Trade is the concept of exchanging goods and
services between two people or entities.
• International trade is then the concept of this
exchange between people or entities in two
different countries.
• International trade theories are simply different
theories to explain international trade.
CLASSICAL TRADE THEORIES
MERCANTILISM
• Oldest theory
• Nation based
• Country’s wealth is determined by the amount of
its gold and silver holdings.
• Aim of trade is to increase these holdings.
• To be done by promoting exports and
discouraging imports.
• Objective: increase trade surplus, avoid trade
deficit.
• Mercantilism flourished because of national
strategy called protectionism.
• Rise of new nation states in 1500s.
• New rulers wanted to strengthen their countries
and control territories.
• Needed to build large armies for which they
needed gold.
• Hence Mercantilism. Perfect example is British
Empire.
• Disadvantages:
• Enriches only a few countries.
• Harms in long term.
• Deals in zero-sum game.
• Politically harmful.
Theory of Absolute Advantage
• In 1776, Adam Smith questioned mercantilism
theory in his work, The Wealth of Nations.
• He offered a new trade theory called Absolute
Advantage.
• Focused on ability of nation to produce goods
efficiently than other nation.
• Produce only those goods where you are most
efficient, trade where less efficient.
•
• Countries should focus on specialization because it
makes their labour, workforce more skilled.
• Production becomes more efficient as there is an
incentive to create faster and better production
methods to increase the specialization.
• Trade between countries shouldn’t be regulated or
restricted by government policy or intervention.
(laissez Faire)
• Trade should flow naturally according to market
forces.
Theory of comparative advantage
• ascribed to David Ricardo, an Englishman who
wrote in the early 19th century.
• Comparative advantage is the ability to produce a
particular good at a lower opportunity cost than
another country.
• Comparative advantage occurs when a country
cannot produce a product more efficiently than the
other country; however, it can produce that product
better and more efficiently than it does other goods.
 2 countries, 2 goods, 100 workers each.
easterners make 2 bikes/ grow 4 bushels of wheat.
Westerners make 1 bike/grow 1 bushel of wheat.
Workforce split evenly between 2 industries.

East Shift ten workers fro

Bike factories to field
West shifts 25 to bikes

Terms of trade:
33 bushels
trades for 22
bikes.
• Theory of comparative advantage says that it
pays countries to trade because they are
different.
• Deals in non zero sum game.
• Impossible for countries to have no comparative
advantage in anything.
limitations
• Restrictive model
• Labour theory of value
• Assumption of full employment
• Ignore transportation cost
• Demand is taken for granted
• Mobility of factor of production
• Complete specialization is unrealistic.
• Did not explain why comparative costs of
producing various commodities differ as
between different countries.
• Didn’t explain how countries determine which
products would give a country an advantage.
• assumed free and open markets would lead
countries to determine which goods they could
produce more efficiently.
Heckscher-Ohlin Theory
• In the early 1900s, two Swedish economists, Eli
Heckscher and Bertil Ohlin, focused on how a
country could gain comparative advantage.
• This theory inquired deeper into the underlying
forces which cause differences in comparative
cost.
• differences in factor endowments of different
countries and different factor-proportions
needed for producing different commodities that
account for difference in comparative costs.
• No difference between regional and
international trade.
• International trade is a special kind of trade.
• Transportation cost does not make any
difference because exchange rate comes into
picture.
• Ohlin used General Theory of Value to explain
international trade.
• According to General equilibrium theory of
value, relative prices of commodities are
determined by demand and supply.
• In long term equilibrium, under conditions of
perfect competition, prices of commodities- as
determined by demand and supply, are equal to
average cost of production.
• Cost of production of a commodity depends
upon-prices paid for the factor of production.
• Factor prices-in turn determine the income of
factor owners, hence the demand for goods.
• by producing products that utilized factors that
were in abundance in the country.
• theory based on a country’s production factors—
land, labor, and capital, providing funds for
investment in plants and equipment.
• cost of any factor or resource was a function of
supply and demand.
• Also called the factor proportions theory, stated
that countries would produce and export goods that
required resources or factors that were in great
supply and, therefore, cheaper production factors.
• In contrast, countries would import goods that
required resources that were in short supply, but
higher demand.
• For example, China and India are home to
cheap, large pools of labor. Hence these
countries have become the optimal locations for
labor-intensive industries like textiles and
garments.
Marxist Notions Affecting Trade
• Karl Marx supported free trade.
• Objective of free trade was freedom of capital.
• Object of freedom of capital was to prevent
capitalism from being constrained within the
national frontiers.
• Thereby hastening the process of national
disintegration, accentuating the contradiction
between bourgeoisie and the proletariat.
• Thus bringing social revolution nearer.
• one important character and dynamics of free
trade is trade between unequal trading partners.
• Theory of comparative advantage is based on
reciprocal exchange of natural or acquired
advantage in particular branches of production
on the principle of international division of
labour.
• Marx specifically related the difference in factor
endowment to unequal economic development
of trading nations.
• Trade between unequal partners.
• Trade whether home or foreign, produced
exchange value which was inseparable from the
creation of surplus profit through exploitation of
surplus labour.
• Inherently unequal exchange.