CHAPTER 2

Theories of
International Trade
Why study trade
theory?
• Talks about benefits of international
trade – theories show why countries
should trade for products/ services
even when they can produce them
domestically.
• Talks about patterns of international
trade – theories show why countries
specialize the way they do
• Talks about the role of intervention –
theories help articulate the role of
government policy (tariffs, quotas, etc.)
 Theory of
Mercantilism
• A trade theory prevailed during 16th to 19th centuries
• The wealth of a nation is measured based on its
accumulated wealth in terms of gold and silver
• Nations should accumulate wealth by encouraging exports
and discouraging imports
• Theory of mercantilism aims at creating trade surplus and
in turn accumulate nation’s wealth
• Common in Europe from the 16th to the 18th century that
promoted governmental regulation of a nation’s economy
for the purpose of augmenting state power at the expense
of rival national powers. 
2. Absolute Advantage
Theory
• Adam Smith, ‘An Enquiry into the Nature
and Causes of the Wealth of Nations’, 1776
• There is international benefit from trade
• When one country can produce a unit of
good with less cost than another country,
the first country has an absolute (cost)
advantage in producing that good
• Cost is considered based on number of
labor units used
 Absolute Advantage
Theory Assumptions:
• Two countries (A&B), both producing two products
(x&y)
• Labor is the only factor of production and its
productivity remains the same
• Perfect mobility of labor between the sectors within a
country
• No mobility of labor between the other countries
• Assumes perfect competition – No transportation cost
– No restrictions on the movement of goods between
the countries (free trade)
For example:
Extracting oil in Saudi Arabia is pretty much just a
matter of “drilling a hole.” Producing oil in other
countries can require considerable exploration
and costly technologies for drilling and extraction
—if indeed they have any oil at all.
The United States has some of the richest
farmland in the world, making it easier to grow
corn and wheat than in many other countries.
Guatemala and Colombia have climates especially
suited for growing coffee.
Chile and Zambia have some of the world’s
richest copper mines.
 3. Comparative Advantage
Theory
• David Ricardo, ‘The Principles of
Political Economy & Taxation’, 1817.
• Nations can still gain from trade even
without an absolute advantage.
• A country has a Comparative Advantage
in producing a good if the opportunity
cost of producing that good in terms of
other goods is lower in that country
compared to other countries
Comparative Advantage
example
For example, if Zambia focuses its resources on
producing copper, its labor, land and financial
resources cannot be used to produce other goods
such as corn. As a result, Zambia gives up the
opportunity to produce corn.
How do we quantify the cost in terms of other
goods?
Let’s assume that Zambia just needs labor to
produce copper and corn. The companies that
produce either copper or corn tell you that it takes
10 hours to mine a ton of copper and 20 hours to
harvest a bushel of corn. This means the
opportunity cost of producing a ton of copper is 2
bushels of corn.
4.National Competitive
Advantage (Porter, 1990)
• Introduced by Michael Porter, a famous
Harvard business professor in 1990
• Conducted a comprehensive study of 100
industries in 10 nations to learn ‘what leads
to success’
• A nation’s competitiveness depends on
the capacity of its industry to innovate and
upgrade. Companies gain advantage
against the world’s best competitors
because of pressure and challenge. They
benefit from having strong domestic rivals,
aggressive home-based suppliers, and
demanding local customers.
Four determinants of National
Competitive Advantage (“Porter’s
Diamond”)

1. Factor Conditions
2. Demand Conditions
3. Related and Supporting Industries
4. Firm Strategy, Structure and Rivalry
 1. Factor Conditions
• ‘Key’ factors of production (or specialized or
advanced factors like skilled labor, capital and
infrastructure) are created, not inherited
• They are difficult to duplicate, and create
competitive advantage
• ‘Non-key’ factors (basic factors) like unskilled labor
can be obtained by any firm and do not generate
sustained competitive advantage
• Lack of resources actually helps countries to become
competitive
 2. Demand Conditions

• Sophisticated domestic market is an important

element in producing competitiveness
• Makes firms to sell superior products as the market
demands high quality
• Closeness to such consumers enables the firm to
learn the needs & desires of consumers
• Helps the firm to be competitive in the global
market
• Example: French Wine industry
 3. Related and Supporting
Industries
• A set of strong related and supporting industries is
important to the competitiveness of firms
• Includes suppliers and related industries
• local suppliers cluster around producers (upstream
and/or downstream industries), and add to
innovation
• Advantages of such clustering or agglomeration: –
Potential technology knowledge spillovers
• Disadvantages: – Potential poaching of your
employees by rival companies – Increase in
competition, decreasing profit margin
4. Firm Strategy, Structure
and Rivalry

• Strategy Investment plans, use of labor

force – all depends on the country’s capital
market and labor market, conditions in the
home market
• Structure Management styles but there is
no single managerial, ownership or
operational strategy universally appropriate
• Rivalry Intense competition spurs
innovation Example: Japanese automobile
and electronics industries