ALTERNATIVE THEORIES

OF INTERNATIONAL TRADE
CHAPTER 5 AND 6
CONTENT
 1. Mercantilism
 2. Theory of absolute advantage
 3. Theory of comparative advantage
 4. Heckscher-Ohlin theory
 5.Imperfect competition and international trade
 6. Gravity Equation
 7. Product Life-Cycle Theory
 8. Stolper –samuelson theorem
 9. Rybczynski theorem
 10. Immizerizing growth
 11. Product life cycle theory
1. MERCANTILISM
 17-18th centuries
 The way for a nation to become rich and powerful is to

export more than it imports

 The more gold and silver a nation had the richer and

more powerful it was.

 By encouraging exports and restricting imports, the

government would stimulate economic growth and

employment.
Advantages and disadvantages
 It realized the importance of international
trade in a country’s economic development .
 However, conflict happens if all countries

promoted exports and restricted imports 

(where to export if all countries restricted
imports?)
 Beggarthy- Neighbor way of development.

(win-loss inter-trade)
2. Absolute Advantage Theory
 Developed by Adam Smith
 A country can benefit from international trade when it

specializing producing and exporting the product it has

absolute advantage.
 It can explain the international trade between

developed and developing countries.

 What happens if a country didn’t have absolute

advantages on any products?

 It could not explain the trade among developed

countries.
3. Comparative Advantage Theory
 David Ricardo (also called Ricardian Model)
 A country can benefit from international trade if it

specializes in producing and exporting the products it

has comparative advantage.
 In other words, a country can benefit from trade if it

specializes in producing and exporting the products it

has lowest opportunity costs.
 Trade is based on differences in labor productivity

among countries.
Advantages and disadvantages
 It could explain the pattern of trade among
developed countries.
 It confirmed that a country could benefit from

trade even if it had no absolute advantage on any

goods.
 However, it just assumed that there are

differences in labor productivity among countries

as a base for international trade but it did not
explain why they were different.
 It didn’t mention the effect of international trade

on the earnings of factor of production (labor)

4. Heckscher-Ohlin Theory
 A labor-abundant country can benefit from
trade if it specializes in producing and
exporting the labor –intensive products
 A capital- abundant country can benefit from

trade if it specializes in producing and

exporting capital-intensive products
 International trade will make labor wage (w) the

same in the two nations; similarly, it will cause

the price of capital (r) to be the same in both
nations (The relative and absolute factor-price
equalization theorem)
Leontief Paradox
 When taking the empirical tests on the H-O
theory, Leontief found that the United States,
which was a capital-abundant country, has
produced and exported large amount of
labor-intensive products and imported
capital-intensive products. So, he insisted
that the H-O theory had problem.
Explanation of the Leontief Paradox
 The year in which Leontief used data for the test
was 1947 which was closed to the Second World
War. So the data collected were not reliable.
 The labor-intensive industries were highly

protected by the US government at that time. It

restricted the imports of labor-intensive products.
 Leontief mainly mentioned physical capital

(machines, factories, etc.) and ignored the human

capital. Adding human capital to physical capital
would make US export more capital intensive
products.
Disadvantages of the H-O theory
 The H-O is useful in explaining the pattern of
trade between the developing countries
(labor-abundant) and developed countries
(capital abundant).
 International trade increases labor income

among countries.
 The H-O theory could not explain why the

Unites States produces and export cars and,

at the same time, imports cars from other
countries (Intra-Industry Trade).
 5. Imperfect Competition and
International Trade
 Intra-Industry Trade: A country can benefit
from trade if it produces the goods whose
production is based on economies of scale or
product differentiation.
Empirical Applications of Monopolistic Competition and
Trade
 Intra-Industry Trade
◦ Countries will specialize in producing different
varieties of a differentiated good and will trade those
varieties back and forth.

◦ The index of intra-industry trade tells us what

proportion of trade in each product involves both
imports and exports.
 100 = equal quantities of exports and imports
 0 = only exports or imports

Min of Imports & Exports

Index of IIT 
1  Exports  Imports 
2
Empirical Applications of Monopolistic
Competition and Trade
 Index of Intra-Industry Trade
◦ For the golf clubs, we can use data from Table 6.1.
◦ The minimum of imports and exports is $305.8.
◦ Using the other data, we have
Index of IIT = 305.8/[.5(305.8+318.7)] = 98%.
◦ In Table 6.1 there are other examples of intra-
industry trade in other products for the U.S.
◦ To obtain a high index of intra-industry trade, it is
necessary for the good to be differentiated and for
costs to be similar in the Home and Foreign
countries, leading to both imports and exports.
Empirical Applications of Monopolistic
Competition and Trade
Table 6.1 Index of Intra-Industry Trade for the U.S.
6. Empirical Applications of
Monopolistic Competition and Trade
 The Gravity Equation
◦ To explain the value of trade, we need a different equation
called the gravity equation.

◦ Dutch economist and Nobel laureate, Jan Tinbergen was

trained in physics and thought the trade between countries
was similar to the force of gravity between objects.
 Objects with larger mass or those that are close together have
greater gravitational pull between them.

◦ The force of gravity between these two masses is:

Fg = G[M1M2/d2]
 G is the constant that tells the magnitude of the relationship.
 M1 and M2 are the two objects’ masses.
Empirical Applications of Monopolistic Competition
and Trade
 The Gravity Equation in Trade
◦ We use a similar equation to measure the trade
between two countries.

◦ Instead of mass, we use the GDP of each country.

◦ The distance still matters, but we are not sure of the

precise relationship between distance and trade.

◦ There is also a constant term that indicates the

relationship between the gravity term and trade.
GDP1 GDP2
Trade  B
dist n
Empirical Applications of Monopolistic
Competition and Trade
 The Gravity Equation in Trade

◦ The constant term can also be interpreted as

summarizing the effects of all factors, other than
distance and size, that influence the amount of
trade between two countries.

◦ The effect of size is an implication of the

monopolistic competition model we studied in this
chapter.
 Larger countries export more because they produce
more product varieties, and import more because their
demand is higher.
 Empirical Applications of Monopolistic
Competition and Trade
 Deriving the Gravity Equation
◦ Start with Country 1, which produces a differentiated
product.
◦ Other countries’ demand for Country 1’s goods
depends on:
 The relative size of the importing country
 The distance between the two countries
7. Product-Life Cycle theory
 Due to technological gaps among countries,
an innovating nation can benefit from trade if
it exports new developed products to other
countries.
8. Stolper- Samuelson theorem
 As the relative price of a labor-intensive
product increases, the real labor wage of the
labor-intensive industry will increase and the
real labor wage of capital-intensive industry
will reduce.
 Ex: the relative price of Cloth (labor-intensive

product) increases, the real labor wage in the

Cloth industry will increase and the real labor
wage in the Food industry will reduce.
9. Rybczynski theorem
 At constant relative prices, an increase in the
labor source in a country will lead the
increase in the production of the labor-
intensive product and reduction in the
production of capital intensive product.
 EX: an increase in the labor source will lead to

the increase in the production of Cloth

(labor-intensive) and reduction of production
of Food (capital intensive)
10. Term of Trade
 Terms of Trade : is the ratio between the
export price index and the import price index
 Terms of Trade = P(export)/P(import)
 Terms of Trade are rather low in developing

countries.
 If a home country exports Cloth and the

Foreign country exports Food , then Pc/PF

represents the term of trade of the Home
country. And PF/Pc is the term of trade of the
Foreign country.
11. Immiserizing Growth
 Economic growth may lead to two effects:
◦ The welfare effect: economic growth increases the
country’s welfare : GDP per capita increases
◦ The Term-of-Trade effect: economic growth
deteriorates the country’s Term of Trade, which
leads to the reduction in the country’s welfare
because it reduces the volume of its international
trade.
◦ If the Term-of-Trade effect is larger than the
welfare effect  economic growth but welfare
reduces. This is called Immiserizing Growth.
THE
END