CHAPTER THREE

INTERNATIONAL TRADE THEORIES

 Introduction
• Trade is the voluntary exchange of goods, services,
assets, or money between person or organization
and another.
• Trade will only be complete if both parties of the
transaction believe that they will gain from the
voluntary exchange (win-win approach).
• International trade is voluntary exchange of goods,
services or assets between residents(individuals or
organizations) of two or more countries.
 Discussion Questions

 What is free trade?

 why it is beneficial for countries to
engage in international trade?
What is the pattern of international
trade in the world economy ?
 What is free trade?

• It refers to a situation in which a government

does not attempt to influence through quotas
or duties on what its citizens can buy from
another country, or what they can produce and
sell to another country.
 Question: Why is it beneficial for countries to
engage in free trade?
• International trade allows a country to specialize in
the manufacture and export of products that can
be produced most efficiently in that country.
• Import products and services that can be produced
more efficiently in other countries.
• Limits on imports may be beneficial to producers,
but not beneficial for consumers
• it is beneficial for a country to engage in
international trade even for products it is able to
produce for itself (Make or buy decisions in free market).
 1. Mercantilism

• Mercantilism-is the 1st international trade theory

and it emerged in England in mid-16th century.

• The main hypothesis of mercantilist is that gold

and silver are mainstays of national wealth and
essentials to vigorous commerce.

• During the 17th century gold and silver were the

currency of the trade between countries.
• A country could earn gold and silver by exporting
goods
 Contd

• By the same token importing goods from other

countries would result in outflow gold and silver
to the other countries.

• The main tenet of mercantilist is that it is a

country’s best interest to maintain a trade surplus
- export more than what it imports.

• By doing so, a country can accumulate gold and

silver and increase its wealth and prestige.
 cont‘d

• The mercantilist doctrine advocates that countries

should simultaneously encourage exports and
discourage imports.

• Mercantilist promotes state intervention to achieve

surplus in the balance of trade.

• To achieve surplus , government is expected to

discourage imports by imposing tariffs and
subsiding exports.
 cont‘d

• International trade experts criticize the doctrine of

mercantilist on the ground that it believes in a zero
sum –game.
• A zero sum game is one in which again by one country
results in a loss to another country . But multinational
trade is positive sum game in which all countries can
benefit.
• The mercantilist doctrine is by no mean dead.

• currently government of all the countries today

intervene in their respective external trades by
imposing barriers on imports and offering incentives to
exports.
 2. Theory of Absolute Advantage

• The theory of absolute advantage was propounded by

Adam Smith (1776), generally considered to be the
father of economics.
• This theory was evolved as a strong reaction to
restrictive and to protectionist views on the
international trade.
• He advocated in his theory the necessity of free trade.
• According to Adam smith, countries should
specialize in the production of commodities or goods
for which they have an absolute advantage and then
trade these goods for the goods traded by other
countries.
 Contd

• Smith (1776) - countries differ in their ability

to produce goods efficiently.

• A country has an absolute advantage in the

production of a product when it is more
efficient than any other country in producing it.

• According to Smith, trade is not a zero-sum

game
 For instance
 Just as a tailor does not make his own shoes and
shoemaker does not stitch his own clothes, both gain by
exchanging shoes and clothes.
• the English, by virtue of their superior manufacturing
processes, were the world’s most efficient textile
manufacturers.
• Due to the combination of favourable climate, good
soils, and accumulated expertise, the French had the
world’s most efficient wine industry.

The English had an absolute advantage in the

production of textiles, whereas the French had an
absolute advantage in the production of wine.
 Contd

• Smith’s basic argument, therefore, is that a country

should never produce goods at home that it can
buy at a lower cost from other countries.

• Smith demonstrates that, by specializing in the

production of goods in which each has an absolute
advantage, both countries benefit by engaging in
trade.
 contd

• Assume that two countries, Ghana and South

Korea, both have 200 units of resources that
could either be used to produce rice or cocoa.

– In Ghana, it takes 10 units of resources to produce one

ton of cocoa and 20 units of resources to produce one
ton of rice
– So, Ghana could produce 20 tons of cocoa and no
rice, 10 tons of rice and no cocoa, or some
combination of rice and cocoa between the two
extremes
 Contd

– In South Korea it takes 40 units of resources to

produce one ton of cocoa and 10 resources to
produce one ton of rice.
– So, South Korea could produce 5 tons of cocoa
and no rice, 20 tons of rice and no cocoa, or
some combination in between.
• Ghana has an absolute advantage in the
production of cocoa.
• South Korea has an absolute advantage in the
production of rice.
 Contd

• Without trade (Half Resources for each product)

– Ghana would produce 10 tons of cocoa and 5
tons of rice
– South Korea would produce 10 tons of rice and
2.5 tons of cocoa

• If each country specializes in the product in

which it has an absolute advantage and trades for
the other product
– Ghana would produce 20 tons of cocoa
– South Korea would produce 20 tons of rice
 Contd

• Suppose
– Ghana could trade 6 tons of cocoa to South
Korea for 6 tons of rice

• After trade
– Ghana would have 14 tons of cocoa left, and 6
tons of rice.
– South Korea would have 14 tons of rice left and
6 tons of cocoa.

• Both countries gained from trade.

 Contd

Advantages:
• Every one benefits from the low prices of trade
• More production because of specialization of products
• Lower cost per unit
Drawback:
• Neglected transportation costs between regions
• Neglected factors associated with natural resource
endowments
• What if there is a country with no absolute advantage?
Leads to Theory of Comparative Advantage.
 3. Comparative Advantage
• David Ricardo (19th century) built on Smith ideas
(Comparative Advantage)
• Its quite common that some countries have the
advantage of producing some goods at lower cost
compared to other countries. This is due :
- availability of cheap skilled labor
-availability of cheap raw martials
-Availability of advanced technology and
-Competent management practices, etc
 Availability of these factors enhance productivity
and thereby reduced the cost of production per unit.
• Similarly, other countries have advantage in
producing other goods .
• For instance, Japan has advantage in producing
electronics at low cost where as India has similar
advantage in producing textiles.
 Contd

• According to comparative cots advantage theory ,

countries in long –run will end to specialize in
business ( production and marketing )of those
goods in whose business they enjoy comparative
low cost advantage and import other goods in
which the countries have comparative cost
disadvantage, if free trade is allowed.
• Ricardo (1817) - theory of comparative
advantage - a country should specialize in the
production of those goods that it produces most
efficiently and buy the goods that it produces less
efficiently from other countries
– even if this means buying goods from other countries
that it could produce more efficiently itself.
– trade is a positive sum game in which all gain

• The theory provides a strong rationale for

encouraging free trade
– potential world production is greater with unrestricted
free trade than it is with restricted trade
 How Does The Theory Of Comparative Advantage
Work?
• Assume
– Ghana is more efficient in the production of both
cocoa and rice
– in Ghana, it takes 10 resources to produce one ton of
cocoa, and 13.33 resources to produce one ton of rice
– So, Ghana could produce 20 tons of cocoa and no rice,
15 tons of rice and no cocoa, or some combination of
the two
– in South Korea, it takes 40 resources to produce one
ton of cocoa and 20 resources to produce one ton of
rice
– so, South Korea could produce 5 tons of cocoa and no
rice, 10 tons of rice and no cocoa, or some
combination of the two
 Contd

• With trade
– Ghana could export 4 tons of cocoa to South
Korea in exchange for 4 tons of rice
– Ghana will still have 11 tons of cocoa, and 4
additional tons of rice
– South Korea still has 6 tons of rice and 4 tons of
cocoa
– if each country specializes in the production of
the good in which it has a comparative
advantage and trades for the other, both
countries gain
• Comparative advantage theory provides a strong
rationale for encouraging free trade
 4. Heckscher-Ohlin Theory

• Heckscher-Ohlin have traced the cause of relative

difference in costs.
• They have traced the cause of cost differences to
relative factors endowments .
• 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.
– 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 .
 contd

 According to the theory, countries are abundant

in labor will export labor intensive goods and
those which are richer in capital will export
capital intensive goods.
• Leontief (1953) - since the U.S. was relatively
abundant in capital, it would be an exporter of
capital intensive goods and an importer of labor-
intensive goods.
– but found that U.S. exports were less capital
intensive than U.S. imports - Leontief Paradox
 5. Product life-cycle theory
• Vernon (mid-1960s) - proposed the product life-
cycle theory - as products mature both the
location of sales and the optimal production
location will change affecting the flow and
direction of trade.
• While the theory accurately explains what has
happened for products like photocopiers and a
number of other high technology products
developed in the US in the 1960s and 1970s, the
increasing globalization and integration of the
world economy has made this theory less valid in
today's world.
 6. New Trade Theory
• The new trade theory began to emerge in the 1970s when a
number of economists pointed out that the ability of firm to
attain economies of scale might have important implications
for international trade.

• Economies of scale are unit cost reductions associated with a

large scale of output.
• Economies of scale have a number of sources, including the
ability to spread fixed costs over a large volume, and the
ability of large-volume producers to utilize specialized
employees and equipment that are more productive than
less-specialized employees and equipment.
• Economies of scale are a major source of cost reductions in
many industries
• New trade theory makes two important points:
• First, through its impact on economies of scale,
trade can increase the variety of goods available to
consumers and decrease the average costs of those
goods.
• Second, in those industries where the output
required to attain economies of scale represents a
significant proportion of total world demand, the
global market may be able to support only a small
number of enterprises.
• Thus, world trade in certain products may be
dominated by countries whose firms were first
movers in their production.