Lesson 2: Concepts and Theories

of International Trading
Mark Dariel B. Banuelos, MBA
 Early Theory of Trades

Adam Smith’s Economic Theory

Adam Smith was an 18th-century philosopher whose work
focused on economics. Smith’s most popular work was
probably The Wealth of Nations, which later gave rise to
macroeconomics. Much of modern economic theory is rooted
in Smith’s ideas; he’s often known as the father of
economics. In one of his most famous concepts, the invisible
hand theory, Smith argues that individuals looking out for
themselves (rather than government) ends up doing a better
job deciding what people should produce.
 Early Theory of Trades

Adam Smith’s Economic Theory

Adam Smith’s economic theory
is like learning by trial and
error…
Early Theory of Trades

• Adam Smith’s economic theory is the idea that

markets tend to work best when the government
leaves them alone. Smith argued that rational
people (aka acting in their own interest) would
naturally find the best way to use the nation’s
resources — He viewed government regulation as
potentially detrimental to economic growth.
• “Let it/them do it…”
 Wealth of Nations (Adam Smith)

• The main purpose of Adam Smith’s The Wealth of

Nations was to further the understanding of political
economy (the role of government in economic policy). He
wanted to encourage governments to adopt a free-market
approach to production and commerce.
• The central thesis of Smith's The Wealth of Nations is that our
individual need to fulfill self-interest results in societal
benefit. He called the force behind this fulfillment the
invisible hand.
 Theory of Absolute Advantage (Adam Smith)

• This exists when one country (country A) has a cost advantage over
another country (country B) in the production of one product – (it may be
produced using fewer resources (inputs)) while the second country (B)
has a cost advantage over the first (A) in producing the second product.
• It suggests that a country should:
• Export goods and services for which it is more productive than other countries.
• Import goods and services from other countries which are more productive than it
is.
 Theory of Comparative Advantage (David
Ricardo)

This theory states that trade can be carried out

even if one country has absolute advantage in
producing two products. Here the country
benefits by specializing in exporting the products
in which it has the greatest advantage or a
superior (comparative) advantage, and import
the products in which its advantage is less.
 Theory of Comparative Advantage cont….

Country Textile Rice Domestic

Exchange
Ratio

A 5 15 1:3

B 10 20 1:2
 Heckscher-Ohlin Theory

• The Heckscher-Ohlin model postulates that countries export what

they can produce. This model proposes that countries export what
they can create abundantly or what they are already in abundance
or in reserves. A country will have a comparative advantage in the
good that intensively uses its relatively abundant factor. Though
this model proves to be better than the traditional model, it adopts
assumptions that are tough to accept and expect.
Neo-Classical
Theories
Trade Theory
of Factor
Proportions
Heckscher-Ohlin Theory

• The Heckscher-Ohlin model maintains that the

specific natural resources that a country has
would give it an advantage in producing
related goods, this is coupled with land,
capital, and human resources. This model
shows that a country will export goods or
resources it has in abundance.
Assumptions of Heckscher-Ohlin Model cont..

• Prices are the same everywhere.

• The tastes in the two countries are identical, which signifies the elimination of differences in
preferences as in the case of technology.
The two countries have different relative factor endowments: capital, land, and labor. Based on
the relative factor endowments, countries are classified as capital-abundant, labor-abundant, or
land-abundant.
• Factor intensities may vary. Similar to the above, goods are classified as capital-intensive, labor-
intensive, or land-intensive based on relative factor intensities.
• Perfect competition.
• There are no transport costs and no hindrances in trade.
• There are no trade restrictions between the two countries.
Assumptions of Heckscher-Ohlin Model

• The Heckscher-Ohlin model assumptions that one must be aware of include the
following:
• There are two countries in the picture, which makes the model plain
and simple.
• There are two factors: capital and labor. There is a constraint in
certain aspects, like the limitation in the funding (endowment) of the
country.
• Countries have similar production technology. Therefore, governments
will share the same technologies. Although unrealistic, this assumption
eliminates trade differences because of technological differences.
 Balance of Payments

• There should be equality (surplus) to payments of a

country (imports, bank deposits abroad, etc.) with what it
receives.
• A deficit results when more payments are made than what
it receives. To correct the imbalance investments must be
encouraged and intensify the export of goods and services.
A favorable BOP would have favorable effect on the
economy and strengthen the country’s currency value.
Issues of Protectionism

• Protectionism are those pressures on

individual governments to protect their local
markets from incursion of foreign competition
in the guise of trade barriers. Trade
Barriers are restrictions on the trading of
goods among countries.
 Reasons Why There are Trade Barriers

• Infant Industry – to protect a new and developing industry (local).

• 2. Industrialization – encouragement to industrialize and build companies
(local).
• 3. Conservation of Natural Resources – to protect the environment. To
encourage wise use and management of valuable natural resources.
• 4. National Defense – to help the nation accumulate more crucial materials
for the economic and military welfare in the form of stockpiles, or emergency
capacity to produce.
• 5. Dumping – international price discrimination practice in which an
exporting firm deliberately sells merchandise at a lower price in a foreign market
than it charges in other markets, specifically & usually in its home market.
2 Kinds of Dumping

• Predatory dumping – when the firm discriminately, in favor of some foreign

buyers temporarily lowers its price for the purpose of eliminating
competitors and later raising its price when the competitor is trounced.
• b. Persistent dumping – dumping that goes on indefinitely.
• In other words, if a country feels that its variable costs have already been
recovered with sales in the domestic market, then it can afford to sell the
products outside the country at a lower price.
• 6. Retaliation – a country will impose tariff or any trade barrier if it feels
that another country unduly puts tariffs on their products.
Types of Trade Barriers

1. Tariff – restrictions that are applied explicitly in terms

of quantitative restrictions. A tax or duty on imported goods, to protect
domestic market or to raise government revenues.

• Kinds of Taxes
• a. Specific – a flat charge per physical unit.
• b. Ad Valorem – percentage of the value of the merchandise.
• c. Compound – a combination of both specific and ad valorem
2. Non-Tariff – restrictions that are applied implicitly, as in stringent standard
requirements.
Kinds of Non-Tariff
A. Quotas

Restrictions on the amount, number

of pieces, weight of goods or
services within a given period
A.Import quota
B.Export Quota
B. Monetary Barriers

A.Blocked Currency – used to improve a

difficult balance of payment situation. It is
done by refusing to allow importers to
exchange their national currency for the
seller’s currency.
 B. Monetary Barriers cont…

B. Differential Exchange Rates – control and discourage

importation of goods which the government deems
unnecessary. The government requires the importer to pay
different amounts of national currency for foreign exchange
with which to buy products in different classifications. If the
product is deemed necessary the government may simply
charge one unit of domestic money for one unit of foreign
currency. If the product is deemed unnecessary, the exchange
may be 50 units of domestic currency for one unit of foreign
currency.
 B. Monetary Barriers cont…

C. Government approval to secure foreign exchange

– The importer requests permission to secure foreign
exchange from a government office. This may be in
form of an exchange permit which
stipulates unfavorable exchange rates to the importer.
It may also require that the amount to be exchanged
must be deposited in a bank account for a certain
period prior to the foreign exchange transaction.
C. Embargoes

Embargoes – a trade embargo is the refusal to

sell to a specific country (political purposes).
D. Boycotts-

-the refusal to buy from a certain

country.
 E. Customs & Administrative Entry
Procedures

1. Valuation System
2. Anti-Dumping Practices- to value imported goods higher so
that they will be sold higher than local goods.
3. Tariff Classification – imported goods are classified in such
that they may fall into a high-tariff category.
4. Documentation Requirements – unnecessary papers or
documents that may be required to make importation
difficult.
 E. Customs & Administrative Entry
Procedures
• 5. Fees – fees are charged for different services
that will surely boost the price of imported
goods.
• 6. Standards – standards to protect the health
and safety of consumers, and ensure product
quality.
 E. Customs & Administrative Entry
Procedures
• 7. Government Participation in Trade:
• Procurement Policies – the government patronizes local products
instead of imported ones.
• Countervailing Duties – the government taxes imported goods which
have been given exporting subsidies by their respective countries.
To protect locally produced goods.
• Export Subsidies – the government provides export incentives and
credits to exporters.
• Domestic Assistance Programs – the government assist domestic
firms so that their products may become more competitive against
imported ones.