International Trade Theory

Trade theory is useful because it helps to explain what might be produced compet itively in a given locale, where a company might go to produce a given product e fficiently, and whether governmental practices might interfere with the free flo w of trade among countries. Some trade theories deal with the question of what will happen to international t rade in the absence of governmental interference; others prescribe how governmen ts should interfere with trade flows in order to achieve certain national objecti ves. Mercantilist theory proposed that a country should try to achieve a favorable ba lance of trade (export more than it imports) in order to receive an influx of go ld. Neomercantilist policy also seeks a favorable balance of trade, but its purpo se is to achieve some social or political objective. Adam Smith developed the theory of absolute advantage, which holds that consumer s will be better off if they can buy foreign-made products that are priced more cheaply than domestic ones. According to the theory of absolute advantage, a country may produce goods more efficiently because of a natural advantage (for example, raw materials or climat e) or because of an acquired advantage (for example, technology or skills). The theory of country size holds that because countries with large land areas ar e more apt to have varied climates and natural resources, they are generally mor e nearly self-sufficient than smaller countries are. A second reason for this gr eater self-sufficiency is that large countries' production centers are more like ly to be located at a greater distance from other countries, thus raising the tr ansport costs of foreign trade. David Ricardo's comparative advantage theory holds that total output can be incr eased through foreign trade, even though one country may have an absolute advanta ge in the production of all products. Some of the assumptions of the trade theories of absolute and comparative advanta ge have been questioned by policymakers. These are that full employment exists, t hat output efficiency is always a country's major objective, that there are no t ransport costs among countries, that countries are satisfied with their relative gains, and that resources move freely within countries but are immobile internat ionally. The factor-proportions theory holds that a country's relative endowments of fand , labor, and capital will determine the relative costs of these factors. These f actor costs, in turn, will determine which goods the country can produce most ef ficiently. The product life cycle (PLC) theory states that many manufactured products will be produced first in the countries in which they were researched and developed. T hese are almost always industrialized countries. Over the product's life cycle, production will tend to become more capital-intensive and will be shifted to for eign locations. According to the country-similarity theory, most trade today occurs among industr ial countries because they share very similar market segments. LDCs have been increasingly concerned that they are overly vulnerable to events in other countries because of their high dependence on one export product and/or one trading partner. As LDCs try to become more independent of the external env ironment, however, they face the risk that their own consumers may have to pay hi gher prices or do without some goods. Although most trade theories deal with cross-country benefits and costs, trading decisions usually are made at the company level. Companies must have competitive advantages to be viable exporters. They may seek trading opportunities in order to use excess capacity, lower production costs, or spread risks.