International Trade Theories

Major Trade Theories

Mercantilism Absolute advantage- Adam Smith Comparative advantage : Ricardo Factor Endowments Theory:Eli Heckscher and Bertil Ohlin International Product Lifecycle : Raymond Vernon National Competitive Advantage: Michael Porter

Mercantilism
Emerged in England in the mid-16th century. The main hypothesis of this trade theory is that gold and silver are the mainstays of national wealth and essential to vigorous commerce. During the 17th century, gold and silver were the currency of trade between countries.

A country could earn gold /silver by exporting goods.

Mercantilism
By the same token, importing goods from other countries would result in an outflow of gold and silver to other countries. Earning of gold/silver is the main motive for countries to trade with each other. The main tenet of mercantilism is that it is in a countrys best interest to maintain trade surplus. I.e. export more than what it imports. By doing so, a country can accumulate gold and silver and increase its wealth and prestige.

Mercantilism
Consistent with this belief, the mercantilist doctrine advocates state intervention to achieve surplus in the balance of trade. To achieve surplus, govt is expected to discourage imports by imposing tariffs and quotas and subsidizing exports. International trade experts criticize the doctrine of mercantilism on the ground that it believes in zero-sum game.

Mercantilism
A zero sum game is one in which a gain by one country results in a loss to another country. But multinational trade is a positive sum game in which all countries benefit.

Theory of Absolute Advantage.

Propounded by Adam Smith. In his book, The wealth of Nations (1776, London), Smith argued that countries differ in their ability to produce goods efficiently. During his times, England by virtue of their superior manufacturing processes was the worlds most efficient textile manufacturers. Similarly, due to the combination of favourable climate, good soils and accumulated expertise, the French had the worlds most efficient wine industry.

England had an absolute advantage in the production of textiles

France had the absolute advantage in the production of wine.

Theory of Absolute Advantage.

According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods traded by other countries. Thus England should specialize in the production of textiles and France in wine. England could get all the wine it needed by selling its textile to France and buying wine in exchange.

Theory of Absolute Advantage.

By specializing in the production of goods in which each nation has an advantage and by selling/buying from the other, both countries stand to gain by engaging in trade. This was the argument on which Smith denounced the doctrine of zero-sum game and advocated in its place, the principle of positive-game. The theory of absolute advantage has certain implications

Theory of Absolute Advantage.

If a country has an absolute advantage in producing a product there exists a potential for gains from trade Within one country, the gains from trade are not evenly distributed by the competitive market. A more complicated picture emerges when one of the trading partners has an absolute advantage in the production of both the goods , namely textile and wine.

Trade under these conditions still brings gains as David Ricardo demonstrated with his theory of comparative advantage.

Theory of comparative advantage

This theory holds that nations should produce those goods for which they have the greatest relative advantage. In his book, Principles of Political Economy (1817), Ricardo argued that it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy those goods that it produces less efficiently from other countries , even if this means buying goods, from other countries, that it could produce itself efficiently.

Theory of comparative advantage

The theory of comparative advantage is based on certain assumptions given below a) There should be two countries that produce the same two commodities b) Labour is the only factor applied in production . C) Labour is available and is homogeneous d) There is no change in taste and preference of people. e) No change in technology is expected in the near future. f) Factors of production are perfectly mobile within two countries but are not freely mobile between the countries.

Theory of comparative advantage

e.g as given by Ricardo England to produce cloth must require labour of 100 men for one year. If England made wine it would require the labour of 120 men for one year. England would therefore find it in her interest to import wine and purchase it by export of cloth. Similalry Portugal , to produce wine , might require the labour of 80 men for one year To produce the cloth may require the labour of 90 men for one year. Thus Portugal should export wine and import Cloth.

Theory of comparative advantage

The above theory can also be explained in the following way. For Portugal the relative cost of production of a unit of wine is 80/120 which is less than the relative cost of producing a unit of cloth (90/100). On the other hand , England has the least disadvantage in the production of cloth , whose relative cost (100/90) is less than the relative cost of wine (120/80) . Thus Portugal should concentrate on the production of wine and England should concentrate on production of cloth, thus benefiting both countries.

Theory of comparative advantage

This exchange might even take place not withstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though Portugal can make cloth with the labour of 90 men , she would import it from a country which requires 100 men to produce cloth , because it would be advantageous to her rather to employ the capital in the production of wine , for which she would obtain more cloth from England , than she could produce by diverting a portion of her capital from the cultivation of wines to the manufacture of cloth.

Theory of comparative advantage

The major limitations of this theory 1) It is based on the value of labour. It considers labour as the only factor of production and assumes that all labour is homogeneous. However labor alone doesnot produce goods. There are other factors such as availability of raw materials, capital etc which has been ignored. 2) In practice labour is never homogeneous , as there are skilled, unskilled and semiskilled labour

Theory of comparative advantage

3) The assumption that labour is used in the same fixed proportions in production of both goods in both countries is too simplistic. 4) The theory assumes constant labour costs even when output of goods increases due to specialization under international trade. In reality costs decrease with increased production giving rise to comparative advantage. This theory doesnot take into account these changes in costs.

Theory of comparative advantage

5) The theory is one sided as it considers only the production costs i.e only supply side. The demand factors , which affect the price of goods and through them prices of the other factors of production are not taken into account.

Heckscher-Ohlin Theory :
General Equilibrium Theory or Factor Endowment Theory or Factor Proportion theory or Modern Theory of International Trade. Ricardos theory stresses that comparative advantage arises from differences in productivity.

Thus whether England is more efficient than Portugal in the production of cloth depends on how productively it uses its resources particularly labour productivity.
Ricardo emphasized that differences in labour productivity between nations underlie the nature of comparative advantage. Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (1923) put forward a different explanation of comparative advantage..

Heckscher-Ohlin Theory
They argued that comparative advantage arises from difference in national factor endowments. By factor endowments , they meant the extent to which a country is endowed with such factors as land, labour and capital. Different nations have different factor endowments and different factor endowments explain differences in factor costs. The more abundant a factor, the lower its cost. The theory postulates that countries will export those goods that make intensive use of those factors that are locally abundant , while importing goods that make intensive use of factors that are locally scarce.

Heckscher-Ohlin Theory
e.g South Korea has excelled in exports of goods produced in labour-intensive manufacturing industries such as textiles and footwear. This reflects South Koreas relative abundance of low cost labour. The country that has abundant capital will produce and export capital intensive goods and the countries with abundant supply of labour will produce and export labour intensive commodities. e.g USA which has abundance of capital made cars and aeroplanes (Boeing) and exported around the world.

The theory of International Product life cycle Raymond Vernon.

This theory elaborates on the stages of production of a product with a new know-how Such a product is first introduced by the parent firm , then by its foreign subsidiaries and finally anywhere in the world where costs are the lowest. This theory helps to explain why a product that begins as a nations export ends up becoming an import. Stage 1 : the introduction stage : The company launches the product in the home country.

The theory of International Product life cycle Raymond Vernon.

Price is inelastic , profits are high and the company seeks to sell to those willing to pay premium price. As production increase and exceeds local consumption , export start taking place. Thus in the growth phase (Stage 2) the company experiences higher sales in home country. Simultaneously , it also exports in a big way. Also at this stage competitors begin to eat into the innovators market share.

The theory of International Product life cycle Raymond Vernon.

As years go by , the product enters the mature phase of its lifecycle (Stage 3) , an increasing percentage of sales is achieved through exporting. Simultaneously competitors form other countries will be working to develop similar product and will launch in the innovators home country. The innovator thus has to switch production to low-cost countries in order to survive. Also they will tap less developed countries. Finally in the decline phase (stage 4) the innovator will import from the low cost countries.

The theory of International Product life cycle Raymond Vernon.

The Photocopier market in US demonstrates this theory perfectly. Xerox first launched plain paper photocopier in USA. After catering to local users, it introduced its photocopiers in Japan and Europe (advanced countries). As demand began to grow in these countries, Xerox entered into JV IN JAPAN (Fuji-Xerox) and Britain (Rank-Xerox). In addition once Xeroxs patent on photocopier process expired, competitors began to enter the market (Canon in Japan, Olivetti in Italy) .

The theory of International Product life cycle Raymond Vernon.

As a result exports from US declined and users in US began to buy some of their photocopiers from lower cost foreign sources /comparable technology sources like Japan. More recently Japanese companies are finding manufacturing costs are too high in their country.

So they have began to switch production bases to Thailand, Malaysia and Singapore.
As a result , U.S and other advanced countries have switched from being exporters to importers of photocopiers. The evolution in the international trade in photocopiers is consistent with the prediction of the product life cycle.theory.

The theory of International Product life cycle Raymond Vernon.

This theory thus predicts that initially , the comparative advantage will exist in the innovating country. Over time , as the product becomes standardised , the country of comparative advantage will shift to lower factor cost locations . Also the theory points out that the innovative firm will start out as exporter and increasingly move towards direct investment abroad.