INTERNATIONAL

ECONOMICS
International Trade Theories
Lecture 3
The Importance of Trade Theory
Trade theory helps managers and government
policymakers focus on three critical questions;

What products should we import and export?

How much should we trade?
With whom should we trade?

While descriptive theories suggest a laissez-faire

treatment of trade, prescriptive theories suggest that
governments should influence trade patterns.
What is laissez- faire????
Trade and Investment Policies
Import substitution: a policy of developing domestic
industries to manufacture goods and provide services
that would otherwise be imported

Strategic trade policy: the identification and

development of targeted domestic industries in order
to improve their competitiveness at home and abroad
International Trade Theories
Interventionist Theories
Meaning that government intervention in trade or trade related
aspects;
 Mercantilism
 Neo-mercantilism

Free Trade Theories

Which supports the argument of nations should neither
artificially limit imports or promote exports;
 Absolute advantage
 Comparative advantage
International Trade Theories
cont…
Theories Explaining Patterns of Trade
Theories which examine trade patterns such as; How much
countries depend on trade, what products they trade and with
which partner nations they trade, etc…
 Country Size
 Factor proportion
 Country similarity

Theories dealing with dynamics & stability of

countries
 Product Life Cycle
 Porter Diamond
 Interventionist Theories
Interventionist trade theories prescribe government action
with respect to the international trade process.
Mercantilism: A theory that purports that a country’s wealth is
measured by its holdings of treasure (usually gold)
To amass a surplus (a favorable balance of trade), a country must export more than it imports and
then collect gold and other forms of wealth from countries that run trade deficits (unfavorable
balances of trade).
Neomercantilism: the more recent strategy of countries that use
protectionist trade policies in an attempt to run favorable balances of
trade and/or accomplish particular social or political objectives.
Free Trade Theories:
Absolute Advantage
Absolute advantage [Adam Smith, 1776]:
A country can;
(i) maximize its own economic well being by
specializing in the production of those goods and
services that it produces more efficiently than any
other nation and
(ii) Enhance global efficiency through its participation
in free trade.
Free Trade Theories:
Absolute Advantage cont…
Smith reasoned that:
Workers become more skilled by repeating the same
tasks
Workers do not lose time in switching from the
production of one kind of product to another
Longer production runs provide greater incentives for
the development of more effective working methods
Natural vs. Acquired Advantages
A natural advantage may exist because of:
given climatic conditions
access to particular resources
the availability of labour, etc.
An acquired advantage may exist because of:
superior skills
better technology
greater capital assets, etc.
Real income depends on the output of products as
compared to the resources used to produce them.
Free Trade Theories:
Comparative Advantage
Comparative advantage [David Ricardo, 1817]:
A country can;
(i) maximize its own economic wellbeing by
specializing in the production of those goods and
services it can produce relatively efficiently and
(ii) enhance global efficiency via its participation in free
trade.
Free Trade Theories:
Comparative Advantage cont...
Ricardo also reasoned that:
A country can simultaneously have an absolute and a
comparative advantage in the production of a given
product.

By concentrating on the production of the product in

which it has the greater advantage, a country can further
enhance both global output and its own economic well-
being
Production Possibilities with comparative
advantage
Assumptions and Limitations of free trade
theories
The theories of absolute and comparative advantage
both make assumptions that may not be entirely valid.
 Full employment of resources
 Exclusive pursuit of economic efficiency objectives
 Equitable division of gains from specialization
 Only two countries and two commodities
 Exclusion of transport costs
 A static rather than a dynamic view
 Exclusion of services
 Unrestricted factor mobility
Theories Explaining Patterns of Trade:
Country Size/How much a country trade?
Large countries differ from small countries in at least
two critical ways:
Large countries tend to export a smaller portion of their
output and import a small portion of their consumption.
Large countries are more apt to have varied climates and a greater
assortment of natural resources than smaller countries, thus making large
countries more self-sufficient.
Large countries tend to have higher transportation costs for
exported and imported products.
Given the same types of terrain and modes of transportation, the greater the
distance, the higher the associated transport costs. Thus, firms in large
countries often face higher transport costs in terms of sourcing inputs from
and delivering outputs to distant foreign markets than do their closer foreign
competitors.
Leading 2003 Exporting and Importing
Nations: Merchandise Trade
Theories Explaining Patterns of Trade: Factor
Proportions Theory/What type of products
Factor proportions [Eli Heckscher, 1919; Bertil Ohlin,
1933]:
Differences in a country’s relative endowments of
land, labour, and capital explain differences in the cost
of production factors.
A country will tend to export products that utilize
relatively abundant production factors because they
are relatively cheaper than scarce factors.
The composition of a country’s trade depends on both its natural and acquired
advantages. With respect to the latter, both production and product technology can
be very important.
 World Trade by Major Product Category as a
Percentage of World Trade for Selected
Years

Source: International Trade Statistics, 2004 (Geneva: World Trade Organization)

Country Similarity Theory
When a firm develops a new product in response to
observed conditions in its home market, it is likely to turn
to those foreign markets that are most similar to its
domestic market when commencing its initial
international expansion activities.
This tendency is reflective of:
the cultural similarity of nations
the similarity of national political/economic interests
the economic similarity of industrialized countries
Countries that are near to one another enjoy relatively lower transportation costs
than those that are more distant, but they may or may not be similar with respect
to culture, level of economic development, and/or political/economic interests.
 Product Life Cycle (PLC) Theory
The optimal location for the production of certain types of
goods and services shifts over time as they pass through the
stages of: (i) introduction, (ii) growth, (iii) maturity, and (iv)
decline.
Exceptions to the typical pattern of the PLC would include:
products that have very short life cycles
luxury goods and services
products that require specialized labour
products that are differentiated from competitive offerings
products for which transportation costs are relatively high
During the decline stage, a product is often imported by the country where it was
initially developed; however, the importing firm may or may not be the innovating
firm.
Porter’s Diamond of National
Competitive Advantage [1990]
The Porter Diamond theorizes that national competitive
advantage is embedded in four determinants:
factor endowments
demand conditions
related and supporting industries
firm strategy, structure, and rivalry
All four determinants are interlinked and generally must be
favourable for a given national industry to attain global
competitiveness.
At times, determinants can be affected by the roles of chance and government.
Implications/Conclusions
Production factors are neither as mobile nor as
immobile as theories assume.
While the free trade theories of absolute and
comparative advantage are descriptive in nature, the
interventionist theories of mercantilism and
neomercantilism are prescriptive in nature.
The theories of country size, factor proportions, and
country similarity help explain patterns of trade; the
product life cycle and Porter’s Diamond help explain
the dynamics of trade.