Theories of

international trade

Introduction
International trade becomes possible
for mutual benefits to the two
countries due to the differences in
opportunity cost
It has gain a comparative advantage
There are nine types of theories
developed by the international
economist

Types of theories

Mercantilism
Theory of absolute cost advantage
Comparative cost advantage
Comparative cost advantage with money
Relative factor endowments/HukscherOwen theory
Country similarity theory
Product life cycle theory
Global strategic rivalry theory
Porters national competitive advantage

Mercantilism
Holdings of the country treasure primarily in
form of gold constituted its wealth
It specifies that countries should export more
than they import and receive the value of
trade surplus in form of gold from those
countries which experience trade deficits
This theories suggest for maintaining
favorable balance of trade in the form of
import of gold for export of goods and
services

Neo-Mercantilism
It proposes that countries attempt to
produce more than the demand in the
domestic country in order to achieve a
social objective
It attack on the ground that the wealth of
a nation is based on its available goods
and services rather than the gold

Theory of Absolute Cost

Advantage
Adam Smith advocates free trade
among countries to increase a
countries' wealth
Free trade enables a country to
provide a variety of goods and
services to its people by specializing
in the production of some goods and
services and importing others
Which is to produce and which is to
import?

Skilled labor and specialization

advantage
Suitability of the skill of the labor of the
country in producing certain products
Specialization of labor
Economies of scale would reduce the
labor cost per unit of output
Natural advantage it is due to climatic
conditions and natural resources
Acquired advantage it is due
technology and skill development

Assumption of this
theory
Trade between two countries
Only two commodities are traded
Free trade exist between the
countries
The only element of cost of
production is labor

Implications
Two countries have more quantities of
both the products
Increased standard of living
Inefficiency in producing certain products
can be avoided
Global efficiency and effectiveness can be
increased
Global labor and resource productivity can
be increased

Criticism

No Absolute Advantage
Country size
Variety of resources
Transport cost
Scale economies
Absolute advantage for many
products

Comparative Cost
Advantage Theory
A country should produce and export
those products for which it is relatively
more productive than that of others
countries and import those goods for
which other countries are relatively more
productive than it is

Assumptions

It exist full employment

Only element of cost of production
There are no trade barriers
Trade is free from cost of production
Trade takes place between two
countries
Only two products of traded
There are no cost of transport etc.

Implications
Efficient allocation of global resource
Maximization of global production at least
cost
Product price become more or less equal
among world markets
Demand for resources and products
among world nation will be optimized

Comparative advantage with

money
Absolute differences in money prices
determine international trade
According to F.W.Taussig
comparative differences in labor cost of
commodities can be translated into
absolute difference in prices without
affecting the real exchange relations
between products

Criticisms

Two countries
Transportation cost
Two products
Full employment
Economic efficiency
Division of gains
Mobility
services

Relative factor
endowment
Factors endowments are:
Land
Capital
Natural resources
Labor
Climate etc
It may vary among countries

 According to this economist

If labor is available in abundance in relation
to land and capital in a country, the price of
labor would be low and the price of land
and capital would be high in that country
These relative cost would lead countries to
produce at low costs
Countries participate in trade by exporting
those products which they can produce at
low cost upon abundance of factors and
import other products which they can
produce comparatively at high cost

Land-labor relationship
Labor-capital relationship
Leontief paradox
Technological complexity

Firm based theory

Country similarity theory

Product life cycle theory
Global strategic rivalry theory
Porters national competitive
advantage theory

Country similarity theory

International trade takes place within each industry
between two countries
Economic similarity of developed countries
International trade takes place among the
countries that are at the same stage of economic
development
Similarity of location
Advantage of less transportation cost
Cultural similarity
Similarity of political and economic interest
Made agreement with politically friendly countries

Product life cycle theory

PLC theory provides inputs for
manufacturing, trade and investment
decisions.
It consists of four stages:
Introduction
Growth
Maturity
decline

Four stages of PLC

New product
Firm innovate new product based on
needs and problem in domestic country
Location of innovation (financial ability,
customers demand, availability of R&D,
severe competition)
Labor as a major input ( customer
feedback)
Feedback and development

Four stages of PLC

Growth
Attracting competitors
Increased exports
Further innovation
Shift manufacturing to foreign countries
Maturity
Standardized products
Large scale production and economies
Low unit cost of production
Shift manufacturing to developing countries

Four stages of PLC

Decline
Location of manufacturing facilities in
developing countries
Original innovating country becomes net
importer

Limitations of PLC theory

it cannot achieve cost reduction with rapid
innovation
Non cost strategies reduce opportunity for
cost minimization
Rapid technological development may not
shift production to various foreign units
MNC take advantage on raw material, HR,
transportation cost etc. but not based on
PLC model

Global strategic rivalry

theory
It focus on firms strategic decision to
acquire and develop competitive advantage
in order to compete internationally
Company acquire competitive advantage
through:
Owning intellectual property rights
Investing in research and development
Achieving large scale economies
Exploiting the experience curve

Porters national competitive

advantage theory
It depends upon four factors:
Factors conditions ( research, innovation
and training)
Demand conditions
Related and supported industries
Firm strategy, structure and rivalry
( quality, design and R&D)