INTERNATIONAL

UNIT 4 SECTION 1 COUNTRY-BASED TRADE THEORIES

BUSINESS Unit 4, section 1: Country-based trade theories

You are welcome to the first Section of Unit 4 that deals with the country-
based trade theories. International trade is trade between residents
(individuals, firms, not-for-profit organisations, or other forms of
association) of two countries. Why do nations trade? These residents believe
that they will benefit from the voluntary exchange. A more useful
explanation is provided by trade theories, which focus on specialisation of
effort. Businesses, consumers, workers, and scholars have attempted to
develop theories to explain and predict the forces that motivate such trade.

By the end this Section, you should be able to;

 define the term international trade and discuss the role of mercantilism
in modern international trade.
 contrast the theories of absolute advantage, comparative advantage and
relative factor endowment

Read on

Theory of Mercantilism
At the national or country level, there are two basic questions: why do
nations trade? And how can nations enhance their competitive advantage?
One of the earliest, and simplest, answers was provided by mercantilism in
the 1500s, which held the view that a government could improve economic
well-being by encouraging exports and stifling (or discouraging) imports.

Nations received payment for exports in gold, so exports increased their

gold stock, while imports reduced it because they paid for imports with their
gold. Thus, exports were seen as good and imports as bad. Because a
nation’s power and strength increase as its wealth increases, mercantilism
argued that national prosperity resulted from a positive balance of trade
achieved by maximising exports and minimising or even impeding imports.
Support for this theory was based on the impact of trade on domestic
production and employment. Exports increased domestic production and
provided jobs for domestic workers, while imports were seen to replace
domestic production and force workers out of job.

Many people still believe that running a trade surplus is beneficial. They
subscribe to a view known as neo-mercantilism. Labour unions (which seek
to protect home-country jobs), farmers (who want to keep crop prices high),
and certain manufacturers (those that rely heavily on exports) all tend to
support neo-mercantilism. But, mercantilism tends to harm the interests of
firms that import, especially those that import raw materials and parts used
in the manufacture of finished products. It also harms the interests of
consumers because restricting imports reduces the choice of products to
buy. Product shortages that result from import restrictions may lead to
higher prices. When taken to an extreme, mercantilism may promote the
benefits of one country at the expense of others, as it also fails to recognise
potential gains in economic welfare that arise from the comparative

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advantage of using resources in the most efficient manner. Finally, it is

incorrect to believe gold has value in itself. Gold has value when it is used
or traded for other consumption or production goods. If a nation exchanges
productive assets and consumption goods in other to accumulate gold, it is
decreasing its productive capacity in exchange for an idle resource.

The Theory of Absolute Advantage

In 1776, Scottish political economist Adam Smith attacked the mercantilist
view by suggesting that nations benefit most from free trade. He argued that
by trying to minimise imports, a country wastes much of its national
resources in the production of goods it is not suited to produce efficiently.

Relative to others, each country is more efficient in the production of some

products and less efficient in the production of other products. Smith’s
absolute advantage principle states that ‘a country benefits by producing
primarily those products in which it has an absolute advantage or that it can
produce using fewer resources than another country’. Each country thus
increases its welfare by specialising in the production of certain products,
exporting them, and importing others. This approach allows the nation to
consume more than it otherwise could, generally at lower cost.

Assuming Ghana and Nigeria are engaged in a trading relationship. It takes

an average worker in Ghana 30 days to produce one ton of cloth and 40 days
to produce one ton of wheat. It takes an average worker in Nigeria 100 days
to produce one ton of cloth and 20 days to produce one ton of wheat. Ghana
has an absolute advantage in the production of cloth, since it takes only 30
days of labour to produce one ton compared to 100 days for Nigeria. Nigeria
has an absolute advantage in the production of wheat, since it takes only 20
days to produce one ton compared to 40 days for Ghana. If both Ghana and
Nigeria were to specialise, exchanging cloth and wheat at a ratio of one-to-
one, Ghana could employ more of its resources to produce cloth and Nigeria
could employ more of its resources to produce wheat. Ghana can import one
ton of wheat in exchange for one ton of cloth, thereby “paying” only 30
labour-days for one ton of wheat. If Ghana had produced the wheat itself, it
would have used 40 labour-days, so it gains 10 labour-days from the trade.

In a similar way, Nigeria gains from trade with Ghana. Another example is
that Japan has no natural holdings of oil but makes some of the best
automobiles around. Saudi Arabia has no car manufacturing to speak of but
has much crude oil. Thus, it would be wasteful for either to focus on their
weakness. Instead, by trading together, both countries benefit.

The Theory of Comparative Advantage

In 1817, British political economist David Ricardo explained why it is
beneficial for two countries to trade even though one of them might have
absolute advantage in the production of all products. He demonstrated that

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what matters is not the absolute cost of production, but rather the relative
efficiency with which the two countries can produce the products. Hence,
the comparative advantage principle states that it can be beneficial for two
countries to trade without barriers as long as one is relatively more efficient
at producing goods or services needed by the other. The principle of
comparative advantage is the foundation and overriding justification for
international trade.

The theory holds that nations should produce those goods for which they
have the greatest relative advantage. Thus, there are gains from trade
whenever the relative price ratios of two goods differ under international
exchange from what they would be under conditions of no trade. Trade
provides greater economic output and consumption to the trade partners
jointly as they specialise in production, exporting the goods in which they
have a comparative advantage and importing the goods in which they have a
comparative disadvantage. Also known as country-specific advantage,
comparative advantage includes ‘inherited’ resources, such as labour,
climate, arable land, and petroleum reserves, as enjoyed by the Gulf nations.
Other types of comparative advantages are acquired over time, such as
entrepreneurial orientation, availability of venture capital, and innovative
capacity. Japan showed that massive investment in an industry (consumer
electronics) can act to acquire comparative advantage.

To illustrate, let’s modify the example of Ghana and Nigeria. Suppose now
that Nigeria has an absolute advantage in the production of both cloth and
wheat. That is, in labour-per-day terms, Nigeria can produce both cloth and
wheat in fewer days than Ghana. Based on this new scenario, you might
initially conclude that Nigeria should produce all the wheat and cloth it
needs and not trade with Ghana at all. However, even though Nigeria can
produce both items more cheaply than Ghana, it is still beneficial for
Nigeria to trade with Ghana.

Rather than the absolute cost of production, it is the ratio of production costs
between the two countries that matters. In the exhibit, Nigeria is
comparatively more efficient at producing cloth than wheat: It can produce
three times as much cloth as Ghana in the same number of labour days
(30/10), but only two times as much wheat (40/20). Thus, Nigeria should
devote all its resources to producing cloth and import all the wheat it needs
from Ghana. Ghana should specialise in producing wheat and import all its
cloth from Nigeria. Both countries can then each produce and consume
relatively more of the goods they desire for a given level of labour cost.
Ghana and Nigeria should specialise in what they do best. Nigeria should
import wheat since Nigeria makes cloth most efficiently.

Factor Endowment Theory

In the 1920s, two Swedish economists, Eli Heckscher and his student, Bertil
Ohlin, proposed the Factor endowment theory otherwise referred to as

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Heckscher-Ohlin theory. The theory holds that countries will produce and
export products that use large amounts of production factors that they have
in abundance, and will import products requiring large amounts of
production factors that are scarce in their country. The theory is useful in
extending the concept of comparative advantage by bringing into
consideration the endowment and cost of factors of production. The theory
also helps explain why nations with relatively large labour forces, such as
China, concentrate on producing labour-intensive goods, while countries
such as the Netherlands, which have relatively more capital than labour,
specialise in capital-intensive goods.

One weakness about the theory is that some countries have minimum wage
laws that result in high prices for relatively abundant labour. As a result, the
country may find it less expensive to import certain goods rather than to
produce them internally. Another weakness is that countries like the United
States actually export relatively more labour-intensive goods and import
capital-intensive goods, an outcome that appears surprising. This result,
known as the Leontief paradox, has been explained in terms of the quality of
labour input rather than in terms of just man-hours of work. The United
States produces and exports technology-intensive products that require
highly educated labour. These problems with factor endowment theory help
us understand why no single theory can explain the role of economic factors
in trade theory.

Lessons that could be derived from the afore-mentioned country-based

theories are that;
 international trade should be encouraged as there are possible gains from
trade
 division of labour and specialisation are essential for developing
competitive edge in international trade
 trade can still go on if a country possesses absolute advantage in both
products it produces and vice versa, thanks to the theory of comparative
advantage
 Notwithstanding the gains, the theories also failed to account for factors
that make trade complex such as;
 high transportation costs involved in international transactions
 governments restrictions that hamper trade such as tariffs, import
barriers, and other regulations
 difficulty or inability to trade in some services such as banking and
retailing
 large scale production in certain industries may bring about scale
economies
 traded goods aren’t commodities – customers have strong brand
preferences and desire unique features

Governments and managers use these theories when they design policies
they hope will benefit their countries’ industries and citizens, and

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identifying promising markets and profitable strategies respectively. While

no one theory offers a complete explanation of why nation’s trade, they
collectively provide important insights into the area. Other key
considerations that offer explanations for why nations trade include
monetary currency valuation and consumer tastes.

Activity 4.1
 Explain what the world would be like without international trade.
 How is the theory of absolute advantage similar to that of comparative
advantage? How is it different?
 Does the theory of comparative advantage apply to China’s trade with
industrialized countries? How?
 In Adam Smith's opinion, mercantilism has a positive impact on a
nation's wealth because it makes many wealthy people wealthier.
True/False
 Farm land, diamond mines, and good climate conditions would all be
categorized as comparative advantages for a region. True/False

Did you score all? That’s great! Keep it up.

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