MNGT6: International Business and Trade 1
LESSON 2
TRADE THEORIES AND CONCEPTS
Learning Objectives:
1. Compare and contrast different trade theories.
2. Determine which international trade theory is most relevant today and how it continues to evolve.
Reasons for trade
A. Proximity
The proximity of Canada to the United States means lower transportation costs relative to trade
between the United States and countries in Asia or Europe. This close distance between two
neighboring countries may explain why Canada is not only one of the top exporters of snowboards
to the United States but also its largest trading partner. Proximity may also the reason why
European countries mainly trade with each other, whereas Japan and China is the largest trading
partner for many Asian countries. Countries located in close proximity of one another often join into
a free trade area to promote trade by eliminating barriers to trade such as tariffs and quotas.
B. Resources
Land, labor and capital are often referred to as factors of production because these resources are
used to produce goods and services. Taiwan is able to sell at considerably low prices because the
snowboards imported from this country are unfinished. The process of spreading production
across several countries by a company that imports the unfinished goods for further processing at
lower price is known as outsourcing. The available resources of China is the reason why it became
the top exporter of snowboard in United States.
Classical Theories of International Trade
1. Mercantilism
Developed in the sixteenth century, mercantilism was one of the earliest efforts to develop an
economic theory. This theory stated that a country’s wealth was determined by the amount of its
gold and silver holdings. This mercantile system was based on the premise that national wealth and
power were best served by increasing exports and collecting precious metals in return.
2. Smith’s Theory of Absolute Advantage
The ability of a party (individual, firm or country) to produce a greater quantity ofthgoods and services
than competitors using the same resources. This theory was developed by 18 century economist
Adam Smith in his book “The Wealth of Nation”.
3. Comparative advantage (Ricardian Model)
To determine trade partners, we need to examine the relative rather than absolute differences
between countries. A country with maximum absolute advantage in the creation of more than one
product as compared to other, can still trade with another country.
MNGT6: International Business and Trade 2
4. Heckscher-Ohlin Trade theory of Factor Proportions
According to this theory, one condition for trade is that the countries differ with respect to the
availability of the factors of production. The Heckscher-Ohlin Theory suggests that a country
specializes in the production of goods that it is particularly suited to produce.
5. Leontief Paradox
The observation by Wassily Leontief (1906–1999) that in spite of being the world's most capital-rich
country, the US appeared on average to have exports that were slightly more labor-intensive than
its imports. This was thought to be paradoxical because the Heckscher–Ohlin model of international
trade led people to expect that US exports would be capital-intensive and its imports would be labor
-intensive.
Modern or Firm-Based Trade Theories
1. Country Similarity Theory
This theory was developed by Swedish economist Steffan Linder. The idea that countries with
similar qualities are most likely to trade with each other. These qualities may include level of
development, savings rates, and natural resources, among others.
2. Product Life Cycle Theory
Raymond Vernon, a Harvard Business School professor, developed the product life cycle theory in
the 1960s. The theory, originating in the field of marketing, stated that a product life cycle has three
distinct stages: (1) new product, (2) maturing product, and (3) standardized product. The theory
assumed that production of the new product will occur completely in the home country of its
innovation.
3. Global Strategic Rivalry Theory
Global strategic rivalry theory emerged in the 1980s and was based on the work of economists Paul
Krugman and Kelvin Lancaster. Their theory focused on MNCs and their efforts to gain a
competitive advantage against other global firms in their industry.
4. Porter’s National Competitive Advantage Theory
In the continuing evolution of international trade theories, Michael Porter of Harvard Business
School developed a new model to explain national competitive advantage in 1990. Porter’s
theory stated that a nation’s competitiveness in an industry depends on the capacity of the industry
to innovate and upgrade. His theory focused on explaining why some nations are more competitive
in certain industries.
Porter identified four determinants:
local market resources and capabilities
local market demand conditions
local suppliers and complementary industries, and
local firm characteristics.
