International Trade Theories

There are two approaches in international trade

theories
Laissez-faire approaches:
In this approach market forces determine trading
relationships between two countries.
Free trade theories believe that government policies
lead to inefficiency.
Interventionist theory: believes that certain
percent of intervention is needed in international trade
to balance import and export of any country.
 Mercantilism

believes that country’s wealth is measured by its holding

of treasure (gold). Country should export more than they
import. Get gold for trade difference.
Government policies: government should impose
restrictions on some products and subsidized local
products so that domestic products can compete in
both domestic and international market.
This theory was developed by colonizing countries to
import low valued raw materials from colonized
countries and export high valued manufactured goods
to them.
 Mercantilism

The concept of balance of trade:

A favorable balance of trade: Export>Import
An unfavorable balance of trade: Import>Export
Nowadays difference in trade is made up by holding the
deficit country’s currency denominated in that currency.
Surplus country grants credit to deficit country to buy
product and services from them.
Neomercantilism: A country that practices
Neomercantilism attempts to run an export surplus to
achieve social or political objectives.
 Classical Trade Theories

Absolute Advantage
This theory was developed by Adam Smith. This theory
believes that country’s wealth is based on its available
goods and services rather than on gold.
Some countries produce some goods more efficiently than
other countries.
Why the citizens of any country should have to buy
domestically produced goods when they could buy those
goods more cheaply from abroad?
Each country would specialize in those products that gave
it competitive advantage if trade were unrestricted.
 Classical Trade Theories

Benefits of specialization
Labor could become more skilled by repeating the
same tasks.
Labor would not lose time in switching from the
production of one kind of product to another
Long production runs would provide incentives for
the development of more effective working methods.
 Classical Trade Theories

Natural advantage: considers climate, natural

resources and labor force availability
Costa Rica: coffee, bananas
USA: wheat
Acquired advantage: consists of either product or
process technology
Germany: car, USA: software, Japan: steel
 Classical Trade Theories

How it works?
Country name
Costa Rica United States of America
100 resources 100 resources
 4 unit = 1 ton of coffee 100 unit = 5 ton of coffee
10 unit = 1 ton of wheat 100 unit = 20 ton of wheat
 Half/half
12.5 ton of coffee 2.5 of coffee
5 ton of wheat 10 tons of wheat
 
Total production
15 tons of coffee
15 tons of wheat
 
Using absolute advantage
25 tons of coffee 20 tons of wheat.
 Theory of comparative advantage

What happens when one country can produce all products at an

absolute advantage?
Gains from trade will occur even in a country that has absolute
advantage in all products because country must give up less
efficient output to produce more efficient output.

How it works?

Costa Rica United States of America

10 units = 1 ton of wheat or coffee 5 unit = 1 ton of coffee
4 unit = 1 ton of wheat
Here USA has absolute advantage on both products
 Theory of comparative advantage

Half/half
5 tons of wheat 10 tons of coffee
5 tons of coffee 12.5 tons of wheat
Total
15 tons of coffee
17.5 tons of wheat
After comparative advantage
Costa Rica USA
10 tons of coffee 25 tons of wheat
 Factor – proportion theory

What types of products does country trade?

This theory was developed by Eli Heckscher and bertil
Ohlin
This theory is based on production factors – land, labor
and capital
This theory said that difference s in countries’
endowments of labor compared to their endowments of
land or capital explain differences in cost of production.
According to FPT, factors in relative abundance are
cheaper than factors in relative scarcity
 Factor – proportion theory

People and land

Canada and Australia: wheat and wool
Hong Kong and Germany: textile and manufacturing
goods
Manufacturing locations:
Hong Kong clothing production but not automobile
Capital, labor rates and specialization
Nepal: handicrafts, carpet. USA: outsource customer
service job. India: call center
 Factor – proportion theory

Process technology:
South Asian countries use small machines that need
human labor for growing rice. Developed countries
like Italy used capital intensive method.
Product technology:
Manufacturing needs acquired advantage, large
number of skilled man power and capital.
Developed country: Acquired advantage
Developing country: Natural advantage
 Neo-Factor proportion Theory

Some of the economist emphasis on the point that it

is not only the abundance of a particular factor, but
also the quality of that factor of production that
influences the pattern of international trade.
 The quality is so important in their view that they
analysis the trade theory in a three-factor
framework:
 Neo-Factor proportion Theory

Human capital: It is the result of better education and training. Human

capital should be treated as a factor input like physical labor and capital. A
country with human capital maintains an edge over other countries with
regards to the export of commodities produces with the help of improved
human capital.

Skill Intensity: The skill intensity hypothesis is similar to human capital

hypothesis as both of them explain the capital embodied in human beings. It
is only empirical specification that differs.

Economies of Scale: It explains that with rising output, unit cost decreases.
The producers achieve internal economies of scales. A country with large
production possesses an edge over other countries with regards to export.
However, a small country can reap such advantages if it produces exportable
in large quantities
 Country similarity theory

With whom do countries do trade?

Says that any product produced in home country can
be easily marketed and consumed in similar
countries. ( similar in terms of development, culture,
religion and distance)
IPhone from USA has good market in Europe too.
Luxury cars from Germany have good market in USA
too.
 Country similarity theory

Specialization and Acquired advantage

Germany: machinery and equipment, France:
perfumes and cosmetics, USA: Boeing
Developing countries also gained advantage through
specialization
Bangladesh: textile, apparel, Pakistan: sports kits.
 Country similarity theory

Product differentiation:
Trade also occurs because companies differentiate
products thus creating two-way trade in similar
products.
USA: Boeing, tourism. Europe: Airbus, tourism.
The effects of cultural similarity
Spain and Latin America, France and Africa,
England and south Asia.
 Country similarity theory

The effects of political relationship and economic

agreement:
Political relationships and Economic agreements
among countries may encourage or discourage trade
between them.
USA imports sugar from Mexico and Dominican
Republic instead of Cuba. European Union.
The effects of distance:
Greater distance means higher transportation cost. Acer
Taiwanese computer maker built a plant in Finland to
serve Russia.
 The porter diamond (national
competitive advantage)
Why do specialized competitive advantages differ among
countries?
Why Italian companies have an advantage in the ceramic
tile industry?
Porter diamond theory says company needs four
conditions (listed below) favorable for an industry within a
country to attain global supremacy.
Demand condition
Factor condition( natural advantage)
Relating and supporting industries
Firm strategy, structure and rivalry
 Gains from trade

Specialization:
Because of natural advantages some countries are
better in producing certain things than other
countries.
When this natural advantage become countries
absolute advantage then specialization starts
Specialization makes any country better in
production by doing same thing again and again.
 Gains from trade

Employment:
Professor/ secretary analogy
Professor has absolute advantage over secretary on
both research and office works. (suppose)
But professor will choose research work because
research work makes more money than office works
and create an employment for secretary.
 Gains from trade

Maximum utilization of resources:

Because of international trade any country can get any product
from other countries.
Now country can produce only those products which are
suitable to country’s natural environment. This leads to
maximum utilization of available resources.
Greater choice of products for consumers in good price:
Why the citizens of any country should have to buy domestically
produced goods when they could buy those goods more cheaply
from abroad?
Each country can produce only those products on which they
good at. Other items they can trade with other countries
 Gains from trade

Trade speeds up the pace of technological progress

innovation:
Natural advantage leads to specialization.
Specialization to acquired advantage
Acquired advantage leads to technological progress and
innovation.
Economies of scale:
Natural advantage and specialization leads to mass
production
Mass production means less operating cost. Now
customers can get products in good price.
 Gains from trade

Political benefits from expansion of global

trade:
Because of absolute and comparative advantage
countries are forced to do international trade.
International trade will leads to other ideas and
information too.
International trade will leads to political agreements
and that will be mutually beneficial for participating
countries
 Terms of trade

The terms of trade measures the rate of exchange

of one good or service for another when two
countries trade with each other. 
For international trade to be mutually beneficial for
each country, the terms of trade must lie within the
opportunity cost ratios for both country. 
 Terms of trade

ToT = 100 x Average export price index / Average import price

index
If export prices are rising faster than import prices, the terms
of trade index will rise. This means that fewer exports have to
be given up in exchange for a given volume of imports. 
If import prices rise faster than export prices, the terms of
trade have deteriorated. A greater volume of exports has to be
sold to finance a given amount of imported goods and services.
The terms of trade fluctuate in line with changes in export and
import prices. Clearly the exchange rate and the rate of
inflation can both influence the direction of any change in the
terms of trade.
 Terms of trade

OIL PRICES AND THE TERMS OF TRADE

OPEC countries are heavily dependent on exporting oil.
And volatility in international commodity markets creates
serious problems with these countries’ terms of trade.
When oil values collapsed in 1998, OPEC countries faced
the enormous problem of having to export much more oil
to pay for a given volume of imports. The worsening in
the terms of trade will have adversely affected living
standards in these countries.
There has been a sharp rebound in global oil prices this
year, helping to boost the terms of trade for oil exporters.