International Trade Theories

1. Theories of International Trade
• Mercantilism is the oldest international trade theory that
formed the foundation of economic thought during about
1500 to 1800.
• According to this theory the holding of a country’s
treasure primarily in the form of gold constituted its
wealth. The theory specifies that countries should export
more than they import and receive the value of trade
surplus in the form of gold from those countries which
experience trade deficit.
• GOVT. imposed restriction on imports and encouraged
exports in order to prevent trade deficit and experience
trade surplus.

2. • Colonial powers like the British used to
trade with their colonies like India, Srilanka
etc. by importing the raw material from
and exporting the finished goods to
colonies.
• The colonies had to export less valued
goods and import more valued
Thus colonies were prevented
goods.
from
manufacturing.
• This practice allowed the colonial power to
enjoy trade surplus and forced the
colonies to experience deficit.

3. • The mercantilism theory suggests for maintaining
favorable balance of trade in the form of import of gold
for export of goods and services. But the decay of gold
standard reduced the validity of theory. Consequently
this theory was modified in neo mercantilism.
• Neo mercantilism proposes that countries attempt to
produce more than the demand in the domestic market
in order to achieve a social objective like full employment
in the domestic country or a potential objective like
assisting a friendly country.
• The theory was criticized on the ground that the wealth
of nation is based on its available goods and services
rather than gold.
• Adam smith developed the theory of absolute cost
advantage which says that different countries can get the
advantage of international trade by producing certain
goods more efficiently than others .

4. Absolute Cost Advantage Theory
• Adam smith, the Scottish economist viewed free trade
enables to country to produce a variety of goods and
services. Smith proposes the theory of absolute cost
advantage theory of international trade based on the
principle of division of labor.
• According to theory the principle of absolute cost
advantage will help the countries to specialize in the
production of those goods in which they have cost
advantage over others.
According to theory every country should specialize in
producing those products at the cost less than that of
other countries.
Trade between two countries takes place when one
country produces one product at less cost than that of
another country and having a cost advantage and vice
versa.
•
•

5. Skilled advantage and specialization advantage
• Countries have absolute cost advantage due to:
• Economies of scale
• Suitability of the skill of the labor of the country
in producing certain products.
• Specialization of labor in producing certain
products leads to higher productivity and less
labor cost per unit of output.
• Natural Advantage natural advantage is due to
climatic conditions and natural resources.
• Acquired Advantage acquired advantage is
due to technology and skill development.

6. Assumption of the theory
• Trade is between two countries only
• Only two commodities are traded
• Free trade exists between the countries
• The only element cost of production is
labor

7. Explanation of theory
Output per
labor for 1 day
Japan India
pens 20 60
Tape recorder 6 2

8. • In the table given below two countries India and
Japan are two countries having advantage in
producing the pens and tape recorder.
• Ability of labor to produce different goods and
services in a day is known as production
possibility.
• In Japan one day of labor can produce 20 pens
or 6 audio recorder.
• In India one day of labor can produce either 60
pens or 2 tape recorders.
• Japan has an absolute advantage in the
production of audio tape recorder and India’s
advantage is in pens.

9. • Assume that India and Japan are able to
trade with one another, then both will get
the advantage. Suppose Japan agrees to
exchange 4 audio tapes for 40 pens.
• Two days of Japanese labor is needed to
produce 40 pens and only 0.67 days of
labor for 4 recorder. Thus Japan can save
1.33 days of labor(2 - 0.66) if it export tape
recorders to India and imports pens from
India

10. • India needs 2 days of labor to produce 4 audio
tape recorders and 0.67 days of labor is enough
to produce 40 pens. India can save 1.33 days of
labor (2 – 0.67) by exporting pens to Japan and
importing recorders
• Thus two countries can save labor by trading
with each other rather than by producing both
the products. The saved labor hours can be
used for the production of more audio recorder
by Japan and pens by India.
• Japan can consume more pens by allocating its
labor to produce tape recorders and by trading
with India and vice versa in case of India.

11. If countries produce both the
products
30
25
20
15
10
5
0 tape recor pens
Japan 3 10
India 1 30

12. Production possibility of countries
60
50
40
30
20
10
0 tape record. pens
japan 6 20
india 2 60

13. Implications of theory
• By trading two countries can have more
quantities of both the products.
• Living standard of the people of both the
countries can be increased by trading between
the countries.
• Inefficiency in producing certain countries can
be avoided.
• Global efficiency and effectiveness can be
increased by trading.
• Global labor productivity and other resources
productivity can be maximized.

14. Criticism of the theory
• No absolute advantage
• Country size
• Variety of resources
• Transport cost
• Scale economies
• Absolute advantage for many products

15. Comparative Cost Theory
• The comparative cost theory was first systematically
formulated by the English economist David Ricardo in
the principle of political economy and taxation in 1817. it
was later refined by J.S.Mill, Marshall, Taussig and
others.
• In a Nutshell the doctrine of comparative cost maintains
that if trade if left free, each country in the long run tends
to specialize in the production and export of those
commodities in whose production it enjoys a
comparative advantage in terms of real cost and to
obtain by import those commodities which could be
produced at home at a comparative disadvantage in
terms of real cost and that such specialization is to the
mutual advantage of the countries participating in it.

16. Assumptions
•
•
Labor is only element of cost of production.
Goods are exchanged against one another
according to the relative amount of labor embodied
in them.
• Labor is perfectly mobile within the country not
outside.
•
•
•
•
•
•
•
Labor is homogeneous
Production is subject to the law of constant return.
Free trade and no trade barriers.
No transportation cost
There is full employment
There is perfect competition
There are only two commodities and two countries.

17. Explanation
• The law of comparative advantage indicates that
a commodity should specialize in the production
of those goods in which it is more efficient and
leave the production of the other commodity to
the other country. The two countries will then
have more of both goods by engaging in trade.
• Ricardo in his two country two commodity model
has taken the hypothetical example of
production costs of cloth and wine in England
and Portugal to illustrate the comparative cost
theory.

18. Country No of units
of labor per
unit of cloth
No of unit
of labor per
unit of wine
Exchange
ratio
England 100 120 1 wine =
1.2 cloth
Portugal 90 80 1 wine = .
88 cloth

19. • From the above example it is evident that
Portugal has an absolute superiority of
production. However a comparison of the ratio of
the cost of wine production ( 80/120 ) with ratio
of the cost of cloth production (90/100) in both
the countries reveals that Portugal has an
advantage superiority in both the branches of
production. It will concentrate on the production
of wine in which it has comparative advantage
over England, while importing cloth from
England which has a comparative advantage in
cloth production. England will gain by
specialization in producing cloth and selling it to
Portugal in exchange for wine.

20. • In the event of trade taking place under
the assumption that within each country
labor is perfectly mobile between various
industries, Portugal will gain if it can get
anything more than .88 units of cloth in
exchange for one unit of wine and
England will gain if it has to part with less
than 1.2 units of cloth against one unit of
wine. Hence any exchange ratio between
0.88 units and 1.2 units of cloth against
one unit of wine represents a gain for both
the countries. The actual rate of exchange
will be determined by reciprocal demand

21. • Thus according to the comparative cost theory
free and unrestricted trade among countries
encourage specialization on a large scale. It
thereby tends to bring about:
• The most efficient allocation of world resources
as well as maximization of world production.
• A redistribution of relative product demands
resulting in greater equality of product prices
among trading nations and
• A redistribution of relative resource demands to
correspond with relative product demands,
resulting in relatively greater equality of resource
prices among trading nations.

22. Implications of the theory
• Efficient allocation of global resources
• Maximization of global production at the least
possible cost
• Product prices become more or less equal
among world market
• Demand for resources and products among
world nations will be maximized
• It is better for the countries to specialize in those
products which they relatively do best and export
them
• It is better for the countries to buy other goods
from other countries who are relatively better at
producing them

23. • Comparative cost theory is really an
improvement over absolute cost
advantage. This theory is not only an
extension to the principle of division of
labor and specialization but applies the
opportunity cost concept. It is also argued
that lower labor cost need not be a source
of comparative advantage.
• However Ricardo fails to consider the
money value of cost of production.
• F.W.Taussig bridged this gap in
comparative cost advantage theory.

24. Criticism of theory
• Two countries
• Transportation cost
• Two products
• Full employment
• Economic efficiency
• Division of gains
• Mobility servies

25. Product life cycle theory
• Raymond Vermon of the Harvard Business
school developed the Product Life cycle theory.
International product life cycle theory traces the
roles of innovation market expansion
comparative advantage and strategic response
of global rivals in international manufacturing
trade and investment decision.
• International product life cycle consists of four
stages:
• New product innovation
• Growth
• Maturing stage
• decline

26. Basis Introduction Growth Maturity Decline
Product
location
In innovating
(usually
industrial
country
In innovating
and other
industrial
countries
Multiple
countries
Mainly in LDCs
Market
Location
In country with
some exports
Industrial
country
Shift in export
markets as
foreign
production
replaces export
in some
countries
Growth in LDCs
Some decrease
in industrial
countries
Mainly in LDCs
Some LDCs
exports
Competitive
factor
Near monopoly
situation
Fast growing
demand
Overall
stabilized
Overall
declining
demand

27. Sale based on
uniqueness
rather than
price
Evolving
product
characteristics
No of
competitors
increases
Price cutting by
competitors
Product
become more
standardized
No of
competitors
decreases
Price is very
important
Price is key
weapon
No of producers
continues to
decline
Production
technology
Short
production run
Evolving
methods to
coincide with
product
evolution
High labor and
labor skill
relative to
capital input
Capital input
increases
Methods more
standardized
Long production
runs using high
capital inputs
Highly
standardized
Less skilled
labor needed
Unskilled labor
on mechanized
long production
runs

28. Explanation
• Introduction stage: firms innovate new
products based on needs and problems in
domestic country.
• Growth: attracting competitors
• Increased competitor
• Further innovation
• Shift manufacturing to foreign countries
• Maturity : standard product
• Large scale production and economies
• Low unit cost of production
• Shift manufacturing to developing countries

29. • Decline: location of manufacturing facilities in
developing countries
• Original innovating country
importer.
• Limitations of Theory :
becomes net
• Production facilities do not move to foreign
countries to achieve cost reduction due to short
product life cycle consequent upon very rapid
innovation.
• Cost reduction has a little concern to the
consumer in case of luxury products.
• Export may not be in significant volume where
cost of transportation is very low.

30. • Non cost strategies like advertising may
nullify the opportunity to move to foreign
countries for cost minimization.
• Requirement of specialized knowledge
and expertise reduce the chances of
locating production facilities in foreign
countries.
• The rapid development may not shift the
production to various foreign countries.

31. Global Strategic Rivalry Theory
• International trade takes place
relative competitive advantage but
between/among companies based on
not
countries competitive advantage.
• Companies acquire and develop
competitive advantage through a number
of means:
• Owing intellectual property rights
• Investing in research and development
• Achieving large scale economies
• Exploiting the experience curve.

32. Porter’s National Competitive
Advantage Theory
• Companies get competitive advantage or
superiority from:
• Demand conditions
• Factor endowment
• Related and support industries
• Firm strategy, structure and rivalry