This document summarizes several theories of international trade, including mercantilism, classical trade theory, factor proportions theory, product cycle theory, and strategic trade theory. It discusses how each theory views why and how trade benefits countries. It also briefly outlines common barriers to trade such as tariffs, quotas, and regulations that countries use to encourage local production and protect domestic industries and jobs.

1. The Theories of Trade
Learning Objectives
• To understand the traditional arguments of how and why international trade improves
the welfare of all countries
• To explore the similarities and distinctions between international trade and international investment
Evolution of Trade Theory
• The Age of Mercantilism
• Classical Trade Theory
• Factor Proportions Trade Theory
• International Investment and Product Cycle Theory
• The New Trade Theory: Strategic Trade
Mercantilism
• Mixed exchange through trade with accumulation of wealth
• Conducted under authority of government
• Demise of mercantilism inevitable
Classical Trade Theory
• The Theory of Absolute Advantage
– The ability of a country to produce a product with fewer inputs than another country
• The Theory of Comparative Advantage
– The notion that although a country may produce both products more cheaply than another
country, it is relatively better at producing one product than the other
Classical Trade Theory Contributions
• Adam Smith—Division of Labor
– Industrial societies increase output using same labor-hours as pre-industrial society
• David Ricardo—Comparative Advantage
– Countries with no obvious reason for trade can specialize in production, and trade for
products they do not produce
• Gains From Trade
– A nation can achieve consumption levels beyond what it could produce by itself
Factor Proportions Trade Theory
• Developed by Eli Heckscher
• Expanded by Bertil Ohlin
Factor Proportions Trade Theory
Considers Two Factors of Production
• Labor
• Capital
Factor Proportions Trade Theory
A country that is relatively labor abundant (capital abundant) should specialize in the production and export of
that product which is relatively labor intensive (capital intensive).
Product Cycle Theory
• Raymond Vernon
• Focus on the product, not its factor proportions
• Two technology-based premises

2. Product Cycle Theory:
Vernon’s Premises
• Technical innovations leading to new and profitable products require large quantities of capital and
skilled labor
• The product and the methods for manufacture go through three stages of maturation
Stages of the Product Cycle
• The New Product
• The Maturing Product
• The Standardized Product
The Product Cycle and Trade Implications
• Increased emphasis on technology’s impact on product cost
• Explained international investment
• Limitations
– Most appropriate for technology-based products
– Some products not easily characterized by stages of maturity
– Most relevant to products produced through mass production
The New Trade Theory:
Strategic Trade
Two New Contributions
• Paul Krugman-How trade is altered when markets are not perfectly competitive
• Michael Porter-Examined competitiveness of industries on a global basis
Strategic Trade
Krugman’s Economics of Scale:
• Internal Economies of Scale
• External Economies of Scale
Strategic Trade
• Government can play a beneficial role when markets are not purely competitive
• Theory expands to government’s role in international trade
• Four circumstances exist that involve imperfect competition in which strategic trade may apply
• The Four Circumstances Involving Imperfect Competition:
• 1.Price
• 2.Cost
• 3. Repetition
• 4.Externalities
•
Barriers to Trade
Why do countries produce goods and services that could be more cheaply purchased from other countries?
Reasons:
• To encourage local production
• To help local firms export
• To protect local jobs
• Protect infant industries
• Reduce dependency
• Encourage local and foreign direct investment
• Reduce balance of payment problems
• Reduce or avoid dumping

3. Commonly used barriers
• Price based barriers- Ad valorem
• Quantity limits-quotas- embargo
• International price fixing- cartel
• Financial limits- exchange control
• Foreign investment controls-minority stakes, limiting profits etc
Tariffs
• Export tariff
• Transit tariff
• Specific duty
• Ad valorem duty
• Compound duty
• dumping
Non – tariff barriers- rules , regulations and bureaucratic
• Quotas
• Buy national restrictions
• Customs valuation
• Technical barriers
• Counter trade