description of various theories of trade and how they paved way to concept of free trade

1. THEORIES OF
INTERNATIONAL TRADE
Dhriti Saka-172CM013Presented by :

2. Contents
1. What is international trade?
2. Various theories of trade
3. Classical theories
1. Mercantilism
2. Absolute advantage
3. Comparative advantage
4. Hecksher-Ohlin theory
4. Modern theories
1. Country similarity theory
2. Product life cycle
3. Global strategy rival theory
4. Porter’s theory of competitive advantage

3. What is international trade?
 Trade is the concept of exchanging goods and services between two
people or entities. International trade is then the concept of this
exchange between people or entities in two different countries.
 People or entities trade because they believe that they benefit from the
exchange. They may need or want the goods or services.

4. Various theories of trade
Classical country- based
theories
Modern firm- based theories
Mercantilism Country similarity
Absolute advantage Product life cycle
Comparative advantage Global strategy rivalry
Heckscher-Ohlin(H-O theory) Porters national competitive
advantage

5. Classical theories

6. 1. Mercantilism
 Developed in the mid-sixteenth century in
England, 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. Mercantilists believed that a
country should increase its holdings of gold and silver by
promoting exports and discouraging imports.
 The objective of each country was to have a trade surplus, or a
situation where the value of exports are greater than the value of
imports, and to avoid a trade deficit, or a situation where the
value of imports is greater than the value of exports.

7.  This theory formed the basis on which international trade was
carried out until almost mid-nineteenth century
 The colonizing countries ,such as Britain and France, prevented
colonies such as India and indo-china from having manufacturing
industries. they imported a lot of low priced raw materials and
exported high priced manufactured good to the same colonies.
 It was a selfish trade practice, mercantilism was a ‘zero-sum game’
i.e. when one country benefitted the other country lost.
 Mercantilism remain a part of modern trade, countries such as Japan,
Singapore, Taiwan and Germany still favor exports and discourage
imports through a form of neo-mercantilism.

8. 2. Adam smith’s theory of absolute advantage
 In 1776,Adam smith propounded a different theory ,in his book titled
‘The wealth of nations’ .
 Smith offered a new trade theory called absolute advantage, which
focused on the ability of a country to produce a good more
efficiently than any other nation.
 The theory stated that trade between countries shouldn’t be
regulated or restricted by government policy or intervention. He
stated that trade should flow naturally according to market forces.
 He introduced the idea of ‘mutual benefit’ through trade.

9.  Each country should export goods in which they have an absolute advantage
in production.
 This was the beginning of the concept of free trade.
 Due to differences in soil and climate, the United States is better at
producing wheat than Brazil, and Brazil is better at producing coffee than the
United States.
 There are two kinds of advantage
 Natural advantage: a country can have a natural advantage due to the
availability of natural resources/labor or geographical/climatic conditions.
E.g.. Oman,saudi Arabia
 Acquired advantage: this advantage is said to acquired through
continuous effort, here technology plays an important role. E.g.. Japan
and India .

10. 3. Ricardo’s theory of comparative advantage.
 The challenge to the absolute advantage theory was that some countries
may be better at producing both goods and, therefore, have an advantage
in many areas. In contrast, another country may not have any useful
absolute advantages.
 In 1817,David Ricardo introduced the concept of comparative advantage.
 Comparative advantage occurs when a country cannot produce a product
more efficiently than the other country; however, it can produce that
product better and more efficiently than it does other goods.

11.  Comparative advantage focuses on the relative productivity differences.
 Even if the country has comparative advantage in both goods, it can make
profit by giving up the production of the comparatively less efficiently
produced good.
 For example :India has a advantage in both tea and sugar, but makes tea
more efficiently . Mauritius has a comparative advantage of making sugar,
then India can concentrate its production on tea and go into trade with
Mauritius for sugar.
 Both the countries will benefit from this trade.
 It’s a win-win situation or a positive sum game. This forms the principle of
free trade even when a nation does not have an absolute advantage.

12. 4. Hecksher-Ohlin theory
 It is also known as factor proportions/endowment theory.
 They determined that the cost of any factor or resource was a function of
supply and demand. Factors that were in great supply relative to demand
would be cheaper
 Their theory stated that countries would produce and export goods that
required resources or factors that were in great supply and, therefore,
cheaper production factors. In contrast, countries would import goods
that required resources that were in short supply, but higher demand.
 E.g. India and china.

13. Modern theories of trade

14. Country similarity theory
 Swedish economist Steffan Linder developed the country similarity
theory in 1961, he tried to explain the concept of intra-industry trade.
 This theory proposed that consumers in countries that are in the same
or similar stage of development would have similar preferences.
 Firms seek the comfort of familiarity, the companies can trade in
products that are inherently different of different versions of the same
basic product.
 E.g.: USA and Germany trade in automobiles as the design and
engineering is different.

15.  More the dissimilarity between nations ,less is the trade between
them. This dissimilarity can be thought of as a distance between
them.
 Different distances that affect the trade are:
 Geographic distance
 Historic distance
 Linguistic distance
 Cultural distance
 Economic distance
 Political distance
 Monetary distance

16. Product life cycle theory
 Raymond Vernon, a Harvard Business School professor, developed the product
life cycle theory in the 1966.
 The theory, originating in the field of marketing, stated that a product life
cycle has three distinct stages: (1) new product, (2) growth (3) maturity and
(4) standardized product.
 In the 1960s this was a useful theory to explain the manufacturing success of
the United States.
 The product life cycle theory has been less able to explain current trade
patterns where innovation and manufacturing occur around the world.Global
companies even conduct research and development in developing markets
where highly skilled labor and facilities are usually cheaper.

17. Global strategic rivalry theory
 Paul Krugman and Kelvin Lancaster were economists and introduces this
theory in the 1980s.
 Firms will encounter global competition in their industries and in order to
prosper, they must develop competitive advantages.
 Firms will encounter global competition in their industries and in order to
prosper, they must develop competitive advantages.
 he barriers to entry that corporations may seek to optimize include:
 research and development,
 the ownership of intellectual property rights,
 unique business processes or methods as well as extensive experience
 the control of resources or favorable access to raw materials.

18. Porter’s theory of competitive advantage of nations
 Porter’s theory stated that a nation’s competitiveness in an industry
depends on the capacity of the industry to innovate and upgrade.
 Porter identified four determinants that he linked together. The four
determinants are
 local market resources and capabilities.
 local market demand conditions.
 local suppliers and complementary industries.
 local firm characteristics

19. References
 https://saylordotorg.github.io/text_international-business/s06-01-
what-is-international-trade-th.html
 https://fee.org/articles/comparative-advantage/