Introduction

International trade theories are simply different theories to explain 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. While at the surface, this many sound very simple, there is a great
deal of theory, policy, and business strategy that constitutes international trade.

In this section, you’ll learn about the different trade theories that have evolved over the past
century and which are most relevant today. Additionally, you’ll explore the factors that impact
international trade and how businesses and governments use these factors to their respective
benefits to promote their interests.

In more recent centuries, economists have focused on trying to understand and explain these
trade patterns "The Globalization Debate" discussed how Thomas Friedman’s flat-world
approach segments history into three stages: Globalization 1.0 from 1492 to 1800, 2.0 from 1800
to 2000, and 3.0 from 2000 to the present. In Globalization 1.0, nations dominated global
expansion. In Globalization 2.0, multinational companies ascended and pushed global
development. Today, technology drives Globalization 3.0.

To better understand how modern global trade has evolved, it’s important to understand how
countries traded with one another historically. Over time, economists have developed theories to
explain the mechanisms of global trade. The main historical theories are called classical and are
from the perspective of a country, or country-based. By the mid-twentieth century, the theories
began to shift to explain trade from a firm, rather than a country, perspective. These theories are
referred to as modern and are firm-based or company-based. Both of these categories, classical
and modern, consist of several international theories.

On the topic of international trade, the views of economists tend to differ from those of the
general public. There are three principal differences. First, many non-economists believe that it is
more advantageous to trade with other members of one’s nation or ethnic group than with
outsiders. Economists see all forms of trade as equally advantageous. Second, many non-
economists believe that exports are better than imports for the economy. Economists believe that
all trade is good for the economy. Third, many non-economists believe that a country’s balance
of trade is governed by the “competitiveness” of its wage rates, tariffs, and other factors.
Economists believe that the balance of trade is governed by many factors, including the above,
but also including differences in national SAVING and INVESTMENT.

The noneconomic views of trade all seem to stem from a common root: the tendency for human
beings to emphasize tribal rivalries. For most people, viewing trade as a rivalry is as instinctive
as rooting for their national team in Olympic basketball.

To economists, Olympic basketball is not an appropriate analogy for international trade. Instead,
we see international trade as analogous to a production technique. Opening up to trade is
equivalent to adopting a more efficient technology. International trade enhances efficiency by
allocating resources to increase the amount produced for a given level of effort. Classical
liberals, such as Richard Cobden, believed that free trade could bring about world peace by
substituting commercial relationships among individuals for competitive relationships between
states.

To better understand how modern global trade has evolved, it’s important to understand how
countries traded with one another historically. Over time, economists have developed theories to
explain the mechanisms of global trade. The main historical theories are called classical and are
from the perspective of a country, or country-based. By the mid-twentieth century, the theories
began to shift to explain trade from a firm, rather than a country, perspective. These theories are
referred to as modern and are firm-based or company-based. Both of these categories, classical
and modern, consist of several international theories.
 Types of International Trade Theories

1. Classical or Country-Based Trade Theories

(a) 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. In it’s simplest sense, mercantilists believed that a country should
increase its holdings of gold and silver by promoting exports and discouraging imports. In other
words, if people in other countries buy more from you (exports) than they sell to you (imports),
then they have to pay you the difference in gold and silver. 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.

A closer look at world history from the 1500s to the late 1800s helps explain why mercantilism
flourished. The 1500s marked the rise of new nation-states, whose rulers wanted to strengthen
their nations by building larger armies and national institutions. By increasing exports and trade,
these rulers were able to amass more gold and wealth for their countries. One way that many of
these new nations promoted exports was to impose restrictions on imports. This strategy is
called protectionism and is still used today.

Nations expanded their wealth by using their colonies around the world in an effort to control
more trade and amass more riches. The British colonial empire was one of the more successful
examples; it sought to increase its wealth by using raw materials from places ranging from what
are now the Americas and India. France, the Netherlands, Portugal, and Spain were also
successful in building large colonial empires that generated extensive wealth for their governing
nations.

Although mercantilism is one of the oldest trade theories, it remains part of modern thinking.
Countries such as Japan, China, Singapore, Taiwan, and even Germany still favor exports and
discourage imports through a form of neo-mercantilism in which the countries promote a
combination of protectionist policies and restrictions and domestic-industry subsidies. Nearly
every country, at one point or another, has implemented some form of protectionist policy to
guard key industries in its economy. While export-oriented companies usually support
protectionist policies that favor their industries or firms, other companies and consumers are hurt
by protectionism. Taxpayers pay for government subsidies of select exports in the form of higher
taxes. Import restrictions lead to higher prices for consumers, who pay more for foreign-made
goods or services. Free-trade advocates highlight how free trade benefits all members of the
global community, while mercantilism’s protectionist policies only benefit select industries, at
the expense of both consumers and other companies, within and outside of the industry.

KEY TAKEAWAYS

 Mercantilism was the dominant economic system from the 16th century to the
18th century.
 Mercantilism was based on the idea that a nation's wealth and power were best served by
increasing exports and reducing imports.
  It's characterized by the belief that global wealth was static and that a nation's economic
health relied heavily on its supply of capital.
 Due to the nationalistic nature of mercantilism, nations frequently used military might to
protect local markets and supply sources.
 Mercantilism was replaced by free-trade economic theory in the mid-18th century.
(b) Absolute Advantage

In 1776, Adam Smith questioned the leading mercantile theory of the time in The Wealth of
Nations. Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (London:
W. Strahan and T. Cadell, 1776). Recent versions have been edited by scholars and
economists. Smith offered a new trade theory called absolute advantage, which focused on the
ability of a country to produce a good more efficiently than another nation. Smith reasoned 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. In a hypothetical two-
country world, if Country A could produce a good cheaper or faster (or both) than Country B,
then Country A had the advantage and could focus on specializing on producing that good.
Similarly, if Country B was better at producing another good, it could focus on specialization as
well. By specialization, countries would generate efficiencies, because their labor force would
become more skilled by doing the same tasks. Production would also become more efficient,
because there would be an incentive to create faster and better production methods to increase
the specialization.

Smith’s theory reasoned that with increased efficiencies, people in both countries would benefit
and trade should be encouraged. His theory stated that a nation’s wealth shouldn’t be judged by
how much gold and silver it had but rather by the living standards of its people.
KEY TAKEAWAYS

 Absolute advantage is when a producer can provide a good or service in greater quantity
for the same cost, or the same quantity at a lower cost, than its competitors.
 A concept developed by Adam Smith, absolute advantage can be the basis for large
gains from trade between producers of different goods with different absolute
advantages.
 By specialization, division of labor, and trade, producers with different absolute
advantages can always gain more than producing and consuming in isolation.
 Absolute advantage can be contrasted with comparative advantage, which is the ability
to produce goods and services at a lower opportunity cost.
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. To answer this challenge, David Ricardo,
an English economist, introduced the theory of comparative advantage in 1817. Ricardo reasoned
that even if Country A had the absolute advantage in the production of both products,
specialization and trade could still occur between two countries.

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. The difference between these two theories is subtle. Comparative advantage focuses
on the relative productivity differences, whereas absolute advantage looks at the absolute
productivity.

Let’s look at a simplified hypothetical example to illustrate the subtle difference between these
principles. Miranda is a Wall Street lawyer who charges $500 per hour for her legal services. It
turns out that Miranda can also type faster than the administrative assistants in her office, who
are paid $40 per hour. Even though Miranda clearly has the absolute advantage in both skill sets,
should she do both jobs? No. For every hour Miranda decides to type instead of do legal work,
she would be giving up $460 in income. Her productivity and income will be highest if she
specializes in the higher-paid legal services and hires the most qualified administrative assistant,
who can type fast, although a little slower than Miranda. By having both Miranda and her
assistant concentrate on their respective tasks, their overall productivity as a team is higher. This
is comparative advantage. A person or a country will specialize in doing what they
do relatively better. In reality, the world economy is more complex and consists of more than
two countries and products. Barriers to trade may exist, and goods must be transported, stored,
and distributed. However, this simplistic example demonstrates the basis of the comparative
advantage theory.

Heckscher-Ohlin Theory (Factor Proportions Theory)

The theories of Smith and Ricardo didn’t help countries determine which products would give a
country an advantage. Both theories assumed that free and open markets would lead countries
and producers to determine which goods they could produce more efficiently. In the early 1900s,
two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention on how a
country could gain comparative advantage by producing products that utilized factors that were
in abundance in the country. Their theory is based on a country’s production factors—land,
labor, and capital, which provide the funds for investment in plants and equipment. They
determined that the cost of any factor or resource was a function of supply would be more
expensive. Their theory, also called the factor proportions 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.

For example, China and India are home to cheap, large pools of labor. Hence these countries
have become the optimal locations for labor-intensive industries like textiles and garments.

Leontief Paradox

In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US
economy closely and noted that the United States was abundant in capital and, therefore, should
export more capital-intensive goods.
However, his research using actual data showed the opposite: the United States was importing
more capital-intensive goods. According to the factor

proportions theory, the United States should have been importing labor-intensive goods, but
instead it was actually exporting them. His analysis became known as the Leontief
Paradox because it was the reverse of what was expected by the factor proportions theory. In
subsequent years, economists have noted historically at that point in time, labor in the United
States was both available in steady supply and more productive than in many other countries;
hence it made sense to export labor-intensive goods. Over the decades, many economists have
used theories and data to explain and minimize the impact of the paradox. However, what
remains clear is that international trade is complex and is impacted by numerous and often-
changing factors. Trade cannot be explained neatly by one single theory, and more importantly,
our understanding of international trade theories continues to evolve.

Modern or Firm-Based Trade Theories

In contrast to classical, country-based trade theories, the category of modern, firm-based theories
emerged after World War II and was developed in large part by business school professors, not
economists. The firm-based theories evolved with the growth of the multinational company
(MNC). The country-based theories couldn’t adequately address the expansion of either MNCs
or in traindustry trade, which refers to trade between two countries of goods produced in the
same industry. For example, Japan exports Toyota vehicles to Germany and imports Mercedes-
Benz automobiles from Germany.

Unlike the country-based theories, firm-based theories incorporate other product and service
factors, including brand and customer loyalty, technology, and quality, into the understanding of
trade flows.
Country Similarity Theory

Swedish economist Steffan Linder developed the country similarity theory in 1961, as he tried to
explain the concept of intraindustry trade. Linder’s theory proposed that consumers in countries
that are in the same or similar stage of development would have similar preferences. In this firm-
based theory, Linder suggested that companies first produce for domestic consumption. When
they explore exporting, the companies often find that markets that look similar to their domestic
one, in terms of customer preferences, offer the most potential for success. Linder’s country
similarity theory then states that most trade in manufactured goods will be between countries
with similar per capita incomes, and intraindustry trade will be common. This theory is often
most useful in understanding trade in goods where brand names and product reputations are
important factors in the buyers’ decision-making and purchasing processes.

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. In the 1960s this was a useful theory to explain the
manufacturing success of the United States. US manufacturing was the globally dominant
producer in many industries after World War II.

It has also been used to describe how the personal computer (PC) went through its product cycle.
The PC was a new product in the 1970s and developed into a mature product during the 1980s
and 1990s. Today, the PC is in the standardized product stage, and the majority of manufacturing
and production process is done in low-cost countries in Asia and Mexico.

The product life cycle theory has been less able to explain current trade patterns where
innovation and manufacturing occur around the world. For example, global companies even
conduct research and development in developing markets where highly skilled labor and
facilities are usually cheaper. Even though research and development is typically associated with
the first or new product stage and therefore completed in the home country, these developing or
emerging-market countries, such as India and China, offer both highly skilled labor and new
research facilities at a substantial cost advantage for global firms.

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. Firms will encounter global
competition in their industries and in order to prosper, they must develop competitive
advantages. The critical ways that firms can obtain a sustainable competitive advantage are
called the barriers to entry for that industry. The barriers to entry refer to the obstacles a new
firm may face when trying to enter into an industry or new market. The barriers to entry that
corporations may seek to optimize include:

 research and development,

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. To explain his theory, Porter identified four determinants that
he linked together. The four determinants are (1) local market resources and capabilities, (2)
local market demand conditions, (3) local suppliers and complementary industries, and (4) local
firm characteristics.
 1. Local market resources and capabilities (factor conditions). Porter recognized the
value of the factor proportions theory, which considers a nation’s resources (e.g., natural
resources and available labor) as key factors in determining what products a country will
import or export. Porter added to these basic factors a new list of advanced factors, which
he defined as skilled labor, investments in education, technology, and infrastructure. He
perceived these advanced factors as providing a country with a sustainable competitive
advantage.
2. Local market demand conditions. Porter believed that a sophisticated home market is
critical to ensuring ongoing innovation, thereby creating a sustainable competitive
advantage. Companies whose domestic markets are sophisticated, trendsetting, and
demanding forces continuous innovation and the development of new products and
technologies. Many sources credit the demanding US consumer with forcing US software
companies to continuously innovate, thus creating a sustainable competitive advantage in
software products and services.
3. S vffLocal suppliers and complementary industries. To remain competitive, large
global firms benefit from having strong, efficient supporting and related industries to
provide the inputs required by the industry. Certain industries cluster geographically,
which provides efficiencies and productivity.
4. Local firm characteristics. Local firm characteristics include firm strategy, industry
structure, and industry rivalry. Local strategy affects a firm’s competitiveness. A healthy
level of rivalry between local firms will spur innovation and competitiveness.

In addition to the four determinants of the diamond, Porter also noted that government and
chance play a part in the national competitiveness of industries. Governments can, by their
actions and policies, increase the competitiveness of firms and occasionally entire industries.

Porter’s theory, along with the other modern, firm-based theories, offers an interesting
interpretation of international trade trends. Nevertheless, they remain relatively new and
minimally tested theories.