Chapter No.

International Trade
Theories
 Theories
• Mercantilism
• Absolute Advantage
• Comparative advantage
• Heckscher-Ohlin Theory
• New Trade Theory
MERCANTILISM
 MERCANTILISM

• Mercantilism was the first theory of international

trade that emerged in England in 16th Century
• Mercantilism is economic nationalism for the
purpose of building a wealthy and powerful
state. Adam Smith defined the term “mercantile
system” to describe the system of political
economy that sought to enrich the country by
restraining imports and encouraging exports.
• Since gold and silver were viewed as valuable and a
sign of wealth, mercantilism suggested that
countries should design policies that led to an
increase in their holdings of gold and silver.
• The central idea of mercantilism was that countries
should run a balance of trade surplus and have
export of greater value than imports.
• The mercantile system served the interests of
merchants and producers such as the British East
India Company, whose activities were protected or
encouraged by the state.
 MERCANTILISTS
• Most of the European economists who wrote between
1500 and 1750 are today generally considered
mercantilists; this term was initially used solely by critics.
• Thomas Mun (1571–1641) as a major creator of the
mercantile system, especially with his work published as
Treasure by Foreign Trade (1664)
• Perhaps the last major mercantilist work was James
Stuart's Principles of Political Economy published in 1767
• Other’s include Italy's Giovanni Botero (1544–1617)
and Antonio Serra ; France's, Jean Bodin and other
 Criticism
• Adam Smith criticize this idea in his book The Wealth of
Nations. Smith made a number of important criticisms
of mercantilist doctrine.
• First, he demonstrated that trade, when freely initiated,
benefits both parties.
• Second, he argued that specialization in production
allows for economies of scale, which improves efficiency
and growth.
• Finally, Smith argued that the collusive relationship
between government and industry was harmful to the
general population.
 Criticism from Hume
• Second criticism came from Hume in 1752.
• Hume demonstrated how a persistent trade surplus would
begin to affect money supplies, and in long run close the
trade surplus.
• Example: According to Hume if England has balance of trade
surplus with France, the resulting inflow of Gold and Silver in
England would increase the domestic money supply and
generate inflation in England. While inflation would be lower
in France, and French goods would be more competitive.
French consumers would be discouraged to buy English
goods because they would become too expensive.
Absolute Advantage
 ABSOLUTE ADVANTAGE
• Adam Smith was the main critic of the
Mercantilism. Smith put four specific reasons
why a country could gain from trade:
– Mutual gains from voluntary exchange of goods
– Increased competition
– The division of Labour
– Better use of Resources
 Main Idea of Absolute Advantage
• According to Smith countries should specialize in the
production of goods for which they have an absolute
advantage and then trade these goods for the goods produced
by other countries.
• For Example in Smith’s time England was the world’s most
efficient textile producer. At the same time, France had the
world’s most efficient wine industry. England had Absolute
advantage in production of textiles, while the French has an
absolute Advantage in production of wine. So Smith says that
England should concentrate on Textile and England could get
all the wine it need by selling its textile to France and buying
wine in Exchange.
 One more Examples
• To simplify the example we will use units of
resource input instead of money. The
following Hypothetical examples compare the
output resulting from the use of 100 Units of
resources.
Output possibilities from 100 Units of Resources
 Criticism
• Would it still be advantageous to trade where
one nation is more efficient than another in
production of both products?
COMPARATIVE ADVANTAGE
 Main Idea of theory
• In 1817 the theory was presented by David Ricardo in his
work “Principles of Political Economy and Taxation”.
• Theory demonstrates that if a country specializes in the
products in which it has the greatest comparative advantage
relative to other nations and trades those products for goods
in which it has the greatest comparative disadvantage, the
country’s total availability of goods will be enlarged.
• In other words emphasizing comparative rather than
absolute advantages the theory shows that every country has
a basis for trade and that specialization and trade are more
efficient than policies of national self-sufficiency.
 Example
Production Possibilities from 100 Units of Resources

Opportunity Cost:
Opportunity cost of any product is what has to be
sacrificed in order to obtain it.
 Opportunity Cost and Comparative Advantage Opportunity Cost

Production Cheese Cloth

Australia 160/200=0.85 200/160=1.25
UK 120/80=1.5 80/120=0.67
 Production Possibility Frontier
• Opportunity cost can be illustrated with
Production Possibility frontier, or
transformation curve.
• PPF is a curve that shows the alternative
combinations of the two commodities that a
nation can produce by fully utilizing all of its
resources with the best technology available
to it.
 Production Possibility Schedule for wheat
and Cloth
USA UK
Wheat Cloth Wheat Cloth
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
Assumptions of Comparative Advantage

• Ricardo based his law of comparative

advantage on a number of simplifying
assumptions:
– Only two nations and two commodities
– Free trade
– Perfect mobility of labor within each nation
– Constant costs of production
– No transportation costs
– No technical changes
Heckscher-Ohlin Theory
(Factor Endowments)
 HO Theory
• Ricardo’s theory of comparative advantage simply
assumes that different countries have different
opportunity costs, but it makes no attempt to
explain the reasons for these differences.
• Eli Heckscher, the noted Swedish economist
developed the core idea in of HO theory in 1919.
• A clear overall explanation was developed and
published in the 1930’s by Heckscher’s student
Bertil Ohlin.
 Core Idea of Theory
• HO theory predicts hat countries export the
products that use their abundant factors
intensively(and import the products using
their scarce factors intensively). It is generally
agreed that variations in comparative costs
exist because there is an uneven distribution
in both quality and quantity of factors of
production (E.g. land, labour, capital) between
countries.
A country's share of factors of production is
referred to as its factor endowment. Most
countries possess some factors in greater
abundance than others. Like Australia's major
exports are agricultural products and minerals
because of its unusual abundance of cropland
and mineral deposits. While Iceland and Norway
have strong fish exports due to coastal waters
climates conducive to good fish.
 Limitations of the Theory
• Difficulty in moving resources, especially the
labour force, into the desired industries
• Fluctuations in demand, or the collapse of a
market in a country’s product, in a situation of
international recession or unfair (Subsidized)
competition
• Artificial limitations (Import restrictions) placed
on a product by overseas countries
• Other Political restraints.
National competitive Advantage:
Porter’s Diamond
 NCAS :Porter’s Diamond
• NCA is the most recent trade theory . Michael
Porter in 1990 published the results of intensive
research effort that attempted to determine why
some nations succeed and others fail
international competition. Porter and his team
looked at 100 industry clusters in ten countries.
E.g. food additives and furniture in Denmark,
Cutlery and printing presses in Germany, Ceramic
tiles in Italy, Air-conditioning machinery in Japan
etc.
• The main task of the study was to find answers
to various questions such as:
• Why is a small country like Switzerland more
innovative and productive in chemicals and
pharmaceuticals compared to bigger countries
like the UK or Spain.
• This study found four broad attributes. Lets
have a look at these attributes
 Four Attributes of NCA
• Factor Endowments
• Demand Conditions’
• Related and Supporting Industries
• Firm Strategy, Structure and Rivalry
 Factor Endowment
• According to Porter a nation’s position in factors of
production such as skilled labour or infrastructure
necessary to compete in a given industry can be
critical . These factors can be either basic (natural
resources, climate, location) or advanced (Skilled
labour, infrastructure, technological know-how)
• While either can be important , advanced factors
are more likely to lead to competitive advantage.
Like japan which lacks the Basic Factors but invest in
advanced factors such as technology.
 Demand conditions
• The nature of home demand for the industries
product or service influences the development
of capabilities. Sophisticated and demanding
customers pressure firms to be competitive.
Such as Nokia of Finland, where sophisticated
and demanding customers in Finland helped
push Nokia to invest in research and
development in mobile phone technology long
before competitors in other industrial nations.
 Related and Supporting Industries
• The presence in a nation of supplier industries
and related industries that are internationally
competitive can spill over and contribute to
other industries. Switzerland's success in the
dye industry has been the basis for the
expansion of its pharmaceutical industry.
 Firm Strategy, Structure, and Rivalry
• According to Porter, the conditions in the nation
governing how companies are created, organized and
managed and the nature of domestic rivalry impacts
firms competitiveness. One observation is that nations
have different management ideologies..
• Porter notes the predominance of engineers on the top
management teams of German and Japanese firms, while
US firms tend to have in top management teams finance
experts. This has contributed to a technological advance
in Germany and japan compared to the US during the
1970 and 1980
• Firms that face strong competition at home
will be better able to face competitors from
other nations. Japan is again noted as a
positive example on this account