1.

1 What Is International Trade Theory?

LEARNING OBJECTIVES

1. Understand international trade.

2. Compare and contrast different trade theories.

What Is International Trade?

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.

Main definitions of international trade.

Export is the sale of goods and services to other countries.

Import is the import of foreign goods into the territory of a country.
The difference between exports and imports is called the trade balance
A country's foreign trade turnover is the sum of a country's exports and imports.

INTERNATIONAL TRADE THEORIES

Classical Country - Based Theories Modern Firm - Based Theories

Mercantilism Country Similarity
Absolute Advantage Porter’s National Competitive Advantage
Theory
Comparative Advantage
Heckscher-Ohlin

Classical or Country-Based Trade Theories

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.
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 (a hidden
protectionism). 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. (FTAs - free trade agreements)

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 (invisible hand). 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.
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 and demand. Factors
that were in great supply relative to demand would be cheaper; factors in great demand relative
to 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.

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 intraindustry 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.

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. Local 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.

Which Trade Theory Is Dominant Today?

The theories covered in this chapter are simply that—theories. While they have helped
economists, governments, and businesses better understand international trade and how to
promote, regulate, and manage it, these theories are occasionally contradicted by real-world
events. Countries don’t have absolute advantages in many areas of production or services and, in
fact, the factors of production aren’t neatly distributed between countries. Some countries have a
disproportionate benefit of some factors. The United States has ample arable land that can be
used for a wide range of agricultural products. It also has extensive access to capital. While it’s
labor pool may not be the cheapest, it is among the best educated in the world. These advantages
in the factors of production have helped the United States become the largest and richest
economy in the world. Nevertheless, the United States also imports a vast amount of goods and
services, as US consumers use their wealth to purchase what they need and want—much of
which is now manufactured in other countries that have sought to create their own comparative
advantages through cheap labor, land, or production costs.

As a result, it’s not clear that any one theory is dominant around the world. This section has
sought to highlight the basics of international trade theory to enable you to understand the
realities that face global businesses. In practice, governments and companies use a combination
of these theories to both interpret trends and develop strategy. Just as these theories have evolved
over the past five hundred years, they will continue to change and adapt as new factors impact
international trade.

EXERCISES
1. What is international trade?
2. Summarize the classical, country-based international trade theories. What are the
differences between these theories, and how did the theories evolve?
3. What are the modern, firm-based international trade theories?