 International Trade Theory

 An Overview of
Trade Theory
What Is International Trade?
 Trade is the concept of

exchanging goods and

services between two people
or entities.
 International trade theories

are simply different theories

to explain international trade
International Trade Theory
 International trade is then the concept of this
exchange between people or entities in two
different countries
 there is a great deal of theory, policy, and business

strategy that constitutes international trade

What Are the Different International Trade
Theories?
International Trade Theory
(1)Classical or Country Based Theories
 It is the main historical theories which are from
the perspective of a country, or country-based.
(A) Mercantilism
(B) Absolute Advantage
(C) Comparative Advantage
(D) Heckscher-Ohlin Theory (Factor
Proportions Theory)
(A) Mercantilism
 Mercantilism (mid-16th century) suggests that it is
in a country’s best interest to maintain a trade
surplus -to export more than it imports
 This theory stated that a country’s wealth was
determined by the amount of its gold and silver
holdings.
Mercantilism
 The objective of each country was to have a trade
surplus and to avoid a trade deficit
Mercantilism
 In general, Mercantilism views trade as a zero-sum
game - one in which a gain by one country results
in a loss by another
Example:
 Trading in commodities markets: In commodity

trading, when one trader profits from buying low

and selling high, another trader loses an equivalent
amount.
(B) Absolute Advantage
 In 1776, Adam 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.
 In other word, Adam Smith (1776) argued that a
country has an absolute advantage in the
production of a product when it is more efficient
than any other country in producing it
Absolute Advantage
 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
 countries should specialize in the production of goods
for which they have an absolute advantage and then
trade these goods for goods produced by other
countries
 Absolute Advantage
 If each country specializes in the
production of the good in which it has
an absolute advantage and trades for the
other, both countries gain

 “trade is a positive sum game”

(C) Comparative Advantage
 David Ricardo asked what happens when one
country has an absolute advantage in the
production of all goods
 The theory of comparative advantage (1817) -
countries should specialize in the production
of those goods they produce most efficiently
and buy goods that they produce less
efficiently from other countries
Comparative Advantage
 Comparative advantage theory provides a strong
rationale for encouraging free trade
 total output is higher
 both countries benefit
 Trade is a positive sum game
Comparative Advantage
Comparative Advantage
(D) 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.
Heckscher-Ohlin Theory (Factor Proportions
Theory

 Eli Heckscher (1919) and Bertil Ohlin (1933) -

comparative advantage arises from differences in
national factor endowments
 Their theory is based on a country’s production
factors—land, labor, and capital, which provide
the funds for investment in plants and equipment.
Heckscher-Ohlin Theory (Factor Proportions
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; factors in great
demand relative to supply would be more
expensive.
Heckscher-Ohlin Theory (Factor Proportions
Theory

 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
The Political Economy of International Trade

 Introduction
 Free trade refers to a situation where a gov’t does
not attempt to restrict what its citizens can buy
from another country or what they can sell to
another country
 While many nations are nominally committed to
free trade, they tend to intervene in international
trade to protect the interests of politically important
groups
Instruments of Trade Policy

 There are seven main instruments of trade policy

1. Tariffs
2. Subsidies
3. Import quotas and Voluntary export restraints
4. Local content requirements
5. Administrative policies
6. Antidumping policies
Tariffs
 A tariff - a tax levied on imports that effectively
raises the cost of imported products relative to
domestic products
 Specific tariffs defined as a fixed charge for each unit
of a good imported
 Ad valorem tariffs are levied as a proportion of the
value of the imported good
Why Tariffs?
 Tariffs
 increase government revenues
 provide protection to domestic producers against
foreign competitors by increasing the cost of imported
foreign goods
 force consumers to pay more for certain imports
Subsidies
 A subsidy - a government payment to a domestic
producer
 Subsidies help domestic producers
 compete against low-cost foreign imports
 gain export markets
 Consumers typically absorb the costs of subsidies
Import Quotas and Voluntary Export Restraints

 An import quota - a direct restriction on the

quantity of some good that may be imported into a
country

 Voluntary export restraints - quotas on trade

imposed by the exporting country, typically at the
request of the importing country’s government
Administrative trade polices -
bureaucratic rules that are designed to
make it difficult for imports to enter a
country
 Antidumping polices - designed to
punish foreign firms that engage in
dumping
 the goal is to protect domestic
producers from “unfair” foreign
competition