INTERNATIONAL TRADE THEORIES

CHAPTER 2: Lesson 2.1

LESSON OBJECTIVES:

At the end of the lesson, the students should be able to:

1. Explain the meaning of international trade theories;

2. Discuss how international trade affects nations; and

3. Differentiate classical theories from modern theories.

Over time, economists have developed theories to explain the mechanisms of international business
and trade. Trade is the concept of exchanging goods and services between two people or entities.
International trade, therefore, is the concept of this exchange between people or entities in two
different countries. People or entities trade because they believe that they can satisfy their needs
and benefit from the exchange. While at the surface this may sound very simple, there is a great
deal of theory, policy, and business strategy that influence international trade.
International trade theories deal with how countries exchange goods and services and help countries in
deciding what should be exported and what should be imported, in what quantity, and with whom trade
should be done globally. International trade theories were initially company-based and were called
classical theories. Classical economists were oriented primarily toward growth economics, and their main
concern was to explain how the "wealth of nations could be increased.

According to Reyes (2012), the main points of the classical theories of international trade are the
following:

1. Trade is an important stimulator of economic growth. It enlarges a country's consumption capacities,

increases world output, and provides access to scarce resources and worldwide markets for products,
without which poor countries would be unable to grow.

2. Trade tends to promote greater international and domestic equality by equalizing factor prices, raising
real incomes of trading countries.
3. Trade helps countries to achieve development by promoting and rewarding those sectors of the
economy where individual countries have a comparative advantage, whether in terms of labor efficiency or
factor endowments.

4. In a world of free trade, international prices and costs of productions determine how much a country
should trade in order to maximize its national welfare. Countries should follow the dictates of the principle
of comparative advantage and not try to interfere with the free workings of the market.

5. In order to promote growth and development, an outward-looking international policy is required. In all
cases, self-reliance based on partial or complete isolation is asserted to be economically inferior to
participation in a world of free unlimited trade.

6. In the mid-twentieth century, economists shifted from country-based to firm-based or company-

based theories, which were called modern theories. These theories are useful and can help with
international trade by helping a business determine the right country to expand into and make goods more
efficiently than other firms.
LESSON 2.2 MERCANTILISM
The Commercial Revolution which took place between 1450 and 1750 (300 years)
brought a revolutionary change in the economy of Europe. It saw the transition
from local economies to national economies, from feudalism to capitalism from a
rudimentary trade to a globally larger international trade.

NATIONAL
LOCAL ECONOMIES
ECONOMIES FEUDALISM

GLOBALLY LARGER RUDIMENTARY CAPITALISM

INTERNATION TRADE
TRADE
The commercial revolution gave birth to mercantilism, which played a vital role for
the economic prosperity of a nation and created a milestone in the field of European
Economy (historydiscussion.net 2021).

Developed in the 16th 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. 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. This is the reason mercantilism was also known as
“Bullionism”.
Mercantilism believes that the state should actively intervene in the economy. Countries
employed a policy of protectionism protecting the export industries that bring in the gold and
slivers through customs tariffs, quotas, and the like to curtail imports.

The period also mark the rise of new nation-state, who rulers were able to amass more gold and
wealth for their countries by increasing exports and trade. These nation-states expanded their
wealth by using their colonies around the world in an effort to control more trade and amass more
riches.

It aimed to encourage production within the national territories through the concession of
monopolistic privileges granted to the export producing enterprises, granting government
subsidies, and giving tax exemptions. The importation of advanced technology (mostly to benefit
the export industries). acquisition of manufacturing secrets, and encouraging immigration of skilled
workers that will bring in remittances to the country were done. Nation-states also placed lots of
importance on the development of merchants and naval fleets, which would facilitate exports.
In mercantilism, the government strengthens the private owners of the factors of
production, which are the following:

1. Labor

2. Natural Resources

3. Capital Goods (capital)

4. Entrepreneurship

Although mercantilism is one of the oldest trade theories, it remains part of our modern
life. Countries such as Japan, China, Singapore, Taiwan, and even Germany still favor
exports and discourage imports through a form of neo-mercantilism, protectionism
through tariffs and import barriers and domestic industry protection through subsidies
and tax exemptions.
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 both within
and outside the industry. Free trade is when international trade is free from
barriers, such as tariffs, quotas, or other restrictions, and can flourish on its
natural growth. It requires less government regulatory power.

The proponents of the theory were Sir William Petty and Sir Thomas Mun in
England, Jean-Baptiste Colbert, Jean Bodin, Irish-born Richard Cantillon, and Lord
Antoine de Montchrétien in France, and Antonio Serra and Giovanni Botero in
Italy, although they never used the term themselves. It was the Scottish
economist Adam Smith, in his Wealth of Nations (1776), who gave currency to the
term.
 Adam Smith viewed mercantilism as not freely initiated and did not bring benefits to all parties.
He refuted the general notion that the wealth of a nation should be measured by the country's
treasury. Through his book, Adam Smith illustrated that a freely conducted trade (free trade) was
much better than the mercantile doctrine as it would benefit most parties.

Free trade is a system that allowed for liberalization which would pave the way for a freely
initiated trade and engage the maximum possible number of people bringing benefits to most
parties and lead to further development of all participants in the long run.

Laissez-faire economics is a theory that restricts government intervention in the economy. Smith
demonstrated that the free market would translate into an all-encompassing economic
development in a significantly wider sense than mercantilism.
Smith also developed the concept of specialization leading to the development of economies of
scale, creating efficiency with the ultimate effect of achieving sustainable growth. For him, the
collusive relationship between the government and the business class observed in the
mercantile system was detrimental to the citizenry.

Adam Smith described mercantilism as having the following characteristics:

A.) It was used to enhance the economic power of states through building wealth, an important
measure of which was precious metals, especially silver and gold.

B.) It led to massive and rapid unification of control of countries under strict economic and
political policies, in sharp contrast with what was observed under feudalism resulting in
economic nationalism.

C. The countries aggressively sought to have a favorable balance of trade by selling more than
they imported so as to have a surplus of precious metals and accumulate it over time.
Jean-Baptiste Colbert- was considered as a more profound influence on the
development of mercantilism in France, where it was known as "Colbertism."
Jean-Baptiste's system was very similar in concept and application to
mercantilism described by Adam Smith. He carried out the program of economic
reconstruction that helped make France the dominant power in Europe.

Sir William Petty- posits that surplus gain or surplus value leads to expanded
reproduction and that expanded reproduction is conditional on capital
accumulation (productive capital expansion). Expanded reproduction is a model
in which a capitalist economy smoothly reproduces itself. The surplus value
created by the workers is not merely realized but reinvested

Philipp Wilhelm von Hornick- in his Austria Over All, It She Only Will of 1684,
detailed a nine-point program of what he deemed effective national economy,
which sums up the tenets of mercantilism comprehensively.
Sir Thomas Mun was most closely associated with the idea of mercantilism in
England, where Mercantilism was called commercial system or mercantile system,
because it emphasized the importance of commerce and free trade. This school of
thought mainly focused on international trade and the balance of trade through
acquisition of silver and gold.

Antoine de Montchrétien published a book titled A Tract on Political Economy in

which he laid great emphasis on development of agriculture and described it as the
basis of all wealth. He stood for the principle of self-sufficiency and asserted that it
is not the abundance of gold and silver, the quantities of pearls and diamonds,
which make a state rich and opulent, but the convenience of the things necessary to
life.

Richard Cantillon is considered by many to be the first economic theorist. His only
known book, Essai sur la Nature du Commerce en General (the Essai). may
represent one of the single largest steps forward in the social sciences. He
emphasized the need of importing raw materials and exporting finished products to
maintain a favorable balance of trade.
Physiocrats is an eighteenth-century group of French economists who believed
that agriculture was the source of all wealth and that agricultural products should
be highly priced. Advocating adherence to a supposed natural order of social
institutions, they also stressed the necessity of free trade.

The price-specie-flow mechanism was originally attributed to Scottish

economist David Hume to illustrate how trade imbalances can self-correct and
adjust under the gold standard. Fluctuations in prices in a country adjusted
completely or partially by an inflow or outflow of gold or specie which adjusts the
price levels across borders and equalized them bringing balance in international
transactions and payments.

Giovanni Botero and Antonio Serra of Italy did not directly touch on
mercantilism, but developed theories using the city as a unit of analysis and
finding development to be the result of industrialization.
Lesson 2.3
THEORY OF ABSOLUTE ADVATAGE

Absolute Advantage means a producer can produce a good or service better

faster, more efficiently, at a greater volume, and with fewer resources than
others. It means that a producer can produce a good of service at lesser marginal
cost than other producers. If a country has more resources needed to produce a
good or service, it has absolute advantage over a country where does not have
those resources

Marginal cost is the cost incurred in producing an additional unit of a product.

Adam Smith is recognized as the founder of modern economics; hence

considered as the father of economics. He is credited with using the word
mercantilism first and that his book The Wealth of Nations marked the birth of
modern capitalism.
Capitalism, also called free market economy or free enterprise economy is an
economic system, where most means of production are privately owned and
production is guided and income distributed largely through the operation of
markets, which determine prices, products, and services rather than the
government.

Modern capitalism emerged as a result of the appearance of the physiocrats in

France. The physiocrats were a group of economists who believed that the wealth
of nations was derived solely from agriculture; that only agriculture yielded a
surplus.

Physiocracy is perhaps the first well-developed theory of economics It

immediately preceded the first modern school, classical economics the
physiocrats believed that the wealth of a nation lies not in its stocks of gold and
silver, but rather in the size of its net product.
Net product, a measure of the income generated in a production process. It the value
of outputs minus the value of inputs.

Like the physiocrats, Smith recommended leaving economic decisions It the free play
of self-regulating market forces, with the state playing a high limited role.

Smith did not believe that industry was unproductive and that only the agricultural
sector was capable of producing a surplus above the subsisted level. Smith saw that
division of labor and extension of markets created alms limitless possibilities for
society to expand its wealth through production and trade.

The theory of absolute advantage believes that countries should produce and export
such products which they have an absolute advantage on and import those goods that
they produce relatively less efficiently and at a higher cost

Smith used the concept of absolute advantage to explain gains from free trade in the
international market. He upheld in this theory the necessity of free trade as the only
sound guarantee for progressive expansion of trade and increased prosperity of
nations
According to Smith, free trade promotes international division of labor through
specialization in the production and exchange of such commodities, in case of which they
command some absolute advantage Specialization increases productivity through
technical and organizational innovations

An interesting aspect of Smith's analysis of trade has been his vent for surplus doctrine,
which advocates nations exchanging their overproduction for other goods which are in
demand in other countries. In addition, this doctrine implies that the foreign trade results
in the fullest utilization of the idle productive capacity that is likely to exist in the absence
of trade.

Smith also mentioned an additional beneficial aspect of international trade- transfers

knowledge and technology between different nations. The adoption and use of new
production techniques lead to productivity growth and, thus, to an increase in wealth and
economic development.
Lesson 2.4
THEORY OF COMPARATIVE ADVANTAGE
Comparative advantage means a producer can produce a good or service at a
lower opportunity cost than others. If a country can produce goods or services at a
lower cost than other countries, it has comparative advantage. A country has
comparative advantage when it produces a good or service for a lower opportunity
cost than other countries.

The theory of comparative advantage is attributed to David Ricardo and Adam

Smith was among the first to put in writing the theory of comparative advantage.
For Smith, the specialization and division of labor, in the emerging large-scale
industries of his homeland England, provided the base for lowering labor
costs, which ensured effective competition across countries.

The extent of specialization and division of labor was dependent upon the
size of the market. A larger market would encourage a greater degree of
specialization and division of labor, hence, the development of international
trade.

The classical theorists believe that each country will specialize in the
production of those goods for the production of which it is especially suited
on account of its climate, of the qualities of its soil, of its other natural
resources, of the innate and acquired capacities of its people, and of the real
capital which it possesses as a heritage from its past generation, such as
buildings, plants and equipment, and means of transport.
Industrial capitalism is an economic system in which trade, industry, and capital
are privately controlled and operated for profit. It saw the rapid development of
the factory system of production characterized by much more rigid, complex, and
intricate division of labor that Smith was propounding.

Free trade, as opposed to the mercantilist policies of protection, was championed

by both Smith and Ricardo as a route to achieve production efficiency at a global
level. Ricardo's cost calculations were based on labor hours, which were treated as
a single homogeneous input.

It was comparative advantage which was considered both necessary to ensure

mutually gainful international trade across borders warranting complete
specialization in the specific commodity with a comparative advantage in terms of
labor hours used per unit of output.
The theory of comparative advantage was formulated by David Ricardo when
he investigated in detail the advantages and alternative or relative
opportunity in his 1817 book On the Principles of Political Economy and
Taxation in an example involving England and Portugal. He argued that a
country boosts its economic growth the most by focusing on the industry in
which it has the most substantial comparative advantage. According to his
comparative advantage principle, developing countries with a comparative
advantage in agriculture should continue to specialize in agriculture and
import high-technology widgets. from developed countries with a
comparative advantage in high technology.
David Ricardo started out as a successful stockbroker, making $100 million in
today's dollars. After reading Adam Smith's The Wealth of Nations, he became an
economist. He pointed out that significant increases in the money supply created
inflation in England in 1809. Ricardo developed the theory of monetarism, the
theory or practice of controlling the supply of money as the chief method of
stabilizing the economy.

Ricardo also developed the law of diminishing marginal returns, which states that
there is a point in production where the increased output is no longer worth the
additional input.

In 'older economic terms, comparative advantage has been opposed by

mercantilism and economic nationalism. They argue that while a country may
initially be comparatively disadvantaged in a given industry, countries should
shelter and invest in industries until they become globally competitive.
David Ricardo's theory of comparative advantage posits that countries export the
goods they have abundant production factors for, while they import the goods for
which they have scarce production factors. Relative intensities of production
factors (land, labor, and capital) determine the comparative advantage of a
country.

Using the above premise as a starting point, two Swedish economists, Eli
Heckscher and his student Bertil Ohlin, from Stockholm School of
Economics, in the 1920s, studied how a country could gain comparative
advantage by producing products that utilized factors that were in abundance in
the country.

The Heckscher-Ohlin theory or H-O theory is based on a country's production

factors-land, labor, and capital; hence, the theory is also called the factor
proportions theory or the resources and trade theory. Hecksher and Ohlin
determined that the cost of any factor or resource was a function of supply and
demand.
Many elaborations of the model were provided by Paul Samuelson after the
1930s and thus, sometimes the model is referred to as the Heckscher-Ohlin-
Samuelson (HOS) model.

In the 1950s and 1960s, some noteworthy extensions to the model were
made by Jaroslav Vanek, and so occasionally the model is called the
Heckscher-Ohlin-Vanek model.