Theories of International Trade

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Mercantilism• Mercantilism was the primary

economic system of trade used from the 16th to 18th century. Mercantilist theorists believed that the amount of wealth in the world was static. Thus, European nations took several strides to ensure their nations accumulated as much of this wealth as possible.

• The goal was to increase a nation's wealth by imposing government regulation that oversaw all of the nation's commercial interests. It was believed national strength could be maximized by limiting imports via tariffs and maximizing exports.

Jean-Baptiste Colbert: The Champion of Mercantilism

• French Secretary of State Jean-Baptiste Colbert (1619-1683) was one of the most influential proponents of mercantilism .

• He was also a devout monarchist and wanted an economic strategy to protect the French crown from a rising Dutch mercantile class.

• Colbert increased the size of the French navy on the premise that his country would have to take control of trade routes to increase its wealth.

• Even though his practices were ultimately unsuccessful, his ideas became hugely popular until the theory of free market economics was popularized. 

• Mercantilism was popularized in Europe during the 1500s.

• Mercantilism replaced the older, feudal economic system in Western Europe, leading to one of the first occurrences of political oversight and control over an economy.

• At the time, England, the center of the British Empire, was small and contained relatively few natural resources. Thus, to grow England’s wealth, England introduced fiscal policies, including the Sugar Act and Navigation Acts, to move colonists away from foreign products and create another incentive for buying British goods.

• The resulting favorable balance of trade was thought to increase national wealth. 

Affect of Mercantilism on British Colonies

• Controlled production and trade• The expansion of the slave trade• Inflation and taxation• American Revolution

Criticism of Mercantilism Theory

• Mercantilism is a philosophy of a zero sum game – where people benefit at the expense of others. It is not a philosophy for increasing global growth and reducing global problems. Also, increasing other peoples wealth can lead to selfish benefits, e.g. growth of other countries, increases markets for our exports. Trying to impoverish other countries will harm our own growth and prosperity.

• Mercantilism which stresses government regulation and monopoly tends to lead to inefficiency and corruption.

• Mercantilism justified Empire building and the poverty of colonies to enrich the Empire country.

• Economist Adam Smith, who is widely considered the father of modern economics, argued in his seminal book "The Wealth of Nations" that free trade enables businesses to specialize in the production of the goods that they manufacture most efficiently.

• Specialized production leads to economies of scale which, in turn, lead to higher productivity and economic growth. In a free trade system, businesses have incentives to be innovative. By creating more useful products, better production and distribution systems, and more efficient operations, businesses can grow and prosper.

Justification for Mercantilism• Tariffs in response to domestic subsidies• Protection against dumping• Infant industry argument

• Today, mercantilism is considered an outdated philosophy. However, barriers to trade still exist to protect locally entrenched industries.

• For example, the United States adopted a protectionist trade policy toward Japan in the post-war period and negotiated voluntary export restrictions with the Japanese government, which limited the quantity of Japanese exports to the United States.

Adam Smith is recognised as the founder of modern economics and as one of the first and most famous thinkers who argued in favour of free trade and he developed the theory of absolute advantage in 1776.

Theory Of Absolute Advantage

• Export those goods and services for which a country is more productive than other countries.

• Import those goods and services for which other countries are more productive that it is.

• Country should concentrate on production of goods in which it holds an absolute advantage.

• Measures nations wealth by the standard of living of its people.

Absolute Advantage

The main concept of absolute advantage is generally attributed to ADAM SMITH for his 1776 publication An inquiry into the nature and causes of the wealth of nations on which

he countered mercantilist ideas.

Origin Of Theory

• Party X can produce 10 widgets per hour with 5 employees.

• Party Y can produce 20 widgets per hour with 5 employees.

• Assuming that the employees of both parties are paid equally, Party Y has an absolute advantage over Party X in producing widgets per hour because Party Y is producing twice as many as party X with same number of employees.

Example of Absolute Theory

This theory was a step forward in explaining the need for countries to specialize in certain products and

engage in international trade to increase their productivity. This theory was not helpful to those

countries who did not have an absolute advantage in certain goods.

CRITICISM

David Ricardo’s theory of Comparative advantage

David Ricardo came up with the law of comparative advantage in 1817.

It is a theory about political gains from trade of companies, countries and people that arise on account of differences in factor endowments or technological progress.

He demonstrated that if two countries capable of producing two commodities engage in the free market, then each country will increase its overall consumption by exporting the good for which it has a comparative advantage while importing the other good, provided that there exist differences in labor productivity between both countries.

David Ricardo (1772-1823)

Assumptions

Free tradeThere is no transport cost

Labour is homogenous

Cost of production is expressed in terms of labour

Production is subject to constant returns to scale

There are two countries and two commodities

Perfect competition exits

Labour is perfectly mobile

No technological changeFull employment exits

Example

Poorland’s cost of producing wine is higher than Richland’s in terms of hours of labour and is lower in terms of bread.

Poorland has a comparative advantage in producing wine.

Richland has a comparative advantage in producing bread.

If they exchange wine and bread one for one, Poorland can specialize in producing wine and trading some of it to Richland, and Richland can specialize in producing bread.

By shifting ten hours of labours out of producing bread, Poorland gives up the one loaf that this labour could have produced, the reallocated labour produces two bottles of wine, which will trade for two loaves of bread. Trade nets Poorland one additional loaf of bread.

By shifting three hours out of producing wine, Richland cuts wine production by one bottle but increases bread production by three loaves. It trades two of these loaves for Poorland’s two bottles of wine. Richland has one more bottle of wine than it had before, and an extra loaf of bread

CRITICISM

Restrictive model- only two countries and two commodities

Labour theory of valueFull employmentIgnore transport costDemand is ignoredNo free tradeComplete specializationNot applicable to developing countries

Heckscher-Ohlin Theorem of International Trade

Ohlin states that trade results on account of the different relative

price of different goods in different countries. The relative

price commodity difference is the result of relative costs and factor

price differences in different countries.

Differences in factor prices are due to differences in factor endowments in different

countries. It, thus, boils down to the fact that trade occurs because different countries have different

factor endowments. Ohlin’s theory is, therefore, also described as the factor

endowment theory or the factor proportions analysis.

The Heckscher-Ohlin theorem is: countries which are rich in labour will export labour intensive goods and countries

which have plenty of capital will export capital-intensive products.

Ohlin’s theory is usually expounded in terms of a two-factor model with labour and capital as the two factors of endowments. The gist of the theory is: what determine trade are differences in factor endowments. Some countries have plenty of capital; others have an abundance of labour. 

Ohlin’s Simple Model:

Ohlin makes the following assumptions of a simplified static model to the analysis:

1. There are two countries A and B.

2. There are two factors, labour and capital.

3. There are two goods; X and Y of which X is labour-intensive and Y is capital-intensive.

4. Country A is labour-abundant country В is capital-rich.

5. There is perfect competition in both the commodity and factor markets .

6. All production functions are homogeneous of the first degree. Hence there are constant returns to the scale.

7. There are no transport costs or other impediments to trade.

8. Demand conditions are identical in both the countries .

The Price Criterion of Relative Factor Abundance:According to the price criterion, a country having capital relatively cheap and labour relatively dear is regarded as relatively capital-abundant, irrespective of its ratio of total quantities of capital to labour in comparison with the other country. In symbolic terms, when:(PK/PL) A < (PK/PL) B

Country A is relatively capital-abundant. (Here P stands for factor price and К for capital, L for labour, A and В for the two respective countries.) Ohlin’s theorem may be verified diagrammatically in Fig. 1.

In a nutshell, we can interpret Ohlin’s theory as under:

1. Two countries A and В will involve themselves in trade, if relative price of goods X and Y are different. To quote Ohlin, “the immediate cause of inter-regional trade is always that goods can be bought cheaper from outside in terms of money than they can be produced at home.”2. Under comparative market conditions, prices are equal to average costs. Thus, relative price differences are an account of cost differences.3. Cost differences are taking place because of the factor price differences in the two countries.4. Factor prices are determined by factors’ supply and demand. Assuming a given demand, it follows that a capital-rich country has a cheaper or a lower capital price and a labour-abundant country has a relatively lower labour price.5. Ohlin states that each region has advantages in the production of goods into which enter considerable amounts of factors abundant and cheap in that region.6. It follows that country A will tend to specialise in the production of X and export its surplus. Likewise, В will specialise in Y and export it.

i. The basis of internal trade is the

difference in commodity prices in

the two countries.

ii. Differences in commodity prices are

due to cost differences which are

the results of differences in factor endowments in the

two countries.

iii. A capital-rich country specialises in

labour-intensive goods and exports

them. A labour-abundant country

specialises in labour-intensive goods and

exports them.

Thus, Ohlin’s theory concludes that:

Limitations of Heckscher Ohlin's H-O Theory ↓

Unrealistic assumptions Restrictive One sided

theory Static in nature

Wijnhold’s criticism

Consumer’s demand ignored

Leonteif paradox

Product Life-Cycle Theory

In1960 s, Raymond Vernon ′introduces it

Stages : Innovation, Growth, Maturity and Decline

Many products go through a trade cycle

Predicting the product trade performance

Phase I : Innovation

Introduction Of The Product

Low Awareness

Huge Investment Is

MadeLow Profits Low

Competitors

Phase II : Growth

Demand And Profit

Increases

Production Cost

Decreases

Awareness Is High

Competition Increases Export Starts

Phase II : Maturity

Product Awareness is Maximum

Rate of Increase of Sales Decreases

Competition is Very High and Profit Margin Decreases

Foreign Demand Grows

Export Surge Followed by a Fall in Export

Phase II : Decline

Product and Production Process is Well Known

Revenue Drops and Many Products Phase Out

Production Shifts to Developing Countries

Imports Starts

Based on : Raymond Vernon, 1966. International investment and International trade in the product cycle. The Quarterly journal of Electronics 80(2), pp. 190-207

Porter’s theory of competitive advantage

• Michael Porter’s theory of competitive advantage contributes to understanding the competitive advantage of nations in international trade and production.

• He tried to explain why a nation achieves international success in a particular industry and identified four attributes that promote or impede the creation of competitive advantage.

Factor endowments- A nation’s position in factors of production necessary to compete in a given industry.

Can lead to competitive advantage

Can be either basic(natural resources,climate,location) or advanced (skilled labour,infrastructure,technological know how).

Demand conditions- The nature of home demand for the industry’s product or service.

Influences the development of capabilities

Sophisticated and demanding customers pressure firms to be competitive.

Relating and supporting industries- The presence and absence of supplier industries that are internationally competitive.

Can spill over and contribute to other industries

Successful industries tend to be grouped in cluster in countries.

Firm strategy, structure and rivalry- The conditions governing how companies are created,organized,and managed, and the nature of domestic rivalry.

Different management ideologies affect the development of national competitive advantage.

Vigorous domestic rivalry creates pressures to innovate ,to improve quality ,to reduce cost, and to invest in upgrading advance features

•Government policy canAffect demand through product standardsInfluence rivalry through regulation and anti trust lawsImpact the availability of highly educated workers and advanced transportation infrastructure.

•The four attributes, Government policy, and chance work as an reinforcing system, complementing each other and in combination creating the conditions appropriate for competitive advantage.

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