THEORIES OF INTERNATIONAL TRADE

presented at the National conference on International Business at Karunya Deemed University, Coimbatore on 24 March 2006

What is International trade?
An Introduction to International Trade
International trade is the exchange of goods and services across international borders. In most countries, it represents a significant share of GDP. While international trade has been present throughout much of history (see Silk Road, Amber Road), its economic, social, and political importance have been on the rise in recent centuries, mainly because of Industrialization, advanced transportation, Globalization, Multinational corporations, and outsourcing. In fact, it is probably the increasing prevalence of international trade that is usually meant by the term "globalization".
Regulation of international trade
Traditionally international trade was regulated through bilateral treaties between two nations. For centuries under the belief in Mercantilism most nations had high tariffs and many restrictions on international trade. In the nineteenth century, especially in Britain, a belief in free trade became paramount and this view has dominated thinking among western nations for most of the time since then. In the years since the Second World War multilateral treaties like the GATT and World Trade Organization have attempted to create a globally regulated trade structure.
Communist and socialist nations often believe in autarchy, a complete lack of international trade. Fascist and other authoritarian governments have also placed great emphasis on self-sufficiency. No nation can meet all of its people's needs, however, and every state engages in at least some sort of International Trade.
Free trade is usually most strongly supported by the most economically powerful nation in the world. The Netherlands and the United Kingdom were both strong advocates of free trade when they were on top, today the United States, the European Union and Japan are its greatest proponents. However, many other countries - including several rapidly developing nations such as India, China and Russia - are also becoming advocates of free trade.
Traditionally agricultural interests are usually in favour of free trade while manufacturing sectors often support protectionism. This has changed somewhat in recent years, however. In fact, agricultural lobbies, particularly in the United States, Europe and Japan, are chiefly responsible for particular rules in the major international trade treaties which allow for more protectionist measures in agriculture than for most other goods and services.
During recessions there is often strong domestic pressure to increase tariffs to protect domestic industries. This occurred around the world during the Great Depression leading to a collapse in world trade that many believe seriously deepened the depression.
The regulation of international trade is done through the World Trade Organization at the global level, and through several other regional arrangements such as MERCOSUR in South America, NAFTA between the United States, Canada and Mexico, and the European Union between twenty five independent states. There is also the newly established Free Trade Area of the Americas (FTAA), which provides common standards for almost all countries in the American continent.
Theories of International Trade
Imports and exports are the major sectors of international business. Imports and exports take place because of the felt needs of the country. There are other reasons like difference in labour cost, interest on capital, availability of capital, raw materials etc. over and above these needs and advantages there are certain theories behind exports.
1. Mercantilism:
The earliest attempts to describe the function of international trade are known as “Mercantilism”. Mercantilism was developed in the 16th century. It insisted that the acquisition of wealth, particularly wealth in the form of gold, was of paramount importance for a nation. The trade policy dictated by mercantilist philosophy was accordingly simple. Encourage Exports, Discourage imports and take the proceeds of the resulting export surplus in gold. Mercantilists took the virtues of gold almost as an article of faith. But, they never tried to explain adequately why the pursuit of gold deserved such a high priority in their economic plans. With its insistence on the accumulation of national wealth in the form of gold by encouraging imports, mercantilism was an inconsistent and ultimately self defeating theory.
2. Absolute Advantage Theory
The theory of absolute advantage has been propounded by Adam Smith in his book. The “Wealth of Nations” published in 1776 in London, Smith argued that countries differ in their ability to produce goods efficiently. In his time the English by virtue of their superior manufacturing processes, was the world’s most efficient textile manufacturer. Due to the combination of favorable climate, good soils, and accumulated expertise, the French had the world’s most efficient Wine industry. The English had an absolute advantage in the production of textiles in the production of Wine.
According to Adam Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for the goods traded by other countries thus, the English should specialize in the production of textiles while the French should specialize in Wine
This theory explains why trade takes place between countries. The classical economists like Adam Smith, Ricardo, and Mill et al. believed that the value of a product in a country is determined by its labour content. Some countries have absolute advantage in the production of some goods as labour cost is low in such countries. They can export such goods and import other goods for which labour cost is higher in the home country.
For instance, if India has advantage in the production of cloth and USA has advantage in the production of wheat. India should produce only cloth and export it to USA and USA should produce wheat and export it to India. The theory argues that both countries will benefit from this trade.
The absolute advantage theory emphasized the importance of specialization as a source of increased output. Accordingly each nation should specialize in the production of goods it is particularly well equipped to produce. It should export part of this production and import other goods that it cannot produce so cheaply.
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3. The Comparative Cost Theory

David Ricardo, noted economist illustrated the comparative cost theory by using the two country, two commodity model. Ricardo formulated this theory in his book “Principles of Political economy” published in 1817.

In brief, the Comparative Cost theory explains that if trade is free, each country in the long run, will tend to specialize in the production and export of those commodities in whose production it enjoys a comparative advantage, and to obtain by import those commodities which can be produced at home at a comparative disadvantage; and that such specialization is to the mutual advantage of the companies participating in it.

David Ricardo’s illustration of the comparative cost theory shows that trade between nations can be profitable even if one of the two nations produces both commodities more efficiently than the other nation, provided that it can produce one of these commodities with a comparatively greater efficiency than the other commodity. The law further implicates that a country should specialize in the production of that commodity in which it is more efficient and leaves the production of the other commodity to the other country. In this situation the two nations will then have more of both goods by engaging in trade.

To make the theory more understandable Ricardo has cited the example of England and Portugal. This is related to production cost of cloth and wine in both countries.





Country. No. of units of No of units of Exchange Ratio
labour p.u of labour p.u of between
Cloth. wine. Wine & Cloth.


England 100 120 1Wine:1.2 Cloths.

Portugal 90 80 1Wine: 0.88 Cloths.


Here it is obvious that Portugal enjoys absolute advantage in both branches of production. However, a comparison of the cost of production of wine 80/120 with ratio of the cost of production of cloth 90/100 in both countries reveal that, though Portugal has an absolute superiority in both branches of production, it will pay her to concentrate on the production of wine, for she has greater comparative advantage over England in wine relating to cloth 80/120<90/100, and import cloth from England which has a comparative advantage in cloth production. England will gain by specializing in producing cloth and selling it in Portugal in exchange of wine.

In the absence of trade between England and Portugal, one unit of wine commands 1.2 and 0.88 units of cloth in England and Portugal respectively. In the event of trade taking place, on the assumption that, within each country, labor is perfectly mobile between various industries, Portugal will gain if she can get anything more than 0.88 units of cloth in exchange of 1 unit of wine and England will gain if she has to part with less than 1.2 unit of cloth against 1 unit of wine represents a gain to both the countries. The actual rate of exchange will be determined by the reciprocal demand.

Thus, according to Comparative Cost Theory, free and unrestricted trade among nations encourages specialization on a larger scale. It thereby tends to bring about:

Ø The most efficient allocation of world resources as well as the maximization of world production.
Ø A redistribution of relative product demands, resulting in greater equality of product prices among trading nations; and
Ø A redistribution of relative resource demands to correspond with relative product demands, resulting in a relatively greater quality of resource prices among trading nations.
This theory is based on a few simplifying assumptions:
Ø Labour is the only element of cost;
Ø Production is subject to the law of constant returns;
Ø International trade is free from all barriers;
Ø No transport cost.

Quite naturally the Comparative Cost theory has been severely criticized for its unrealistic assumptions. It should, however, be stated that the Comparative Cost Theory does provide some convincing explanation of the basis of international trade.

4. Factor Endowments Theory/ Modern Theory (Heckscher-Ohlin Theory)
Swedish economists Eli Heckscher (in 1919) and Bertil Ohlin (in 1933) are critical of the classical theory of comparative cost. They argue that classical theory does not explain why comparative cost differences take place
. The classical theory demonstrated that the basis of international trade was the comparative cost difference. However, it did not explain the causes of such comparative cost difference. The alternative formulation of the comparative cost doctrine developed by Heckscher and Ohlin explains why a comparative cost difference exists internationally. They attribute international (and inter-regional) differences in comparative costs to:


(A) Different prevailing endowments of the factors of production; and
(B) The fact that the production of various commodities requires that the factors of production be used with different degrees of intensity.


In short it is the difference in factor intensities in the production functions of goods along with the actual differences in relative factor endowments of the countries which explains the international differences in the comparative cost of production.


Thus in a nutshell, the Heckscher-Ohlin theory states that a country will specialize in the production and export of the goods whose production requires a relatively large amount of the factor with which the country is relatively well endowed with capital only if the ratio of capital to other factors is higher than in other countries

For example, assume that:

(1) In Country A

Supply of labour =25 units
Supply of capital =20units
Capital/labor ratio=0.8

(2)In Country B

Supply of labour =12 units
Supply of capital =15units
Capital/labour ratio =1.25

In the above example, even though Country a has more capital in absolute terms, Country B is more richly endowed with capital the ratio of capital to labour in country a(0.8) is lower than in country B (1.25)

The two country, two commodity model of Heckscher and Ohlin is based on a number of explicit and implicit assumptions. The important assumptions of the model are:

(1). Both the product and actor markets in both the countries are characterized by perfect competition.
(2). The factors of production are perfectly mobile within each country but immobile between countries.
(3). The factors of production are of identical quality in both the countries.

(4). Factor supplies in each country are fixed.
(5) The factors of production are fully employed in both the countries.
(6). There is free trade between the countries, i.e there are no artificial barriers to trade.

(7). International trade is costless, i.e. there is no transport cost
(8).The factor endowments of one country vary from those of the other.
(9). the techniques of producing identical goods are the same in both the countries because of this act; the same input mix will give the same quantity and quality of output in both countries.
10).Factor intensity varies between goods for instance; some goods are capital intensive (that is they require relatively more capital for their production). And some others are labor intensive (that is they require more labor for their production).
11).Production is subject to the law of constant returns; either input/output ratio will remain constant irrespective of the scale of the operation.

Most of the above assumptions are obviously; unrealistic the heckscher-ohlien model has been criticed mainly for it’s over simplifying and unrealistic assumptions.

Wassily W.Leontief’s study has revealed that the USA, which is a capital rich country, imported capital intensive goods and exported labour intensive goods. This has come to be popularly known as the Leontief’s paradox, which is a negation of the Heckscher-Ohlin thesis. It should however be pointed out that Leontief’s study has been criticized as unscientific.

Despite its drawbacks, the Heckscher-Ohlin theory has certain definite merits. These are:


(1) The Heckscher-Ohlin theory rightly points out that the immediate basis of international trade is the differences in the final price of a commodity as between countries, although the actual basis or ultimate cause of trade is the comparative cost differences in production. Thus it provides a more comprehensive and satisfactory explanation for the existence of international trade.
(2) The Heckscher-Ohlin theory is superior to the Comparative Cost Theory in some other respects also. The Ricardian theory points out that comparative cost differences is the basis of international trade: but it does not explain the reasons for the existence of comparative cost differences between nations. The Heckcsher- Ohlin theory explains the reasons for the differences in the cost of production in terms of differences in factor endowments. This is another aspect of the Heckscher-Ohlin analysis that makes it superior to the Ricardian analysis.

(3) Further, Heckscher and Ohlin made it very clear that “international trade is but a special case of inter-local or inter-regional trade”, and hence there is no need for a special theory of international trade. Ohlin states that regions and nations trade with each other for the same reasons that individuals specialize and trade. The comparative cost difference is the basis of all trade – inter-regional as well as international. Nations, according to Ohlin, are regions distinguished from one another by such obvious marks as national frontiers, tariff barriers and differences in languages, customs and monetary systems.

The modern theory of trade is also called the General Equilibrium Theory of
International trade because it points out that the general demand and supply
analysis applicable to inter-regional trade may be generally be used without
substantial changes in dealing with problems of international trade.

(iv) Another merit of Heckscher –Ohlin theory is that it indicates the impact of trade on product and factor prices.

The Heckscher-Ohlin theory indicates that international trade will ultimately have the following results:

(a)Equalization of commodity prices: international trade tends to equalize the prices of internationally traded goods in all the regions of the world because trade causes the movement of commodities from areas where they are abundant to areas where they are scarce. This would tend to increase commodity prices where there is abundance and decrease prices where there is scarcity by reasons of redistributions of commodity supply between these two regions as a result of trade. International trade tends to expand up to the point where prices in all the regions become equal. But perfect equality of prices can hardly be achieved because of the existence of transport cost and the absence of free trade and perfect competition.
(b) Equalization of factor prices: international trade also tends to equalize factor prices all over the world. It increases the demand for abundant factors (leading to an increase in their prices) and decreases the demand for scarce factors (leading to a fall in their prices) because, when nations are on trade, specialization takes place on the basis of factor endowment. But in reality, the presence of a number of imperfections makes the achievement of perfect equality in factor prices impossible.



5. The Opportunity Cost Theory

The Opportunity Cost theory ,propounded by Professor Gotfried Haberler in 1983,has been applied to theory of international trade as a substitute for the doctrine of Comparative cost expressed in terms of labor cost or real cost.

The opportunity cost of any thing is the value of the alternatives or other opportunities which have to be forgone in order to obtain that particular thing. For example, assume that given amount of productive resources can produce either 10 units of cloth or 20 units of wine. The opportunity cost of 1 unit of cloth is 2 units of wine.

Thus, the opportunity cost approach defines cost in terms of the value of the alternatives of the other opportunity which have to be forgone in order to achieve a particular thing.]

According to opportunity cost theory, the basis of international trade is the differences between nations in the opportunity costs of production of commodities.

As far as the basis of international trade and specialization are concerned, the logic behind the comparative cost approach and the opportunity cost approach are the same. But there is a notable difference in the treatment .Under the comparative cost approach, we measure the cost of producing wine in terms of labor or in terms of any real cost, but under the opportunity cost approach, we measure, in contrast to the comparative cost approach, the cost of producing wine in terms of the amount of cloth foregone in order to produce one more unit if wine.


There are two theories which explain international trade based on technological factors.

6. The Product Life Cycle Theory
Raymond Vernon initially proposed the product life cycle theory in the mid 1960’s. Vernon’s IPLC model, which concerns the stages of production of a product with new know-how.
The hypothesis of the model is that new products move through a cycle, or a series of stages, in the course of their development. The comparative advantage of the products changes as they move through one phase of cycle to another.
Such a product is first produced by the parent firm, then by its foreign subsidiaries and finally anywhere in the world where costs are the lowest. The theory explains why a product that begins as a nations export ends up becoming an import.
The IPLC has three stages: New product, Maturing product and Standardized Product. A new product is an innovative one and consumption is in the home country. As years go by, product enters the mature phase of its life cycle and exporting started. Competitors try to introduce substitutes. As product enters standardized product stage the technology becomes widely diffused and available. Production tends to be shifted to low-cost locations. The PLC theory predicts that initially, the comparative advantage will exist in the innovating country, but over time, as product becomes standardized the country of comparative advantage will shift to lower factor cost locations.
7. Technological Gap Model
Posner formulated the Technological Gap model according to which a good deal of trade among industrialized countries takes place on the basis of technological innovations. The technological innovations may be the introduction of a new product or a new productive process. The country which makes innovation gets monopoly through patents or copy rights. It exports those products to foreign countries. But in course of time technology gets diffused, and the importing country starts domestic production. The innovator loses the foreign market and may turn into an importer of the very product it had exported. Such situation calls for continuous innovations by the countries. Posner’s theory considers technological change as a continuous process with two time lags-imitation lag and demand lag. The essence of argument is that a continuous process of inventions and innovations would give rise to trade even between countries with similar factor endowments
8. Reciprocal Demand Theory
The classical position on trade was elaborated further by John Stuart Mill and other economists in the 20th century. J.S.Mill argued that the law of reciprocal demand sets the prices at which trade will take place. Reciprocal demand indicates a country’s demand for one commodity in terms of the other commodity; it is prepared to give up in exchange. Reciprocal demand determines the terms of trade and relative share of each country.
For example, Reciprocal demand means the strength of US demand for Indian cloth and Indian demand for US wheat. This theory is also based on the assumption that free trade is allowed. But the real world situation is different. Governments put regulations in trade in order to protect domestic industry and employment, correct imbalances in balance of payment etc. Trade between capital rich industrial countries and developing nations which produce chiefly primary products are conducted for many other reasons. The theory does not give guidance on this.


9. National Competitive Advantage
In 1990, Michael Porter of Harvard Business School published the results of an intensive research work that attempted to determine why some countries succeed and others fail in international trade.
Porter’s thesis is that four broad attributes of a nation shape the environment in which local firms compete, and these attributes promote or impede the creation of competitive advantage.
Determinants of National Competitive Advantage;
· Factor Endowments
· Demand conditions
· Firm Strategy, Structure and Rivalry
· Related and Supporting Industry
Porter’s speaks of these four attributes as constituting the diamond. He argues that firms are most likely to succeed in industries or industry segments where the diamond is most favorable.
For an explanation why international trade takes place, Porter’s theory is useful in as much as it suggests that countries should be exporting products from those countries where all four components of the diamond are favourable, while importing in those areas where the parts are unfavorable.
10. The availability approach

The availability approach to the theory of international trade seeks to explain the pattern of trade in terms of domestic availability and non-availability of goods. Availability influences operation through both demand and supply forces.

In a nutshell, the availability approach purports that a nation would tend to import those commodities which are not readily available domestically and export those whose domestic supply can be easily expanded beyond the quantity needed to satisfy the domestic demand.

Kravis argues that Leontief’s findings that the United States exports have a higher labour content and a lower capital content than its imports may be explained better and more simply by the availability factor. Goods that happen to have high capital content are bought abroad because they are not available at home. Some are unavailable in the absolute sense (e.g.: diamonds); others in the sense that an increase in output may be achieved only at much higher costs (that is; the domestic supply is inelastic). When unavailability at home is due to lack of natural resources (relative to demand), the comparative advantage argument is perfectly adequate.

According to Kravis there are other facts of the availability explanation of trade pattern that cannot be so readily subsumed under the rubric “comparative advantage”. One of these is the effect of technological change. Historical data for the US indicate that exports have tended to increase most in those industries which have new or improved products that are available only in the US or in a few other places at the most. Product differentiation and government restrictions are the other factors tending to increase the proportion of international trade that represents purchases by the improving country of goods that are not available at home.


According to Kravis, there are, thus, four bases of the availability factor, namely:
1. Natural resources
2. Technological progress
3. Product differentiation and
4. Government policy


The first three of the four bases—natural resources, technological progress and product differentiation- probably tend , on the whole , to increase the volume of international trade. The absence of free competition, a necessary condition for the unfettered operations of the law of comparative advantage, tends to limit trade to goods that cannot be produced by the importing country, argues Kravis. The most important restrictions on international competition are those imposed by the governments and by cartels. Those imports that are unavailable or available only at a formidable cost are subject to the least governmental interfaces. Kravis is of the opinion that the quantitative importance of the availability factor in international trade is considerable. This appears to apply especially to half of world trade that consists of trade between the industrial areas on the one hand and the primary producing areas on the other.

The availability approach has, undoubtedly, considerable merit in its explanation of the pattern of trade.

Ø The changes in technologies and availability of alternative production process change in tastes etc. leads to number of alternative explanations to international trade. The emergence of WTO, regional integration etc, also takes international trade to new levels. Kindleberger’s thesis, Metzler Paradox, Eckaus theory etc. are some of the recent theories in this filed.

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