THEORIES OF INTERNATIONAL

TRADE

Vighneswara Swamy

DEVELOPMENT OF MODERN TRADE

Phase I:
Evolution of Modern Trade can be traced from 1500 A.D
Mercantilists (1500-1800) A.D
If a country could achieve a favorable trade balance, it would
realize the net payments in the form of gold and silver.
Critique: possible only for short term; assumes static world economy

DEVELOPMENT OF MODERN TRADE:

PHASE II
Since 18th Century
Influenced by David Hume
Price-Specie-flow doctrine

Price-Specie Flow Mechanism states that under a gold standard, countries with positive trade
balances are effectively importing gold in exchange for exports and those with negative
trade balances are effectively exporting gold in exchange for imports. This causes increase
in gold (money) in the exporting countries causes inflation. Conversely, decrease in gold
(money) in countries with importing countries causes deflation. Thus the balance of trade in
both the countries shifts. Thus, according to Hume balance of trade is relatively unimportant
as it balances out in the longer run.

A favorable trade balance is possible only in the short-run, for over time it
would get automatically eliminated.

DEVELOPMENT OF MODERN TRADE:

PHASE III
Theory of Absolute Advantage
Adam Smith A leading advocate of free trade (open markets)

He argued that nations could concentrate on their production that they could
make most cheaply with consequent benefits of labor.

ADAM SMITHS CONCEPT OF COST

1. Cost differences govern international movement of goods and
services

2. Smiths concept of cost was founded upon the labor theory of

value.
3. Labor Value Theory:
Labor is the only factor of production and is homogenous
Cost of good depends exclusively on the labor involved.

PRINCIPLE OF ABSOLUTE ADVANTAGE

1. In a two nation, two product world, international specialization and trade
will be beneficial when one nation has absolute cost advantage in one
good and the other nation has absolute cost advantage in another good.
2. A nation will import those goods in which it has absolute cost
disadvantage and export those goods in which it has absolute cost
advantage.
3. Free trade benefits a nation as a whole, but individuals may lose jobs
and incomes from the competition from foreign goods and services.

ILLUSTRATION FOR ABSOLUTE ADVANTAGE PRINCIPLE

Consider world output possibilities in the absence of specialization.
Country

Wine

Cloth

United States

5 bottles

20 yards

United Kingdom

15 bottles

10 yards

US has absolute advantage in cloth production

UK has absolute advantage in wine production

COMPARATIVE ADVANTAGE THEORY

Background:
According to the absolute advantage theory, if a country is a least-cost
producer of at least one good that it can export to its trading partner.
But in case a country is least-cost producer in all goods than the trading
partner what may happen?
This question is answered by David Ricardos Comparative Advantage Theory.

COMPARATIVE ADVANTAGE PRINCIPLE

1. Even if a nation has an absolute cost advantage in the production of both goods, a
basis for mutually beneficial trade may still exist.
2. The less efficient country should specialize in and export the good in which it is
relatively less inefficient.
3. The more efficient country should specialize in and export that good in which it is
relatively more efficient (where its absolute advantage is greatest).

4. When nations follow the principle of comparative advantage, they gain. The reason is
that world output increases and each nation ends up with a higher standard of living
by consuming more goods and services than possible without specialization and trade.

ILLUSTRATION FOR COMPARATIVE ADVANTAGE

hour
Country Output per laborWine

Cloth

United States

40 bottles

40 yards

Unite Kingdom

20 bottles

10 yards

According to Ricardos Comparative Advantage theory,

1. US should specialize in and export cloth where it has comparative advantage, and
2. UK should specialize in and export wine in which it has smaller absolute disadvantage.

COMPARATIVE ADVANTAGE THEORY

KEY LEARNINGS
1. In simpler terms, Comparative Advantage Theory maintains that international trade is solely
due to international differences in the productivity of labor.
2. In other words, The basic prediction of Ricardos principle is that countries will tend to export
those goods in which their labor productivity is relatively high.
3. Extends free trade argument
4. Efficiency of resource utilization leads to more productivity
5. Should import even if country is more efficient in the products production than country from
which it is buying.
6. Look to see how much more efficient. If only comparatively efficient, than import.
7. Makes better use of resources

8. Trade is a positive-sum game

PRODUCTION POSSIBILITIES SCHEDULES

According to Ricardos principle of comparative advantage, specialization
and trade can lead to gains for both the countries.
Then production possibilities depend on the Marginal Rate of
Transformation (MRT).
MRT is represented by the slope of production possibilities schedule.

APPLICATION OF LEARNINGS
Student A is an academic scholar who almost constantly gets a GPA of 8.2 out of 10
every semester. This he is able to get by allotting 54 hours of study time every week.
Supposedly, student A is also good at dancing and was planning to join their schools
dance troop.

On the other hand, B is an average student who was also planning to join the troop.
Unfortunately, only one of them can be qualified. Moreover, the troop allots 20 hours for
practice weekly.
Student A is undeniably better than Student B in both dancing and academics.
Should Student A join the troop? Explain and apply the concepts of specialization,
opportunity cost, absolute and comparative advantage and trade.

APPLICATION DISCUSSED..
Student A has an absolute advantage over Student B in both academics and paperwork.
Still, by joining the Dance troop, Student As allotted time for studying will be reduced to 34
hours every week. If he lets Student B join the Dance troop instead, he will not be robbed of
time for study and his grades will not be affected in the process.
Even though Student A is both better at academics and dancing, it is better for him to
specialize in academics (if he wants to maintain his academic standing) in which he has a
comparative advantage, and allow Student B to join the Dance troop. If he allows the other,
there will be trade.
The opportunity cost to Student A of being in the Dance troop is high. For Student B, who is an
average student, the opportunity costs of being in the Dance troop are lesser.

MARGINAL RATE OF TRANSFORMATION

PRODUCTION POSSIBILITIES SCHEDULES:

CONSTANT OPPORTUNITY COSTS
1.
2.
3.

Generalizes theory to include all factors, not just labor

Shows combinations of products that can be made if all factors are used efficiently
Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how
much of one good must be given up to make more of another)

SUPPLY SCHEDULES

(ASSUMING CONSTANT OPPORTUNITY COSTS)

INTERNATIONAL TRADE
(ASSUMING CONSTANT OPPORTUNITY COSTS)

BASIS OF TRADE AND DIRECTION OF

TRADE
According to Comparative Advantage Theory, the Basis of Trade
stems from the mutually favorable specialization and trade owing
to the differences in the countries relative costs.
The Direction of Trade stems from the basis of constant opportunity
costs.

The Terms of Trade is the relative price of the exportable good

expressed in units of the importable good.

POTENTIAL GAINS FROM

SPECIALIZATION
According to Comparative Advantage theory, the two countries
should move the production levels into the areas of specialization
and can result in production gains for both.
In the previous illustration:

US should move from A to B for production of Autos.

Canada should move from A to B for Wheat production.

COMPARATIVE ADVANTAGE THEORY:

PRODUCTION GAINS FROM SPECIALIZATION:
CONSTANT OPPORTUNITY COSTS

Before
Specialization
Autos Wheat

After
Net Gain
Specialization
(Loss)
Autos Wheat Autos Wheat

US
40
Canada 40

40
80

120
0

0
160

80
-40

-40
80

World

120

120

160

40

40

80

CONSUMPTION GAINS FROM TRADE

In the absence of trade (autarky), the consumption alternatives are limited

However, with specialization and trade, two nations can achieve post trade consumption gains.
In the previous illustration; As US specializes in Autos and Canada in Wheat, in the post trade scenario,
US can consume enough Wheat and enough Autos. Similarly, Canada can use enough Autos and enough
Wheat.
Before
Specialization

After
Specialization

Net Gain
(Loss)

Autos

Wheat

Autos

Wheat

Autos Wheat

US
Canada

5
17

18
6

12
13

14
13

7
-4

-4
7

World

22

24

25

26

Trading Possibilities Line

Trading Possibilities line is represents the terms of trade for both the countries.
Trade Triangle is the triangle showing the exports on X-axis and imports on Y-axis and terms of trade (the
slope).
Complete specialization occurs when the countries specialize in and produce only one good.
Trading under increasing costs: US
TRADING UNDER INCREASING COSTS: CANADA

EQUILIBRIUM TERMS OF TRADE

According to Ricardo, the domestic cost ratios set the outer limits for the equilibrium terms of trade.

Domestic cost ratio line essentially becomes the no-trade boundary.

Equilibrium terms of trade happens in the region of mutually beneficial trade.

INTERNATIONAL EQUILIBRIUM TERMS OF TRADE

THEORY OF RECIPROCAL DEMAND

John Stuart Mill (1806-1873)
1. Reciprocal Demand Theory states that within the outer limits of terms of trade, the
actual terms of trade is determined by the relative strength of each countrys
demand for other countrys product.
2. Actual trading prices depend on the interaction of trading partners demands
3. Final terms of trade will be closer to the domestic price ratio of the nation with
stronger demand for the imported good
4. Applies to nations of equal economic size, which will share gains nearly equally
5. Small nations trading with large ones can receive the bulk of the gains from trade

DYNAMIC AND STATIC GAINS FROM TRADE

Dynamic Gains from Trade

Acquiring of additional resources will provide dynamic gains from

international trade.
Increases in economic well-being that accrue to
a country because trade expands the countrys
productive resources or raises resource productivity
For e.g. Switzerland producing watches
Static Gains from trade

Gains in word output that result from specialization and trade are
the static gains from trade.

FACTOR ENDOWMENT THEORY

Heckscher (1919) - Olin (1933) Theory
States that Comparative advantage is explained exclusively by cost differences
in relative national supply conditions. However, the resource endowments are the
key determinants of comparative advantage.
Comparative advantage is explained entirely by different national supply
conditions, especially resource endowments.
Nations export products that use inputs which are relatively abundant (cheap) at
home, and import products which need inputs which are relatively scarce
(expensive) at home

FACTOR ENDOWMENT THEORY..

Relative price levels differ among nations because:
1. Nations have different factor endowments for factor inputs.
2. Different commodities require that the factor inputs be used with differing intensities
in their production.
3. Patterns of trade are determined by differences in factor endowments - not
productivity

THE LEONTIEF PARADOX, 1953

Disputes Heckscher-Olin in some instances.
Factor endowments can be impacted by government policy minimum wage.
US tends to export labor-intensive products, but is regarded as a
capital intensive country.

HECKSCHER VS RICARDO

FACTOR ENDOWMENT THEORY VS COMPARATIVE ADVANTAGE THEORY

1. Economists prefer Heckscher on theoretical grounds but is a relatively

poor predictor of trade patterns.
2. Ricardos Comparative Advantage Theory, regarded as too limited for
predicting trade patterns, actually predicts them with greater accuracy.

3. In the end, differences in productivity may be the key to determining

trade patterns.

THE PRODUCT LIFE CYCLE THEORY

Raymond Vernon, 1966
1. Focuses on the role of technological innovation as a key determinant of trade
patterns in manufactured goods.
2. According to this theory, many manufactured goods such as electronic products
and office machinery undergo a predictable life cycle.
3. During this life cycle, home country initially is an exporter, then looses its
competitive advantage vis-a-vis its trading partners and eventually may become
an importer of the commodity.

THE PRODUCT LIFE CYCLE THEORY

1. As products mature, both location of sales and optimal production changes.
2. Affects the direction and flow of imports and exports.

3. Globalization and integration of the economy makes this theory less valid.

International Product Trade Cycle Model

production

High Income Countries

Exports

Q
u
a
nt
it
y

Imports

10

11

12

13

14

Medium Income Countries

consumption

15

Exports

Imports
1

10

11

12

13

14

15

Low Income Countries

Exports

Imports
1

New Product

Maturing Product

10

11

12

13

14

Standardized Product

Stages of Production Development

15

Time

PORTERS THEORY OF NATIONAL DIAMOND

Michel Porter (1990)
The Competitive Advantage of Nations.
Looked at 100 industries in 10 nations.
Thought existing theories didnt go far enough.

Question: Why does a nation achieve international success in a particular

industry?
Success occurs where these attributes exist.
More/greater the attribute, the higher chance of success.

The diamond is mutually reinforcing.

Porters Diamond

Determinants of National Competitive Advantage

Firm Strategy,
Structure and
Rivalry

Factor Endowments

Demand Conditions

Related and
Supporting
Industries

DETERMINANTS OF NATIONAL COMPETITIVE ADVANTAGE

1. Factor endowments: Nations position in factors of production such as skilled
labor or infrastructure necessary to compete in a given industry.
2. Firm strategy, structure and rivalry: The conditions in the nation governing
how companies are created, organized, and managed and the nature of
domestic rivalry.
3. Demand conditions: The nature of home demand for the industrys product
or service.
4. Related and supporting industries: The presence or absence in a nation of
supplier industries or related industries that are nationally competitive.

PORTERS NATIONAL DIAMOND

Firm Strategy, Structure
and Rivalry

Factor Endowments

Management ideology can Taken from Heckschereither help or hurt you.

Olin
Basic factors:
Presence of domestic
Natural resources,
rivalry improves a
climate, location.
companys competitiveness. Advanced factors:
Communications, skilled
labor, technology

Demand Conditions
Demand creates the
capabilities.

Look for sophisticated

and demanding
consumers.
Impacts quality and
innovation.

Related and
Supporting Industries
Creates clusters of
supporting industries
that are internationally
competitive.
Must also meet
requirements
of other parts of the
Diamond.

Determinants of
National Competitive Advantage
Chance
Company Strategy,
Structure,
and Rivalry

Two external
factors that
influence the four
determinants.

Factor
Conditions

Demand
Conditions

Related
and Supporting
Industries

Government

PORTERS PREDICTIONS
1. Porters theory should predict the pattern of international trade that we observe in the real
world.
2. Countries should be exporting products from those industries where all four components of the
diamond are favorable, while importing in those areas where the components are not
favorable.
3. Location implications:
Disperse production activities to countries where they can be performed most efficiently
4. First-mover implications:
Invest substantial financial resources in building a first-mover, or early-mover advantage

5. Policy implications:
Promoting free trade is in the best interests of the home-country, not always in the best
interests of the firm, even though, many firms promote open markets

INTERNATIONAL TRADE BENEFITS

1. Greater variety of goods available
2. Efficient allocation and utilization

3. Promotes Efficiency in production

4. More employment
5. Consumption at cheaper cost

6. Reduced trade fluctuations

7. Utilization of surplus produce
8. Fosters peace and goodwill

INTERNATIONAL TRADE DEMERITS

1. One may need to wait for long term gains

2. Hiring professional staffs to launch international trade is timely and costly to do

3.
4. Modifying product or packaging
5. Develop new promotional material

INDIAS COMPETITIVENESS RANK

What is Absolute Advantage?

WHAT IS ABSOLUTE ADVANTAGE?

Answer:
The ability of a country to produce a good using
fewer resources than another country

What is Comparative Advantage?

WHAT IS COMPARATIVE ADVANTAGE?

Answer:
The ability of a country to produce a good at a
lower opportunity cost than another country

What is Free Trade?

WHAT IS FREE TRADE?

Answer:
The flow of goods between countries without
restrictions or special taxes

With trade, the production possibilities for two

nations lie
a)
b)
c)
d)

outside their consumption possibilities.

inside their consumption possibilities.
at a point equal to the world production possibilities
curve.
none of the above.

With trade, the production possibilities for two

nations lie
a)
b)
c)

d)

outside their consumption possibilities.

inside their consumption possibilities.
at a point equal to the world production
possibilities curve.
none of the above.

Answer: b.
The Reason: When countries specialize and trade, total world output
increases and potential total world consumption also increases.

Free trade theory suggests that when trade takes place

a)

both nations will be worse off.

b)

one nation must gain at the other nations expense.

c)

both nations are better off.

d)

one nation will gain and the other nation will be neither better nor worse off.

Free trade theory suggests that when trade takes place

a)

both nations will be worse off.

b)

one nation must gain at the other nations expense.

c)

both nations are better off.

d)

one nation will gain and the other nation will be neither better nor worse off.

Answer: C.
Reason: Free trade allows a country to consume a combination of
goods that exceeds its production possibilities curve.

Which of the following is true when two countries specialize

according to their comparative advantage?
a) It is possible to increase their total output of all goods.
b) It is possible to increase their total output of some goods only
if both countries are industrialized.
c) One country is likely to gain from trade while the other loses.
d) None of the above.

Which of the following is true when two countries specialize

according to their comparative advantage?
a. It is possible to increase their total output of all goods.
b. It is possible to increase their total output of some goods only
if both countries are industrialized.
c. One country is likely to gain from trade while the other loses.
d. None of the above.
Answer: A.
Reason: Comparative advantage is the ability of a country to produce a good at a
lower opportunity cost than another country.

According to the theory of comparative advantage, a

country should produce and
a)
b)
c)
d)

import goods in which it has an absolute advantage.

export goods in which it has an absolute advantage.
import goods in which it has a comparative advantage.
export goods in which it has a comparative advantage.

According to the theory of comparative advantage, a

country should produce and
a. import goods in which it has an absolute advantage.
b. export goods in which it has an absolute advantage.
c. import goods in which it has a comparative advantage.
d. export goods in which it has a comparative advantage.
Answer: d.
Reason: Dont confuse comparative advantage and absolute advantage. Absolute
advantage is the ability of a country to produce a good using fewer resources than
another country.

Exhibit 1: Potatoes and Wheat Output (tons per hour)

COUNTRY

POTATOES

WHEAT

U.S.

Ireland

In Exhibit 1, which country has the comparative

advantage in the production of potatoes?
a) The United States because it requires fewer resources to
produce potatoes.
b) The United States because it has the lower opportunity cost of
potatoes.
c) Ireland because it requires fewer resources to produce
potatoes.
d) Ireland because it has the lower opportunity cost of potatoes.

In Exhibit 1, which country has the comparative

advantage in the production of potatoes?
a) The United States because it requires fewer resources to
produce potatoes.
b) The United States because it has the lower opportunity cost of
potatoes.
c) Ireland because it requires fewer resources to produce
potatoes.
d) Ireland because it has the lower opportunity cost of potatoes.
Answer: d.
Reason: To produce 1 ton of potatoes, the opportunity cost for the U.S. is 3 tons of
wheat. To produce 1 ton of potatoes, the opportunity cost for Ireland is 2 tons of
wheat.

In Exhibit 1, the opportunity cost of wheat is

a) 1/3 ton of potatoes in the United States and 1/2 ton of
potatoes in Ireland.
b) 2 tons of potatoes in the United States and 1 1/2 tons of
potatoes in Ireland.
c) 8 tons of potatoes in the United States and 4 tons of potatoes
in Ireland.
d) 1/2 ton of potatoes in the United State and 2/3 ton of potatoes
in Ireland.

In Exhibit 1, the opportunity cost of wheat is

a) 1/3 ton of potatoes in the United States and 1/2 ton of
potatoes in Ireland.
b) 2 tons of potatoes in the United States and 1 1/2 tons of
potatoes in Ireland.
c) 8 tons of potatoes in the United States and 4 tons of potatoes
in Ireland.
d) 1/2 ton of potatoes in the United State and 2/3 ton of potatoes
in Ireland.
Answer: a)
Reason:
U.S. 1 ton potatoes = 3 tons of wheat
1/3 ton of potatoes = 1 ton of wheat
Ireland 1 ton potatoes = 2 tons of wheat
1/2 ton potatoes = 1 ton of wheat

In Exhibit 1, the opportunity cost of potatoes

is
a) 1/2 ton of wheat in the United States and 2/3 ton of
wheat in Ireland.
b) 2 tons of wheat in the United States and 1 1/2 tons of
wheat in Ireland.
c) 16 tons of wheat in the United States and 6 tons of wheat
in Ireland.
d) 3 tons of wheat in the United States and 2 tons of wheat
in Ireland.

In Exhibit 1, the opportunity cost of potatoes

is
a) 1/2 ton of wheat in the United States and 2/3 ton of
wheat in Ireland.
b) 2 tons of wheat in the United States and 1 1/2 tons of
wheat in Ireland.
c) 16 tons of wheat in the United States and 6 tons of wheat
in Ireland.
d) 3 tons of wheat in the United States and 2 tons of wheat
in Ireland.
Answer: d)
Reason:

U.S. 1 ton potatoes = 3 tons of wheat

Ireland 1 ton potatoes = 2 tons of wheat

If the countries In Exhibit 1 follow the principle of

comparative advantage, the United States should
a)
b)
c)
d)

buy all of its potatoes from Ireland.

buy all of its wheat from Ireland.
buy all of its potatoes and wheat from Ireland.
produce both potatoes and wheat and not trade with
Ireland.

If the countries In Exhibit 1 follow the principle of

comparative advantage, the United States should
a)
b)
c)
d)

buy all of its potatoes from Ireland.

buy all of its wheat from Ireland.
buy all of its potatoes and wheat from Ireland.
produce both potatoes and wheat and not trade with
Ireland.

Answer: a)
Reason: The U.S. should specialize in the production of wheat when it has a
comparative advantage (see question 6 for opportunity cost calculations).

If the countries In Exhibit 1 follow the principle of

comparative advantage, the United States should
a)
b)
c)
d)

buy all of its potatoes from Ireland.

buy all of its wheat from Ireland.
buy all of its potatoes and wheat from Ireland.
produce both potatoes and wheat and not trade with
Ireland.

Answer: a)A. The U.S. should specialize in the production of wheat when it has
a comparative advantage (see question 6 for opportunity cost calculations).