THEORIES OF

INTERNATIONAL
TRADE
 INDEX
1.Introduction (outline of the topic).
2.Learning objective.
3.Classical country-based theory.
4.Modern firm-based theory.
5.Conclusion.
 OUTLINE on theories of
international trade.
I. What is trade?
II. What do we understand by international trade?
III. What are international trade theories?
Learning objective
classical Country-based theory is divided
into:-

Hecksher’s
Mercantilism
Theory of ohlin theory.
theory
Theory of comparative
absolute advantage.
advantage.
 Mercantilism theory
• This theory was developed in the 16th century.
• It was a common practice in europe from 16th to 18th
century.
• This theory was the earliest effort to develop economic
theory.
• Mercantilism focused on encouragement of exports for
increase in wealth and discouraged imports.
• Although mercantilism is one of the oldest trade theories,it
remains part of modern thinking.
WHAT EXACTLY MERCANTILISM
THEORY IS.
 POLICIES OF MERCANTILISM.
• Building a network of overseas colonies.
• Forbidding colonies to trade with other nations.
• Banning the export of gold and silver, even for
payments.
• Forbidding trade to be carried in foreign ships.
• Export subsidies.
• Promoting manufacturing with research or direct
subsidies.
• Limiting wages.
• Maximizing the use of domestic resources.
• Restricting domestic consumption with non-tariff
barriers to trade.
 CRITICISM OF MERCANTILISM THEORY.
• Supported only in short run
• Overlooks other resources such as its natural
resources manpower and its skills levels, capital
etc.
• Used by colonial powers as a means of exploitation
and not development .
• Caused much discontent in the colonies like India
and Srilanka etc.
• Led to impaired growth .
• Went against the principles of a laissez-faire
economy.
• EXPORT inflow GOLD = INFLATION.
 ABSOLUTE ADVANTAGE THEORY
• It focuses on the ability of the country to
produce a good more efficiently than the other
nation.
• This theory was introduced by Adam Smith 1776.

HE STATED THAT:-
1.Export productive goods and vice versa.
2.Increase standard of living.
3.He supported laissez faire economy.
4.No government restriction for trade – free trade.
DEMONSTRATION OF ABSOLUTE
ADVANTAGE THEORY.

EXAMPLE
 ASSUMPTIONS OF ABSOLUTE
ADVANTAGE.
• 2 countries 2 commodities.
• Labour as the only input.
• Only single currency assumed.
• Homogeneous factors of production.
• Small units of production.
CRITICISM OF ABSOLUTE ADVANTAGE
THEORY.
• Not beneficial for many countries.
• Unrealistic assumptions.
• Only one country enjoyed absolute advantage over
other.
• Neglected transportation cost.
• It was irrespective of country size.
 THEORY OF COMPARATIVE
ADVANTAGE.
• This theory was introduced by David Ricardo
an english economist in the year 1817.
• It focuses on production of goods at lower
opportunity cost.
• Comparative advantage is different from
absolute advantage.
• Relative productivity.
COMPARATIVE ADVANTAGE.

In short comparative
advantage means
comparison between
2 commodities ,
services or efficiency.

EXAMPLE
 ASSUMPTIONS OF COMPARATIVE
ADVANTAGE.
• Constant cost and no economies of scale.
• Homogeneous goods.
• Perfect knowledge.
• No transport cost.
 CRITICISM OF COMPARATIVE
ADVANTAGE.
• Based on only two countries and only two
commodities.
• Value of goods is not experssed in money.
• It assumes fixed quantity of resources.
• Not applicable to developing countries.
• Neglected transportation cost.
Relative Factor Endowments Or
Heckscher-ohlin Theory.

• Developed by Eli heckscher

and Bertil ohlin (swedish
economists) in early 1900s.

• Their theory is also called

factor proportions theory.
 OHLIN’S THEORY.

• This theory is based on production factors.

• Supply and demand was determined by resource
cost.
• Supply Demand = Cheaper.
AND
supply Demand = Expensive.

• Hence countries would import short supply goods

which have higher demand.
 ASSUMPTIONS OF OHLIN’S THEORY.
• Identical production technology.
• Constant return to scale.
• Different commodities different technologies.
• Mobility of capital and labour.
 CRITICISM OF HECKSCHER OHLIN
THEORY.
• Compared (U.S and U.K) with rest of the world.
• Ignored product difference , transport cost and
trade barriers.
• Same production function for all.
• Leontief Paradox.
• Excluded unemployment factor.
• Unrealistic.
• Prices are not determined by factor cost.
 MODERN FIRM BASED THEORY IS
DIVIDED INTO:-

Country Porter’s
similarity diamond
theory. model.
Product life Global strategic
cycle theory. rivalry theory.
 COUNTRY SIMILARITY THEORY
• Developed by Swedish economist Steffen Linder
• This theory came into existence in 1961
• Based on intra – industry trade
• Explains trade in differentiated goods
• Explains intra – industry trade
• Mostly seen in countries with
1. Same per capita income
2. Similar infrastructure/distribution system
3. Same language/culture/religion/tastes etc.
 COUNTRY SIMILARITY THEORY
Example of intra trade:

Japan exports Toyotas to Germany and Germany exports

BMW to Japan.
 COUNTRY SIMILARITY THEORY
• Countries with similar stage of development would
have similar preferences. For e.g.
1. UK and USA have similar infrastructural needs.

• Brand names and product reputation plays an

importance role. For e.g.
1. Toyota and BMW has a strong brand reputation
hence the buyer country willingly imports them.
 CRITICISM OF COUNTRY SIMILARITY
THEORY.
• Difficult to find similar markets.
• Applies only to differentiated manufactured
goods.
• Ignores opportunities in developing countries.
• Narrow scope.
 PRODUCT LIFE CYCLE THEORY
• Raymond vernon , a Harvard business school
professor , developed the product life cycle theory
in the 1960s.
• This was a useful theory to explain the
manufacturing success of the US.
• Manufacturing and trade flow of a product goes
through 4 phases:
a. INTRODUCTION. c. MATURITY.
b. GROWTH. d. DECLINE.
PRODUCT LIFE CYCLE THEORY.
 CRITICISM OF PRODUCT LIFE CYCLE
THEORY.
• The theory has been less able to explain current trade
patterns.
• Vernon’s view is ethnocentric.
• From the 60s the world’s trading has changed
immensely over the years.
• The relation between the organisation and the country
level was not well structured.
• Theory is stressing the supply side and not the
customer side.
• The research did not consider the emergence of global
consumer segments.
 GLOBAL STRATEGIC RIVALRY THEROY
• This theory emerged in the 1980s by economists
Paul Krugman and Kelvin Lancaster.
• Their theory focused on MNCs and their efforts to
gain competitive advantage against other global
firms in their industry.
• Global competition will led the firms to develop
competitive advantages.
• Competitive advantage will refer to barriers to entry
for a new firm.
 GLOBAL STRATEGIC RIVALRY THEORY.
• Ways of obtaining competitive advantage are:-
a. Research and development.
b. Ownership of intellectual property rights.
c. Economies of scale.
d. Unique business methods or experience in the
industry.
e. Favourable access to raw materials.
 GLOBAL STRATEGIC RIVALRY THEORY

Example of rivalry companies Example of strategic

in the market. alliance of two companies.
 PORTER’S DIAMOND MODEL.
• Michael porter of Harvard business school
developed this new model to explain national
competitive advantage in 1990.
• His theory focused on explaining why some nations
are more competitive in certain industries.
• Four determinants of national advantage are:
 CRITICISM OF PORTER’S DIAMOND
MODEL.
• This model applies only to developed economies as
porter developed this model by looking at 10
developed countries.
• FDI does not increase domestic competition.
• Porter model does not adequately address the role
MNCs.
• It focused on manufacturers, banks and
management consultancy firms.
• Not all firms from a country are successful ,
suggesting that corporate management is more
important than geographical.
 CONCLUSION.
• Trade theory must explicitly take into account
non-economic objectives and place trade
theory in a larger socio-politico-economic
setting if we wish the theory to be of any
practical use.
THANK YOU