Blog on Commerce & Management

Personal Blog site of Anish Thomas Assistant Professor, P.G. Department of

Commerce, Deva Matha College, Kuravilangad, Kottayam DT. Kerala - 686 633
S.India. (Former Course Co-ordinator, P.G. Department of Commerce, Marian
College Kuttikkanam, Peermade, Idukki DT. Kerala, S.India)
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 worlds most efficient textile
manufacturer. Due to the combination of favorable climate, good soils, and
accumulated expertise, the French had the worlds 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.
.
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 Ricardos 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:

The most efficient allocation of world resources as well as the maximization of
world production.
A redistribution of relative product demands, resulting in greater equality of product
prices among trading nations; and
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:
Labour is the only element of cost;
Production is subject to the law of constant returns;
International trade is free from all barriers;
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 its over simplifying and unrealistic assumptions.

Wassily W.Leontiefs 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 Leontiefs paradox, which is a negation of the
Heckscher-Ohlin thesis. It should however be pointed out that Leontiefs 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 1960s.
Vernons 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. Posners 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 countrys
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.
Porters 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
Porters 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, Porters 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 Leontiefs 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 basesnatural 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.

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. Kindlebergers thesis, Metzler Paradox, Eckaus theory etc. are some of
the recent theories in this filed.

BIBLIOGRAPHY
1. Bastable, J., Theory of International Trade.
2. Bhagawati, J., The Theory of International Trade. Indian Economic Journal VIII,
No.167 July 1960.
3. Carbaugh, Robert J., International Economics. Third edition.
4. Aswathappa .K., International Business, Tata Mcgraw Hill
5. Das, S.P. Economies of Scale, Imperfect Competition, and the Pattern of Trade.
Economic Journal, September 1982.
6. Cherunilam, Francis, International Trade and Export Management, 10th Edition,
2001.
7. Deardorff, A.V.: The General Validity of the Heckscher-Ohlin Theorem. American
Economic Review, September 1982.
8. Dr. SubbaRoa.P, International Business, 2003 Edition

9. Haberler, G., A Survey of International Trade Theory.
10. Kindleberge, C., International Economics.
11. Hill ,Charles .W.L., International Business, 2004 Edition.
12. Bennet, Roger, International Business, 2005 Edition.