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International Trade Theory Essay

7 theories of international trade:
1. Mercantilism
2. Absolute Advantage
3. Comparative Advantage
4. Heckscher-Ohlin Theory
5. Product Life-Cycle Theory
6. New Trade Theory
7. The Theory of National Competitive Advantage

1. Mercantilism
-emerged in England in the mid-16th century. The main tenet of mercantilism was that it was in a country’s best interests more than it imported. Consistent with this belief, the mercantilist doctrine advocated government intervention to achieve a surplus in the balance of trade. To achieve this, imports were limited by tariffs and quotas, while exports were subsidized. The flaw with mercantilism was that it viewed trade as a zero-sum game.

Zero-sum Game- is one in which a gain by one country results in a loss by another. 2. Absolute Advantage -In his 1776 landmark book The Wealth of Nations, Adam Smith attacked the mercantilist assumption that trade is a zero-sum game. He argued that countries differ in their ability to produce goods efficiently. According to Smith, countries should specialize in the production of goods for which they have an absolute advantage and then trade these for goods produced by other countries.

He added that a country should never produce goods at home that it can buy at a lower cost from other countries. Smith demonstrates that, by specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade.

3. Comparative Advantage
-In his 1817 book Principles of Political Economy, David Ricardo of Comparative Advantage Theory said that it makes sense for a country to specialize in the production of those goods that it produces most efficiently and to buy the goods that it produces less efficiently from other countries, even if this means buying goods from other countries that it could produce more efficiently itself.

The basic message of this theory is that potential world production is greater with unrestricted free trade than it is with restricted trade. It suggests that consumers in all nations can consume more if there are no restrictions on the trade and that trade is a positive-sum game in which all countries that participate realize economic gains.

Three of the assumptions in the comparative advantage model: 1. Resources move freely from the production of one good to another within a country. 2. There are constant returns to scale. 3. Trade does not change a country’s stock of resources or the efficiency with which those resources are utilized. The Samuelson Critique- looks at what happens when a rich country -the United States- enters into a free trade agreement with a poor country -China- that rapidly improves its productivity after the introduction of a free trade regime.

4. Heckscher- Ohlin Theory
-Swedish economists Eli Heckscher (1919) and Bertil Ohlin (1933) put forward a different explanation of comparative advantage. They argued that comparative advantage arises from the differences in national factor endowments. Factor endowments meant the extent to which a country is endowed with such resources as land, labor, and capital. Nations have varying factor endowments, and these explain differences in factor costs; specifically, the more abundant a factor, the lower its cost.

This theory predicts that countries will export those goods that make intensive use of factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce.

This also argues that free is beneficial. But unlike Ricardo’s theory, this theory argues that the pattern of
international trade is determined by differences in factor endowments, rather than differences in productivity. The Leontief Paradox- a famous study published in 1953 by Nobel Prize winner Wassily Leontief. The result of the study was at variance with the predictions of the Heckscher- Ohlin Theory.

5. The Product Life-Cycle Theory
-this was originally proposed by Raymond Vernon in the mid-1960s. This theory tells us that where a new product was introduced is important. This theory suggests that early in their life cycle, most new products are produced in and exported from the country in which they were developed. As a new product becomes widely accepted internationally, production starts in other countries. As a result, the theory suggests, the product may ultimately be exported back to the country of its original innovation.

6. New Trade Theory
-this was developed by economist Paul Krugman in 1980s who pointed out that the ability of firms to attain economies of scale might have important implications for international trade. Economies of scale are unit cost reductions associated with a large scale of output. They are a major source cost reductions in many industries. Two important points of the New Trade Theory:

 First, through its impact on economies of scale, trade can increase the variety of goods available to consumers and decrease the average costs of those goods.  Second, in those industries when the output required to attain economies of scale represents a significant proportion of total world demand, the global market may only be able to support a small number of enterprises. Another theme of the New Trade Theory is that the pattern of trade we observe in the world economy may be the result of economies of scale and first mover advantages.

The theory suggests that a country may predominate in the export of a good simply because it was lucky enough to have one or more firms among the first to produce that good. 7. The Theory of National Competitive Advantage: Porter’s Diamond -this was developed by Michael Porter in 1990. For him, the essential task was to explain why a nation achieves international success in a particular industry. Four attributes that constitute the Porter’s Diamond:

 Factor Endowments- a nation’s position in factors of production such as skilled labor or the infrastructure necessary to compete in a given industry.  Demand Conditions- the nature of home demand for the industry’s product or service.  Relating and supporting industries-the presence or absence of supplier industries and related industries that are internationally competitive.  Firm strategy, structure, and rivalry- the conditions governing how companies are created, organized, and managed and the nature of domestic rivalry.

Porter argues that firms are more likely to succeed in industries where the diamond is most favorable. He also argues that the diamond is a mutually reinforcing system. The effect of one attribute is contingent on the state of others.

The theories discussed have at least three main implications for international businesses:  Location Implications
 First-mover Implications
 Policy Implications

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