International Trade

INTERNATIONAL TRADE:
International trade is the exchange of capital, goods, and services

across international borders or territories because there is a need or
want of goods or services. (see: World economy) In most countries,
such trade represents a significant share of gross domestic product
(GDP).
The main historical theories are called classical and are from the perspective of a country, or
country-based. By the mid-twentieth century, the theories began to shift to explain trade from a firm,
rather than a country, perspective.
These theories are referred to as modern and are firm-based or company-based. Both of these
categories, classical and modern, consist of several international theories.
Classical or Country-Based Trade Theories

Mercantilism
Developed in the sixteenth century, This theory stated that a country’s wealth was determined by the
amount of its gold and silver holdings. In it’s simplest sense, mercantilists believed that a country
should increase its holdings of gold and silver by promoting exports and discouraging imports.
EXPLANATION:
n other words, if people in other countries buy more from you (exports) than they sell to you
(imports), then they have to pay you the difference in gold and silver
Absolute Advantage
Smith offered a new trade theory called absolute advantage, which focused on the ability of a country
to produce a good more efficiently than another nation. Smith reasoned that trade between countries
shouldn’t be regulated or restricted by government policy or intervention. He stated that trade
should flow naturally according to market forces. In a hypothetical two-country world, if Country A
could produce a good cheaper or faster (or both) than Country B, then Country A had the advantage
and could focus on specializing on producing that good.
EXPLANATION:
Smith’s theory reasoned that with increased efficiencies, people in both countries would benefit and
trade should be encouraged. His theory stated that a nation’s wealth shouldn’t be judged by how
much gold and silver it had but rather by the living standards of its people.
Comparative Advantage
the absolute advantage theory was that some countries may be better at producing both goods and,
therefore, have an advantage in many areas. In contrast, another country may not have any useful
absolute advantages.
EXPLANATION:
if Country A had the absolute advantage in the production of both products, specialization and trade
could still occur between two countries. Comparative advantage focuses on the relative productivity
differences, whereas absolute advantage looks at the absolute productivity.
Heckscher-Ohlin Theory (Factor Proportions Theory)

Their theory is based on a country’s production factors—land, labor, and capital, which provide the
funds for investment in plants and equipment. They determined that the cost of any factor or
resource was a function of supply and demand. Factors that were in great supply relative to demand
would be cheaper; factors in great demand relative to supply would be more expensive. Their theory,
also called the factor proportions theory, stated that countries would produce and export goods that
required resources or factors that were in great supply and, therefore, cheaper production factors. In
contrast, countries would import goods that required resources that were in short supply, but higher
demand.
EXPLANATION:
For example, China and India are home to cheap, large pools of labor. Hence these countries have
become the optimal locations for labor-intensive industries like textiles and garments.
Leontief Paradox
the Leontief Paradox because it was the reverse of what was expected by the factor proportions
theory. In subsequent years, economists have noted historically at that point in time, labor in the
United States was both available in steady supply and more productive than in many other countries;
hence it made sense to export labor-intensive goods. Over the decades, many economists have used
theories and data to explain and minimize the impact of the paradox. However, what remains clear is
that international trade is complex and is impacted by numerous and often-changing factors. Trade
cannot be explained neatly by one single theory, and more importantly, our understanding of
international trade theories continues to evolve.
EXPLANATION:
According to the factor proportions theory, the United States should have been importing labor-
intensive goods, but instead it was actually exporting them.
Modern or Firm-Based Trade Theories

In contrast to classical, country-based trade theories, the category of modern, firm-based theories
emerged after World War II and was developed in large part by business school professors, not
economists. The firm-based theories evolved with the growth of the multinational company (MNC).
The country-based theories couldn’t adequately address the expansion of either MNCs
or intraindustry trade, which refers to trade between two countries of goods produced in the same
industry.
EXPLANATION:
For example, Japan exports Toyota vehicles to Germany and imports Mercedes-Benz automobiles
from Germany. Unlike the country-based theories, firm-based theories incorporate other product
and service factors, including brand and customer loyalty, technology, and quality, into the
understanding of trade flows.
Country Similarity Theory
the country similarity theory in 1961, as he tried to explain the concept of intraindustry trade.
Linder’s theory proposed that consumers in countries that are in the same or similar stage of
development would have similar preferences. In this firm-based theory, Linder suggested that
companies first produce for domestic consumption. When they explore exporting, the companies
often find that markets that look similar to their domestic one, in terms of customer preferences,
offer the most potential for success. Linder’s country similarity theory then states that most trade in
manufactured goods will be between countries with similar per capita incomes, and intraindustry
trade will be common.
EXPLANATION:
This theory is often most useful in understanding trade in goods where brand names and product
reputations are important factors in the buyers’ decision-making and purchasing processes.
Product Life Cycle Theory

the product life cycle theory in the 1960s. The theory, originating in the field of marketing, stated
that a product life cycle has three distinct stages: (1) new product, (2) maturing product, and (3)
standardized product. The theory assumed that production of the new product will occur completely
in the home country of its innovation. In the 1960s this was a useful theory to explain the
manufacturing success of the United States. US manufacturing was the globally dominant producer
in many industries after World War II.
EXPLANATION:
The product life cycle theory has been less able to explain current trade patterns where innovation
and manufacturing occur around the world. For example, global companies even conduct research
and development in developing markets where highly skilled labor and facilities are usually cheaper.
Global Strategic Rivalry Theory
Global strategic rivalry theory emerged in the 1980s and was based on the work of economists Paul
Krugman and Kelvin Lancaster. Their theory focused on MNCs and their efforts to gain a competitive
advantage against other global firms in their industry. Firms will encounter global competition in
their industries and in order to prosper, they must develop competitive advantages. The critical ways
that firms can obtain a sustainable competitive advantage are called the barriers to entry for that
industry. The barriers to entry refer to the obstacles a new firm may face when trying to enter into an
industry or new market. The barriers to entry that corporations may seek to optimize include:
 research and development,
 the ownership of intellectual property rights,

 economies of scale,
 unique business processes or methods as well as extensive experience in the industry, and
 the control of resources or favorable access to raw materials.
Porter’s National Competitive Advantage Theory

Porter’s theory stated that a nation’s competitiveness in an industry depends on the capacity of the
industry to innovate and upgrade. His theory focused on explaining why some nations are more
competitive in certain industries. To explain his theory, Porter identified four determinants that he
linked together. The four determinants are (1) local market resources and capabilities, (2) local
market demand conditions, (3) local suppliers and complementary industries, and (4) local firm
characteristics.
1. Local market resources and capabilities (factor conditions). Porter recognized the
value of the factor proportions theory, which considers a nation’s resources (e.g., natural
resources and available labor) as key factors in determining what products a country will
import or export.
2. Local market demand conditions. Porter believed that a sophisticated home market is
critical to ensuring ongoing innovation, thereby creating a sustainable competitive
advantage. Companies whose domestic markets are sophisticated, trendsetting, and
demanding forces continuous innovation and the development of new products and
technologies.
3. Local suppliers and complementary industries. To remain competitive, large global
firms benefit from having strong, efficient supporting and related industries to provide the
inputs required by the industry. Certain industries cluster geographically, which provides
efficiencies and productivity.
4. Local firm characteristics. Local firm characteristics include firm strategy, industry
structure, and industry rivalry. Local strategy affects a firm’s competitiveness. A healthy level
of rivalry between local firms will spur innovation and competitiveness.
Which Trade Theory Is Dominant Today?
The theories covered in this chapter are simply that—theories. While they have helped economists,
governments, and businesses better understand international trade and how to promote, regulate,
and manage it, these theories are occasionally contradicted by real-world events. Countries don’t
have absolute advantages in many areas of production or services and, in fact, the factors of
production aren’t neatly distributed between countries. Some countries have a disproportionate
benefit of some factors. The United States has ample arable land that can be used for a wide range of
agricultural products. It also has extensive access to capital. While it’s labor pool may not be the
cheapest, it is among the best educated in the world. These advantages in the factors of production
have helped the United States become the largest and richest economy in the world. Nevertheless,
the United States also imports a vast amount of goods and services, as US consumers use their
wealth to purchase what they need and want—much of which is now manufactured in other countries
that have sought to create their own comparative advantages through cheap labor, land, or
production costs.
EXPLANATION:
As a result, it’s not clear that any one theory is dominant around the world. This section has sought
to highlight the basics of international trade theory to enable you to understand the realities that face
global businesses. In practice, governments and companies use a combination of these theories to
both interpret trends and develop strategy. Just as these theories have evolved over the past five
hundred years, they will continue to change and adapt as new factors impact international trade.

International Trade

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INTERNATIONAL TRADE:

International trade is the exchange of capital, goods, and services

Classical or Country-Based Trade Theories

Heckscher-Ohlin Theory (Factor Proportions Theory)

Modern or Firm-Based Trade Theories

Product Life Cycle Theory

Global Strategic Rivalry Theory

 research and development,

 the ownership of intellectual property rights,

 the control of resources or favorable access to raw materials.

Porter’s National Competitive Advantage Theory

3. Local suppliers and complementary industries. To remain competitive, large global

efficiencies and productivity.

4. Local firm characteristics. Local firm characteristics include firm strategy, industry

of rivalry between local firms will spur innovation and competitiveness.

Which Trade Theory Is Dominant Today?

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