Theories of International Trade
International trade theories are the base for a person, firm, and nation to understand how international trade or businesses work. They help to understand how is the international market, what factors hinder companies from success, and how a company will make its share in the international market.
Behavior and motivation of buyers are the significant factors to consider in domestic business and knowledge of basic causes and nature of business is more emphasized in international business or trade.
For this, it is necessary to gain a clear knowledge of international business or trade theories.
These trade theories attempt to answer questions like why business takes place among nations and what determines the pattern of international trade.
Let’s understand the 7 main international trade theories which are mentioned below:
Mercantilism Theory
Mercantilism can be considered the oldest theory of international trade. Mercantilism promoted international business or trade.
It was systematically developed in the 15th century by an Italian Economist, Antonio Serra, and lasted nearly 300 years. Mercantilism talks about how a nation should increase its exports and reduce imports as far as possible.
During the mercantilism period, gold, silver, and other precious metals were the only means of exchange of trade between nations. A nation was considered strong and had enough of these precious metals.
It assumed increasing exports would earn more silver and gold and a nation’s economy will be stronger and importing means an outflow of precious metals means weakening the nation.
Thus, the main theme of the mercantilist theorists is to promote exports and reduce imports by means of different restrictions such as barriers, quotas, etc. and it is a state-controlled theory.
It aims to protect a nation’s wealth from the outflow to other nations by different restricting means which is also called protectionism.
It also assumes a zero-sum game which means if two nations participate in international trade one should face a loss equal to the benefit of the next nation and vice versa.
Absolute Cost Advantage Theory
Adam Smith, the father of economics propounded the absolute cost advantage theory by addressing the weakness of mercantilism theory. He introduced the concept of free trade policy which was totally ignored by mercantilism.
Absolute cost advantage refers to the advantage a nation gets from producing products more efficiently with the same input than other nations.
It suggests a nation should specialize its production in the product in which it gets an absolute cost advantage and ignore in which it gets an absolute disadvantage.
The specialized products should be exported to another nation and products having the absolute disadvantage of the home country should be imported from another nation, as such international trade occurred.
Smith also ignores the zero-sum game of mercantilism – rather he assumes a positive-sum game which means if two countries participate in international both can benefit.
And, here government plays the role of facilitator.
Comparative Cost Advantage Theory
By criticizing Adam Smith’s absolute cost advantage theory David Ricardo introduced the comparative cost advantage theory.
He argued that absolute advantage is not necessary rather a nation should focus on where it gets comparatively more advantage.
Ricardo suggests there can be no trade if two nations’ absolute cost advantage is equal. It suggests a nation should specialize its production on the product in which it gets comparatively more advantage or in case of disadvantage, should choose the product having less disadvantage.
Ricardo suggests while producing the costs should be checked carefully and compared and then the product asking for comparatively less cost should be produced.
Other principles of comparative advantage are the same as the absolute advantage such as free trade, a positive-sum game, no government intervention, etc.
Heckscher-Ohlin’s Factor Endowment Theory (H-O Model)
Eli Heckscher and Bertil Ohlin propounded the theory of factor endowment and further explained Ricardo’s comparative cost advantage theory.
Here, factor endowment refers to the richness or easy availability of basic production factors like land, labor, and capital to a nation.
The H-O model suggests that a nation should specialize its production in products in which it has an abundance of production factors.
This theory assumes factors relative to abundance are cheaper and factors relative to scarcity are expensive to a nation.
According to this theory, if India, China, Nepal, etc. are rich in labor factors then they should produce labor-intensive products. And, the USA, Japan, etc. are rich in capital they should produce capital-intensive products.
In this way, capital-rich countries should import labor-intensive products, and labor-rich countries import capital-intensive products as such international trade takes place.
While understanding the H-O model, it is necessary to understand the Leontief Paradox – which means just the opposite of the principle of the H-O model i.e. capital-rich countries exporting labor-intensive products and vice versa.
International Product Life Cycle (IPLC) Theory
The IPLC theory was created by Reymond Vernon in 1966. He explained how a new product of a nation gets domestic and international attention and starts exporting and at the end of IPLCs the last stage how the domestic nation starts importing the same product.
Raymond explains when a country produces new products it begins to export to foreign markets, as such, foreign nations find it cheaper to produce the same product in their home.
And, where originally the new product originated, their people find it cheaper and beneficial to use the foreign same products over their domestic country.
And, originated country’s product sales decline, and the country is liable to import products from foreign countries to satisfy its people’s needs.
Raymond mentioned four stages in which an international product walks,
- Introduction Stage – The new or innovative product is introduced. Mainly labor-intensive. Sales or exports grow at the turtle’s speed.
- Growth Stage – Exports increase. The competition takes place. Capital-intensive means are assumed.
- Maturity Stage – Exports reach the top and remain constant. Intense competition. Availability of substitute products. Exports start to decline.
- Decline Stage – Exports of new products from the home country rapidly decline. The nation has three options whether to exit the product, import, or enter into a totally new market.
National Competitive Advantage Theory: Porter’s Diamond
Michael Porter 1990, introduced the national competitive advantage theory which explains why a nation succeeds in international competition.
He wanted to address what makes a firm achieve a competitive advantage in a nation or a nation in a particular industry.
With research in 100 industries in 10 countries, he identified four factors that help a firm to gain a national competitive advantage which he introduced as Porter’s Diamond.
And, after achieving it such factors also strengthen the exporting capacity of the firm.
The Porter’s Diamond is shortly mentioned below:
- Demand Conditions – The stronger the demand of a domestic market the more high-quality products would be produced and exporting may be attained.
- Factor Endowments – A nation having better production factors would do better in the international market.
- Related and Supporting Industries – E.g. schools are the supporting institutions for universities.
- Firm Structure, Strategy, and Rivalry – The better the firm’s strategy and structure the better the firm will win against rivalries.
New Trade Theory (NTT)
New trade theory (NTT) is developed by Paul Krugman in late 1970. In this theory, Krugman introduces the concept of economies of scale and first-mover advantage which are the essential factors for success in the international market.
Economies of scale refer to minimizing the per-unit cost and first-mover advantage means realizing the benefits of new entry into the new market.
He explained, there is always not necessary to have factor endowments or structures to have international trade it may occur without it but having economies of scale.
When a nation specializes in a particular product, gains economies of scale, becomes stronger in it, and starts exporting, international trade occurs.
Conclusion…
Hence, a short description is given about the international trade theories as a manager you should understand the actual meaning of each of these theories and how they interpreted the international business.
Although some theories are old-fashioned still they are useful to some extent in international businesses.
Sujan Chaudhary holds a BBA degree. He loves to share his business knowledge with the rest of the world.