Understand the various theories of trade that explain why countries should trade, understand the factors affecting countries’ trade patterns, and understand how global efficiency is increased through free trade.
What Trade theory is important?
Trade theory helps managers and government policymakers focus on three critical questions: What products should be imported and exported? How much should be traded? With whom should they trade?
While descriptive theories suggest a laissez-faire treatment of trade, prescriptive theories suggest that governments should influence trade patterns.
Trade and Investment Policies
- Import substitution: a policy of developing domestic industries to manufacture goods and provide services that would otherwise be imported
- Strategic trade policy: the identification and development of targeted domestic industries in order to improve their competitiveness at home and abroad
Interventionist Trade Theories
Interventionist trade theories prescribe government action with respect to the international trade process.
Mercantilism: an age-old zero-sum game that claims that a country’s wealth is measured by its holdings of treasure (usually gold) To amass a surplus (a favorable balance of trade), a country must export more than it imports and then collect gold and other forms of wealth from countries that run trade deficits (unfavorable balances of trade).
Neomercantilism: the more recent strategy of countries that use protectionist trade policies in an attempt to run favorable balances of trade and/or accomplish particular social or political objectives.
Free Trade Theories: Absolute & Comparative Advantage
The theories of absolute and comparative advantage demonstrate how economic growth can occur via specialization and trade.
Free trade (a positive-sum game) implies speciali-zation and requires that nations neither artificially limit imports nor artificially promote exports.
The invisible hand of the market determines which competitors survive, as customers buy those products that best serve their needs.
Nations specialize in the production of certain products, some of which may be exported; export earnings can in turn be used to pay for imported goods and services.
Theory of Absolute Advantage
Absolute advantage [Adam Smith, 1776]: A country can (i) maximize its own economic well being by specializing in the production of those goods and services that it produces more efficiently than any other nation and (ii) enhance global efficiency through its participation in free trade.
Smith reasoned that: workers become more skilled by repeating the same tasks, workers do not lose time in switching from the production of one kind of product to another, longer production runs provide greater incentives for the development of more effective working methods.
Natural vs. Acquired Advantages
A natural advantage may exist because of: given climatic conditions, access to particular resources, the availability of labor, etc.
An acquired advantage may exist because of: superior skills, better technology, greater capital assets, etc.
Real income depends on the output of products as compared to the resources used to produce them.
Theory of Comparative Advantage
Comparative advantage [David Ricardo, 1817]: A country can (i) maximize its own economic well-being by specializing in the production of those goods and services it can produce relatively efficiently and (ii) enhance global efficiency via its participation in free trade.
Ricardo also reasoned that: a country can simultaneously have an absolute and a comparative advantage in the production of a given product; by concentrating on the production of the product in which it has the greater advantage, a country can further enhance both global output and its own economic well-being.
Assumptions and Limitations of the Free Trade Theories
The theories of absolute and comparative advantage both make assumptions that may not be entirely valid.
The assumptions are: Full employment of resources. Exclusive pursuit of economic efficiency objectives. Equitable division of gains from specialization. Only two countries and two commodities. Exclusion of transport costs. A static rather than a dynamic view. Exclusion of services. Unrestricted factor mobility.
Theories Explaining Patterns of Trade: Country Size, Factor Proportions, Country Similarity
The theories of country size, factor proportions, and country similarity all contribute to the explanations of: what types of products are traded, with which partner nations countries will primarily trade.
Nontradable products are those goods and services that are impractical to export.
Theory of Country Size
Large countries differ from small countries in at least two critical ways:
Large countries tend to export a smaller portion of their output and import a small portion of their consumption. Large countries are more apt to have varied climates and a greater assortment of natural resources than smaller countries, thus making large countries more self-sufficient.
Large countries tend to have higher transportation costs for exported and imported products. Given the same types of terrain and modes of transportation, the greater the distance, the higher the associated transport costs. Thus, firms in large countries often face higher transport costs in terms of sourcing inputs from and delivering outputs to distant foreign markets than do their closer foreign competitors.
Factor Proportions Theory
Factor proportions (Eli Heckscher, 1919; Bertil Ohlin, 1933):
Differences in a country’s relative endowments of land, labor, and capital explain differences in the cost of production factors.
A country will tend to export products that utilize relatively abundant production factors because they are relatively cheaper than scarce factors.
The composition of a country’s trade depends on both its natural and acquired advantages. With respect to the latter, both production and product technology can be very important.
Country Similarity Theory
When a firm develops a new product in response to observed conditions in its home market, it is likely to turn to those foreign markets that are most similar to its domestic market when commencing its initial international expansion activities.
This tendency is reflective of: the cultural similarity of nations, the similarity of national political/economic interests, the economic similarity of industrialized countries.
Countries that are near to one another enjoy relatively lower transportation costs than those that are more distant, but they may or may not be similar with respect to culture, level of economic development, and/or political/economic interests.
Product Life Cycle (PLC) Theory
The optimal location for the production of certain types of goods and services shifts over time as they pass through the stages of: (i) introduction, (ii) growth, (iii) maturity, and (iv) decline.
Exceptions to the typical pattern of the PLC would include: products that have very short life cycles, luxury goods and services, products that require specialized labor, products that are differentiated from competitive offerings, products for which transportation costs are relatively high.
During the decline stage, a product is often imported by the country where it was initially developed; however, the importing firm may or may not be the innovating firm.
Porter’s Diamond of National Competitive Advantage
The Porter Diamond  theorizes that national competitive advantage is embedded in four determinants: factor endowments, demand conditions, related and supporting industries, firm strategy, structure, and rivalry. All four determinants are interlinked and generally must be favorable for a given national industry to attain global competitiveness.
At times, determinants can be affected by the roles of chance and government.
Factor mobility concerns the free movement of factors of production, such as labor and capital, across national borders.
While capital is the most internationally mobile factor, short-term capital is the most mobile of all. Capital is primarily transferred because of differences in expected returns, but firms may also respond to government incentives.
People transfer internationally in order to work abroad, either on a temporary or on a permanent basis. Brain drain occurs when educated citizens leave a country, but a nation may in turn gain from the remittances that citizens who are working abroad send home.
International Trade and Factor Mobility – Potential Effects
Substitution: the inability to gain sufficient access to foreign production factors may stimulate efficient methods of domestic substitution, such as the develop-ment of alternatives for traditional production methods.
Complementarity: factor mobility via foreign direct investment may stimulate foreign trade because of the need for equipment, components, and/or complementary products in the destination country.
While immigrants add to the base of a country’s skills, thus enabling competition in new areas, inflows of capital can be used to develop infrastructure and natural and other acquired advantages, thus enabling increased participation in the international trade arena.
Most production factors are neither as mobile nor as immobile as theories assume. While the free trade theories of absolute and comparative advantage are descriptive in nature, the interventionist theories of mercantilism and neomercantilism are prescriptive in nature. The theories of country size, factor proportions, and country similarity help explain patterns of trade; the product life cycle and Porter’s Diamond help explain the dynamics of trade. Although the international mobility of production factors may be a substitute for trade, that same mobility may stimulate trade because of the need for equipment, components, and/or complementary products in the destination country.
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