Key Theories of International Trade

Key Theories of International Trade

The theories that underpin international trade can be broadly classified into two schools: the Classical School of International Trade and the Modern School of International Trade. Each of these schools presents distinct hypotheses and theories. Below is a brief overview of each.

Classical Theories of International Trade

Among the most prominent classical theories are the following:

Trade Theory

This theory posits that a nation’s wealth is determined by the amount of precious metals it possesses, such as gold and silver. To strengthen its balance of payments by increasing exports while reducing imports, a country must enhance its reserves of these metals.

The ultimate goal is to achieve a trade surplus, where the value of exports exceeds the value of imports. Conversely, if the value of imports surpasses that of exports, it results in a trade deficit, leading to various economic challenges.

Absolute Advantage Theory

This theory asserts that a nation has an absolute advantage if it can produce a good more efficiently or at a lower cost than another nation. As a result, the country should specialize in the production of that good, thereby creating efficiencies. The workforce specializing in that product becomes more adept by focusing on the same production tasks without distractions, which ultimately enhances production efficiency.

Hence, each country will specialize in the production of goods for which it holds an absolute advantage, benefitting the nations involved in trade and improving the quality of life in both.

Comparative Advantage Theory

This theory was introduced to address the shortcomings of the Absolute Advantage Theory. A nation may be efficient at producing multiple products, granting it a comparative advantage in several areas rather than just one. Conversely, another country might lack any comparative advantage and still engage in trade, contrasting with the Absolute Advantage Theory.

Thus, while the Absolute Advantage Theory focuses on a nation’s absolute production capabilities, the Comparative Advantage Theory highlights the relative differences in production abilities.

Heckscher-Ohlin Theory

Also known as the Factor Proportions Theory, this theory posits that a country will export goods that are produced using its abundant and inexpensive production factors while importing goods that rely on scarce and costly production factors.

Production factors refer to the costs associated with producing a commodity, including labor, location, capital, and the equipment used in production.

Leontief Paradox

In line with the previous Factor Proportions Theory, it was expected that a country blessed with abundant production factors would produce goods that depend on these factors. However, economist Wassily Leontief discovered a paradox when he analyzed the American economy; although the United States has a wealth of capital, it paradoxically imports more goods that require capital-intensive production, contradictory to the Factor Proportions Theory. This observation is what led to its designation as the Leontief Paradox.

Modern Theories of International Trade

Among the most notable modern theories are:

Similarity of Nations Theory

This theory suggests that companies within a country primarily manufacture goods for local consumption. When these companies find that global markets mirror their domestic market, they export their products. Hence, trade occurs between countries with similar per capita incomes.

Notably, this theory holds true when brand identity and product quality are key factors in consumer purchasing decisions.

Product Life Cycle Theory

This theory posits that a product undergoes three stages during its lifecycle:

• Phase One: The New Product Stage, where the item is initially manufactured in the country of its innovation.
• Phase Two: The Product Development Stage, involving enhancements that transform the item into an updated version.
• Phase Three: The Standard Product Stage, where manufacturing begins in select countries at a lower cost.

Global Strategic Competition Theory

This theory focuses on multinational companies producing goods to compete against global firms, facing challenges when entering new markets to enhance their products for competitive parity.

The primary obstacles include:

• Research and development.
• Intellectual property rights.
• Economic standards.
• Trade practices.
• Industry expertise.
• Access to raw materials necessary for production.

Local Competitive Advantage Theory

This theory proposes that a nation’s competitiveness in industry is influenced by its industrial sector’s ability to innovate and continually generate new product ideas.

Four key factors govern a nation’s competitive capability, including:

• The availability of raw materials within the local market and the market’s ability to optimally exploit them.
• The demand for the product within the local market.
• The sector of local suppliers and complementary industries.
• The characteristics of domestic companies.