What Is International Trade?

 

 What Is International Trade?
International trade theories are simply different theories to explain international trade. Trade
is the concept of exchanging goods and services between two people or entities. International
trade is then the concept of this exchange between people or entities in two different
countries.
People or entities trade because they believe that they benefit from the exchange. They may
need or want the goods or services. While at the surface, this many sound very simple, there
is a great deal of theory, policy, and business strategy that constitutes international trade.
In this section, you’ll learn about the different trade theories that have evolved over the past
century and which are most relevant today. Additionally, you’ll explore the factors that
impact international trade and how businesses and governments use these factors to their
respective benefits to promote their interests.
What Are the Different International Trade Theories?
“Around 5,200 years ago, Uruk, in southern Mesopotamia, was probably the first city the
world had ever seen, housing more than 50,000 people within its six miles of wall. Uruk, its
agriculture made prosperous by sophisticated irrigation canals, was home to the first class of
middlemen, trade intermediaries…A cooperative trade network…set the pattern that would
endure for the next 6,000 years.”Matt Ridley, “Humans: Why They Triumphed,” Wall Street
Journal, May 22, 2010, accessed December 20, 2010,
http://online.wsj.com/article/SB10001424052748703691804575254533386933138.html .
In more recent centuries, economists have focused on trying to understand and explain these
trade patterns. Chapter 1 "Introduction" , Section 1.4 "The Globalization Debate" discussed
how Thomas Friedman’s flat-world approach segments history into three stages:
Globalization 1.0 from 1492 to 1800, 2.0 from 1800 to 2000, and 3.0 from 2000 to the
present. In Globalization 1.0, nations dominated global expansion. In Globalization 2.0,
multinational companies ascended and pushed global development. Today, technology drives
Globalization 3.0.
To better understand how modern global trade has evolved, it’s important to understand how
countries traded with one another historically. Over time, economists have developed theories
to explain the mechanisms of global trade. 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, mercantilism was one of the earliest efforts to develop an
economic theory. 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. In

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. The objective of each
country was to have a trade surplus, or a situation where the value of exports are greater than
the value of imports, and to avoid a trade deficit, or a situation where the value of imports is
greater than the value of exports.
A closer look at world history from the 1500s to the late 1800s helps explain why
mercantilism flourished. The 1500s marked the rise of new nation-states, whose rulers
wanted to strengthen their nations by building larger armies and national institutions. By
increasing exports and trade, these rulers were able to amass more gold and wealth for their
countries. One way that many of these new nations promoted exports was to impose
restrictions on imports. This strategy is called protectionism and is still used today.
Nations expanded their wealth by using their colonies around the world in an effort to control
more trade and amass more riches. The British colonial empire was one of the more
successful examples; it sought to increase its wealth by using raw materials from places
ranging from what are now the Americas and India. France, the Netherlands, Portugal, and
Spain were also successful in building large colonial empires that generated extensive wealth
for their governing nations.
Although mercantilism is one of the oldest trade theories, it remains part of modern thinking.
Countries such as Japan, China, Singapore, Taiwan, and even Germany still favor exports and
discourage imports through a form of neo-mercantilism in which the countries promote a
combination of protectionist policies and restrictions and domestic-industry subsidies. Nearly
every country, at one point or another, has implemented some form of protectionist policy to
guard key industries in its economy. While export-oriented companies usually support
protectionist policies that favor their industries or firms, other companies and consumers are
hurt by protectionism. Taxpayers pay for government subsidies of select exports in the form
of higher taxes. Import restrictions lead to higher prices for consumers, who pay more for
foreign-made goods or services. Free-trade advocates highlight how free trade benefits all
members of the global community, while mercantilism’s protectionist policies only benefit
select industries, at the expense of both consumers and other companies, within and outside
of the industry.
Absolute Advantage
In 1776, Adam Smith questioned the leading mercantile theory of the time in The Wealth of
Nations.Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations
(London: W. Strahan and T. Cadell, 1776). Recent versions have been edited by scholars and
economists. 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. Similarly, if Country B was better at producing another good, it could
focus on specialization as well. By specialization, countries would generate efficiencies,
because their labor force would become more skilled by doing the same tasks. Production
would also become more efficient, because there would be an incentive to create faster and
better production methods to increase the specialization.

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 challenge to 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. To answer this challenge, David
Ricardo, an English economist, introduced the theory of comparative advantage in 1817.
Ricardo reasoned that even if Country A had the absolute advantage in the production of both
products, specialization and trade could still occur between two countries.
Comparative advantage occurs when a country cannot produce a product more efficiently
than the other country; however, it can produce that product better and more efficiently than
it does other goods. The difference between these two theories is subtle. Comparative
advantage focuses on the relative productivity differences, whereas absolute advantage looks
at the absolute productivity.
Let’s look at a simplified hypothetical example to illustrate the subtle difference between
these principles. Miranda is a Wall Street lawyer who charges $500 per hour for her legal
services. It turns out that Miranda can also type faster than the administrative assistants in her
office, who are paid $40 per hour. Even though Miranda clearly has the absolute advantage in
both skill sets, should she do both jobs? No. For every hour Miranda decides to type instead
of do legal work, she would be giving up $460 in income. Her productivity and income will
be highest if she specializes in the higher-paid legal services and hires the most qualified
administrative assistant, who can type fast, although a little slower than Miranda. By having
both Miranda and her assistant concentrate on their respective tasks, their overall productivity
as a team is higher. This is comparative advantage. A person or a country will specialize in
doing what they do relatively better. In reality, the world economy is more complex and
consists of more than two countries and products. Barriers to trade may exist, and goods must
be transported, stored, and distributed. However, this simplistic example demonstrates the
basis of the comparative advantage theory.
Heckscher-Ohlin Theory (Factor Proportions Theory)
The theories of Smith and Ricardo didn’t help countries determine which products would
give a country an advantage. Both theories assumed that free and open markets would lead
countries and producers to determine which goods they could produce more efficiently. In the
early 1900s, two Swedish economists, Eli Heckscher and Bertil Ohlin, focused their attention
on how a country could gain comparative advantage by producing products that utilized
factors that were in abundance in the country. 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.

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
In the early 1950s, Russian-born American economist Wassily W. Leontief studied the US
economy closely and noted that the United States was abundant in capital and, therefore,
should export more capital-intensive goods. However, his research using actual data showed
the opposite: the United States was importing more capital-intensive goods. According to the
factor proportions theory, the United States should have been importing labor-intensive
goods, but instead it was actually exporting them. His analysis became known as 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.
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. 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
Swedish economist Steffan Linder developed 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. 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
Raymond Vernon, a Harvard Business School professor, developed 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.
It has also been used to describe how the personal computer (PC) went through its product
cycle. The PC was a new product in the 1970s and developed into a mature product during
the 1980s and 1990s. Today, the PC is in the standardized product stage, and the majority of
manufacturing and production process is done in low-cost countries in Asia and Mexico.
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. Even though research and development is typically associated
with the first or new product stage and therefore completed in the home country, these
developing or emerging-market countries, such as India and China, offer both highly skilled
labor and new research facilities at a substantial cost advantage for global firms.
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
In the continuing evolution of international trade theories, Michael Porter of Harvard
Business School developed a new model to explain national competitive advantage in 1990.
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. Porter added to these basic factors a new list of
advanced factors, which he defined as skilled labor, investments in education,
technology, and infrastructure. He perceived these advanced factors as providing a
country with a sustainable competitive advantage.
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. Many sources credit the demanding US consumer with forcing US
software companies to continuously innovate, thus creating a sustainable competitive
advantage in software products and services.
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.
In addition to the four determinants of the diamond, Porter also noted that government and
chance play a part in the national competitiveness of industries. Governments can, by their
actions and policies, increase the competitiveness of firms and occasionally entire industries.
Porter’s theory, along with the other modern, firm-based theories, offers an interesting
interpretation of international trade trends. Nevertheless, they remain relatively new and
minimally tested theories.
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.
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.
Key Takeaways
 Trade is the concept of exchanging goods and services between two people or entities.
International trade is the concept of this exchange between people or entities in two
different countries. While a simplistic definition, the factors that impact trade are
complex, and economists throughout the centuries have attempted to interpret trends
and factors through the evolution of trade theories.
 There are two main categories of international trade—classical, country-based and
modern, firm-based.
 Porter’s theory states that a nation’s competitiveness