INTERNATIONAL TRADE REVISION
Mercantilism: One of the earliest trade ideology most present in the EU during the 1500 to 1800’s,
where imports were restricted favoring a greater number of exports and increase the nation’s
possession of gold obtained from export surplus, which were used as a measurement of the
commonwealth and strengthen the national power through i.e., improved military. This theory
suggests one trading party will gain more than the other, as raw materials were extracted from
colonies to be turned into manufactured goods within the home state at a higher value.
Absolute advantage: theory by Adam Smith in 1776 redefines trading partnerships to be beneficial
to all parties, as it would otherwise be breaching the state’s interest in a trade without gaining
profits and thus, discourage trading. However, according to Smith this is only possible where one of
the parties has an absolute advantage in terms of production in comparison to the other. Therefore,
this introduced the concept of ‘specialization’ where for example, a state’s lower costs of production
can increase productivity even with an absolute disadvantage to the second commodity where the
other party has an absolute advantage. These advantages can either be acquired natural to the state
i.e., weather conditions; transports costs etc. or over time through skills and expertise such as the
Swiss watch.
Comparative advantage: economic theory by David Riccardo (1817) states that even if a party has an
absolute advantage in the production of both commodities, trading can still be favorable to parties if
for example, low production costs within the party’s state can be profitable to the other party. This
recommends specialization and exportation of production depending on which of the party’s
commodities has a smaller absolute disadvantage also known as comparative advantage and import
where the absolutive disadvantage is bigger. Therefore, this theory focuses on the efficient
allocation of resources from trading to increase the total output from trading.
To evaluate trading between the two partners, find out which has a comparative advantage by
working out the per unit opportunity cost by dividing the cost of production by the gains.
Consequently, parties should export a commodity which they have comparative advantage over the
other party and import where it has a comparative disadvantage.
Once the comparative advantages are identified the terms of trade must be mutually beneficial to
both trading parties and therefore, must be lower than the highest opportunity cost but higher than
the lowest opportunity cost found.
Notes:
- One country does not have comparative advantage in both commodities and the per unit opportunity cost is always
relational i.e., 3 = 0.3
- STEPS comparative advantage: check which country has absolute advantage in either the commodities; work out the
unit opportunity cost; evaluate which has a comparative advantage for the two commodities and suggest terms of
trade.
Standard trade model
The standard trade theory offers general insight as opposed to other theories like the H-O theorem,
which are specific cases of the standard trade model as it is the origin of all the other theories of
, trade. Within this model, the production possibility frontier (PPF) illustrates the maximum
production of each commodity using all factors of production although these values often show bias
growth, which according to comparative advantage theorem is caused by technological
advancements or triggered by increases of factors of production as argued by the H-O theorem.
The indifference curve shows the preferences of customers within a market and if the indifference
curve is tangent to the PPF then the product has reached ultimate demand and satisfaction by its
customers, also known as autarky equilibrium. On the other hand, the marginal rate of
transformation shows the opportunity cost for producing each commodity in terms of factors of
production, as the relative price of the two products is calculated as for example, oranges to apples
Po/Pa to find out how many oranges it takes to purchase an apple or visa-versa.
New trade theory
Based on the ‘economies of scale’ where the focus is on large-scale production to facilitate and
reduce costs involved in production and specialization. This is because it argues that countries share
similar abilities as opposed to having a greater skill within a sector, as opposed to the old theories
such as the H-O theorem or comparative advantage, as countries may possess similar opportunity
costs and so, specialization increases the extensive scale production which in turn can stimulate
globalization, as companies may achieve this through outsourcing due to lower costs and thus
building a global network rich with benefits. In addition, monopolistic competition where companies
that enter the market in the early stages become dominant and so, NTT suggests that these firms
that can produce at a large-scale because of its resources to outsource, does so at the expense of
local markets and job losses. However, globalization is criticized because it emphasizes the gap
between developed countries and developing countries, which do not have the same ability to
produce at a large-scale due to i.e., fragmented, small-scale, and unincorporated companies as seen
in India’s case study where the government has prohibited the entering of foreign direct
investments protested mainly by their local workers and retailers.
The Heckscher-Ohlin Theory
the Heckscher-Ohlin theory developed by two Swedish economists also encourages free trade but
focuses on the factor abundance, where the ratio of capital to labor possessed by the trading state is
assessed to explain trade relationships. Consequently, recommends parties to export products which
intensively use relatively abundant factor endowments such as land, capital, and labor possessed by
the state and thus, relatively cheaper and import products which depend on the intensive use of
scarce factors which are often more expensive to produce.
Factor price equalization theorem
Following the H-O theory, Paul A. Samuelson argued in 1948 that free international trade equalizes
factor prices like interest rates and wages across countries, introducing the idea of mobility factors
within international trade. For example, pre-trade in labor abundant states like India the wages are
low and according to the H-O model should specialize/ export in commodities which depend on the
factor abundance. Consequently, post-trade will increase the low wages due to the higher demand
for labor whilst demand for capital decreases. Vice-versa, if the capital abundant with high wages
specializes in the production of capital than the demand for labor decreases and so, do the wages.
As a result, wages are equalized to an extent after trading as the returns for capital/labor become
more homogenous. However, many scholars disagree with this economic theory and the concept of
total equalization, which is arguably impossible to achieve, because of the lack of multiple factors
