Most countries are engaged in international trade. The exchange of capital, goods, and services among countries and across the global stage has been instrumental in advancing domestic and global economies. Most countries have also depended on international trade for a sizeable portion of their gross domestic product. Nevertheless, to understand how these exchanges occur, the major theories of international trade have provided arguments and frameworks for explaining and contextualizing the mechanisms behind and implications of these activities.
Understanding Global Trade: The Major Theories of International Trade
It is worth noting that international trade theory is a subfield of economics and has also been used as a concept in several theories of international relations and in influencing foreign policy. The theories of international trade do not serve as a single solution for optimizing trade with other countries and guaranteeing economic success. These theories primarily serve as models for analyzing the patterns of international trade, its origins, and the various socioeconomic implications.
The major theories of international trade are divided into two. These are the classical theories and the modern theories. The classical trade theories focus on the role of countries in international trade and explain why countries trade based on resources. Modern trade theories focus on the role of non-state actors like firms or organizations and sectors or industries or how the competitive and innovative pursuits of these organizations promote international trade.
Classical Theories of International Trade
1. Absolute Advantage Theory of Adam Smith
Background
Scottish economist and philosopher Adam Smith discussed in his “The Wealth of Nations” that countries should concentrate on producing goods or delivering services more efficiently than other countries. Doing so would result in an increase in their overall wealth and standard of living. This position has become the central argument of the theory of absolute advantage.
Description
Absolute advantage refers to the ability of a country to produce goods or deliver services more efficiently than other countries using the same amount of resources. For example, if a country can produce 1000 personal computers with 100 workers, while another country can produce 800 personal computers using the same number of workers, it has an absolute advantage.
Implications
The introduction of this theory challenged the prevailing mercantilist notion that wealth was solely derived from the constant accumulation of gold and silver. This notion was dominant during the 16th to 18th centuries. The principle of absolute advantage also laid down the foundation for understanding further how countries can benefit from international trade.
2. Comparative Advantage Theory of David Ricardo
Background
David Ricardo, a British classical political economist and politician, in his book “On The Principles of Political Economy and Taxation,” introduced the theory of comparative advantage or the Ricardian theory in 1817. This theory explains why certain countries engage in international trade although other countries are more efficient at producing every single good.
Description
Comparative advantage is the ability of a country to produce goods or deliver services at a lower opportunity cost than other countries. Specifically, even if a country does not have an absolute advantage, it can still benefit from international trade participation by specializing in what it produces relatively best. It is about relative efficiency rather than overall efficiency.
Implications
The introduction of this theory significantly expanded the understanding of international trade beyond the principles of absolute advantage. It has demonstrated that trade can mutually benefit participating countries. This theory also provides a strong foundation for free trade. It has also fueled global interdependence through trade and economic globalization.
Modern Theories of International Trade
1. Heckscher-Ohlin Theory
Background
Swedish economists Eli Heckscher and Bertil Ohlin introduced one of the first modern theories of international trade in the early 1900s. They suggested that a country should export goods that intensively use its abundant factors of production and import goods that intensively use its scarce factors. Their theory became known as the Heckscher-Ohlin Theory.
Description
The Heckscher-Ohlin Theory or the H-O Model specifically argues that countries will specialize in producing goods they are good at making because of the factors of production or resources they have readily available. Examples of these resources are labor, capital, or natural resources. Countries that have demonstrated this are China and Saudi Arabia.
Implications
Note that this theory expands on the concept of comparative advantage by considering factor endowments as the basis of trade. It also argues that trade can lead to the equalization of factor prices like wages or rental rates between countries. The theory also suggests that trade can benefit countries that own abundant factors and harm countries that own scarce factors.
2. Product Life Cycle Theory
Background
Harvard Business School professor Raymond Vernon is credited with developing the Product Life Cycle Theory of international trade in the 1960s. This theory was a response to the limitations of the Heckscher-Ohlin Theory. Vernon argued that the H-O model struggled to explain why the United States became an exporter despite being a capital-abundant country.
Description
The Product Life Cycle Theory suggests that products go through distinct stages from introduction to decline. The movements of these products through these stages result in shifts in the patterns of production and trade. This suggests that exporting countries initially dominate but their imports from lower-cost countries gradually increase as their exported products mature.
Implications
Countries can reference this theory to determine opportunities to participate in global trade by focusing on products in the growth or maturity stages. It can also be used to inform government policies that will support domestic industries across different stages in their life cycle. It is still worth noting that not all products or industries follow the classic life cycle curve.
3. New Trade Theory
Background
Paul Krugman, an American economist, began working on analyzing the patterns of international trade and the geographic distribution of economic activity by observing the effects of economies of scale and consumer preferences for diverse products in the 1970s with other economists. This led to the Dixit-Stiglitz-Krugman and the Helpman–Krugman models.
Description
The Dixit-Stiglitz-Krugman and the Helpman–Krugman trade models became one of the basis of the New Trade Theory. The theory emphasizes the role of economies of scale, increasing returns to scale, and imperfect competition in explaining international trade patterns. It emerged as a response to the limitations of traditional theories of international relations.
Implications
One of the use cases of the theory centers on how it explains why few large automakers dominate the global market. It explains why countries like Japan and the United States have dominated the automotive industry because of their large domestic markets and large-scale production facilities. This theory explains the role of competitive advantage and market competition.
4. Gravity Model of Trade
Background
American economist Walter Isard first introduced the Gravity Model of Trade in 1955. This theory of international trade argues that trade between two countries is proportional to the product of their gross domestic products and inversely proportional to the distance between them. It essentially predicts bilateral trade flows based on economic sizes and distance.
Description
The theory essentially argues that large and wealthy countries tend to trade more with each other, and geographical proximity tends to increase trade. It posits that countries like the United States and Canada, Brazil and Argentina, Germany and France, or China and Japan have substantial bilateral trade flows because both have large economies and shared borders.
Implications
One of the main implications of the Gravity Model of Trade is that it provides a useful framework for predicting bilateral trade flows between countries. Deviations from this model can also help in identifying trade barriers. It can also be used for assessing trade agreements. Note that this model is a descriptive one and not causal. It does not explain why trade occurs.
5. Theory of National Competitive Advantage
Background
Michael E. Porter, a professor who is also known for the Five Forces Model and Generic Strategies, introduced the Theory of National Competitive Advantage or the Diamond Model in his 1990 book “The Competitive Advantage of Nations.” It was developed as a departure from traditional trade theories which focused on factor endowments and comparative advantage.
Description
The Theory of National Competitive Advantage seeks to explain why certain countries excel in specific industries. The model consists of four components. These are factor conditions or inputs needed for competition, demand conditions or domestic market demand for a product, related and supporting industries, and firm strategy, structure, and rivalry.
Implications
A key implication of the theory is that it can determine the strengths and weaknesses of industries in a particular country. The model can also inform government policies aimed at supporting sectors or industries with high growth potential. It can also provide a framework for businesses to analyze their competitive position, the environment, and growth opportunities.