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International Trade Theory

 Overview of Trade Theory

• Free Trade occurs when a government does not

attempt to influence, through quotas or duties, what
its citizens can buy from another country or what
they can produce and sell to another country
• The Benefits of Trade allow a country to specialize
in the manufacture and export of products that can
be produced most efficiently in that country
 Trade Theory-Overview
• The Pattern of International Trade displays patterns
that are easy to understand (Saudi Arabia/oil or
China/crawfish).
– Others are not so easy to understand (Japan
and cars)
• The history of Trade Theory and government
involvement presents a mixed case for the role of
government in promoting exports and limiting
imports
• Later theories appear to make a case for limited
involvement
 Mercantilism: Mid-16th Century

• A nation’s wealth depends on accumulated

treasure
– Gold and silver are the currency of trade
• Theory says you should have a trade
surplus
– Maximize export through subsidies
– Minimize imports through tariffs and quotas
• Flaw: “zero-sum game”
 Mercantilism-Zero-Sum Game

• In 1752, David Hume pointed out that:

– Increased exports lead to inflation and higher prices
– Increased imports lead to lower prices
• Result: Country A sells less because of high prices
and Country B sells more because of lower prices
• In the long run, no one can keep a trade surplus
 Theory of Absolute Advantage
• Adam Smith argued (Wealth of Nations, 1776):
Capability of one country to produce more of a
product with the same amount of input than another
country can vary
– A country should produce only goods where it is most efficient, and
trade for those goods where it is not efficient
• Trade between countries is, therefore, beneficial
• Assumes there is an absolute balance among nations
– Example: Ghana/cocoa
Theory of Absolute Advantage
Absolute Advantage and the
Gains From Trade
 Theory of
Comparative Advantage
• David Ricardo (Principles of Political
Economy, 1817):
– Extends free trade argument
– Efficiency of resource utilization leads to more
productivity
– Should import even if country is more efficient in the
product’s production than country from which it is
buying
– Look to see how much more efficient
• If only comparatively efficient, than import

• Makes better use of resources

• Trade is a positive-sum game
 Theory of
Comparative Advantage
Comparative Advantage and the
Gains From Trade
 Simple Extensions of the
Ricardian Model

• Immobile resources:
– Resources do not always move easily from one
economic activity to another

• Diminishing returns:
– Diminishing returns to specialization suggests that after
some point, the more units of a good the country
produces, the greater the additional resources required
to produce an additional item
– Different goods use resources in different proportions
 Simple Extensions of the
Ricardian Model

• Free trade (open economies):

– Free trade might increase a country’s stock
of resources (as labor and capital arrives
from abroad)
– Increase the efficiency of resource utilization
PPF Under Diminishing Returns
Influence of Free Trade on PPF
 Heckscher (1919)-Olin (1933) Theory
• Export goods that intensively use factor endowments which
are locally abundant
– Corollary: import goods made from locally scarce
factors
• Note: Factor endowments can be impacted by
government policy - minimum wage
• Patterns of trade are determined by differences in factor
endowments - not productivity
• Remember, focus on relative advantage, not absolute
advantage
 Product Life-Cycle
Theory - R. Vernon (1966)

• As products mature, both location of sales

and optimal production changes
• Affects the direction and flow of imports
and exports
• Globalization and integration of the
economy makes this theory less valid
 Product life cycle theory

Fig 4.5
 New Trade Theory

In industries with high fixed costs:

– Specialization increases output, and the ability
to enhance economies of scale increases
– Learning effects are high.
• These are cost savings that come from “learning by
doing”